Think now of the Greek debt crisis as being like a fuse steadily burning towards the combustible material at one end – in other words, towards an explosion. Until recently this image would have been out of place. We would not have worried greatly about the economic difficulties of a small country on the fringes of Europe. What makes the difference is that Greece is part of the euro currency zone. In any case, everything connects nowadays. Somebody recently compared the financial markets with the E.coli outbreak. When the disease appeared in northern Germany, suddenly Spanish cucumber-growers experienced a precipitous drop in sales – for no good reason, as it turns out. Likewise, if the Greek debt crisis blows, it couldeasily be the case that straightaway a British company is refused a loan because its bank has too much Greek debt on its books.
The spark running along towards a Greek default is dangerous. That is why people with the best financial and political minds in Europe are bent over it. They are desperately trying to work out how its dreadful progress can be halted. For a Greek default would immediately place intense pressure on two other eurozone countries, Ireland and Portugal which, like Greece in June 2010, have already had to be rescued from a debt crisis by the combined forces of the European Union and the International Monetary Fund. Spain's difficulties would increase as its cost of external borrowing rose. Belgium and Italy would shiver with apprehension. Indeed the viability of the eurozone itself would be in doubt.
All that sounds bad enough. But it is not a full account of the ill consequences. For Greek debt is mainly held by Continental and British banks whose cautious lending policies would be further restricted if it turned out that the value of their holdings of Greek government securities had sharply declined. Then on top of these considerations, add one more. The widespread chaos and confusion caused by a Greek default would in and of itself substantially undermine confidence, and for that reason alone, if for no other, bring about a contraction in economic activity. The double-dip recession would have arrived.
The problem of the burning fuse has two aspects, the financial and the political. Throughout history, countries have defaulted on their debts. I have a friend who systemically buys up Cuban bonds even though the country defaulted in 1986 and hasn't paid a penny in interest or capital since then. He believes that, post- Castro, there will be a settlement, a repayment schedule will be agreed and he will do well.
Greece, however, isn't like that at all – free to go bust and suffer the consequences alone. After all, the European Central Bank holds £40bn of Greek debt. It doesn't want to suffer the substantial losses that a default would impose. Yet Greece literally cannot meet its obligations as matters stand. And a lot of its debt is due to be repaid very soon. So the precise financial problem is this: how to ease Greece's repayment obligations without creating what is known as a credit event, something that leads to a deterioration in the terms of the loan compared with what was originally agreed. Credit events are the triggers for the write-downs in balance sheets or the "crystallising" of losses as it is called, which in turn bring about all the unwelcome consequences described above.
Germany and the European Central Bank have put forward similar solutions to the conundrum. Crucially, they both avoid compelling debt holders to accept unfavourable terms. Instead they rely upon a voluntary acceptance of new arrangements and in this way hope to avoid the fatal credit event. Under the German plan, investors would be asked to exchange their existing Greek bond holdings for new bonds with a later repayment date. German officials hope that as many as half of private creditors holding bonds due in 2012 and 2013 would sign up, thus substantially reducing the requirement for further advances by the IMF and individual member countries of the Euro union.
The European Central Bank idea is for a "roll over" of current bond holdings. Holders of Greek debt would be asked to buy new longer maturing bonds at the very same moment that their current debt became due. A voluntary rollover of debt – whereby investors reinvested their money in fresh bonds at prevailing rates – would not involve losses and would therefore not be a default is the argument.
Proposals along these lines may well work in the sense that the banks holding Greek debt might very well tell themselves that their own self-interest was best served by not precipitating a crisis. To the extent that they did, there would be less need for fresh funds. However there is a political condition to which we must now turn. To gain fresh assistance from the European Union, the Greek Parliament must first vote in favour of a series of additional austerity measures. Only then would the European Council of Ministers be prepared to support the advancing of fresh rescue monies. What is being proposed for Greece is very tough.
Thousands more public-sector jobs would have to go. Apart from any other considerations, such measures would fall disproportionately heavily on members of the Prime Minister's own party, Pasok, which has traditionally provided jobs in state entities for its supporters. No wonder there have been threats of mass resignation by Pasok deputies. At the same time, taxes are due to rise again and there are demands that the Greek government sells off some £45bn of state assets.
Greece has to decide, then, whether it will pay the substantial price for remaining a member of the eurozone. It could reject the conditions and crash out of the eurozone, even though no formal exit mechanism exists. It would then have tore-establish its national currency while suffering a substantial devaluation. Its borrowing power on international markets would be zero. It would remain part of the European Union, but it might find it painful to belong to a club where it had lost the goodwill of its fellow members.
So will the European institutions and the holders of Greek debt do what is required? Probably yes. Will the Greek political class and the Greek electorate also take a positive decision? That is less likely. Will there be an explosion? There could be.