Greece's Long, Slippery Slope to Default

Is Greece defaulting? It's a question definitely worth exploring, because what's happening now on these rocky shores of the Mediterranean Sea may be a mere warm-up for much bigger debt crises to come.

The European Union might help Greece roll over its existing 300 billion euro debt. But EU assistance would severely limit the amount of new debt Greece could issue. And the Greek government's 30 billion euro fiscal deficit would be hard to finance.

As financial institutions in western Europe hold most of Greece's existing debt, it is in the EU's best interest to protect their value. Otherwise, Europeans could plunge into another financial crisis.

Greece may have hidden a large amount of debt through revenue securitization, interest rate swaps or other derivative agreements off the balance sheet. It's unlikely the EU would guarantee such contracts, unless the counterparties are European banks. Fallout from noncompliance of such derivative contracts would trigger market shocks.

In the long run, Greece may have to officially default. It has accumulated foreign debt to support consumption. It could tighten its belt and stop borrowing money, i.e. import less. But to pay off existing debt, Greece may have to increase exports to create a large, current account surplus.

Greece's debt is 120 percent of national GDP, excluding hidden debt, and it's running a current account deficit that's more than 12 percent of GDP. An estimated 70 percent of Greece's national debt is owed to foreigners. To repay, Greece has to build current account surpluses of 10 percent of GDP or more. But Greece doesn't appear to have industries competitive enough to swing its current account by one-fifth GDP.

East Asian economies made precisely that kind of swing in current accounts to pay off foreigners after the Asian Financial Crisis of the 1990s. They could do so because they were export-oriented to begin with and accumulated foreign debt to finance investment. To stop borrowing, countries in the region could just stop investing. To increase current account surplus, the region could devalue to increase market share in global trade.

Greece's need for foreign borrowing is due to a budget deficit that ultimately supports the country's consumption level. It must cut the budget deficit, i.e. stop paying millions of people, to end demand for foreign borrowing.

This step would be politically difficult. Even though two-thirds of Greece's population supports retrenchment, the one-third against could make it impossible. If the EU assistance program is structured to make it impossible for financing a fiscal deficit, Greece has to cut spending. As a result, we can expect political turmoil in Greece for years to come.

Greece can't devalue a currency to increase exports. Even if it withdraws from the euro and devalues, it doesn't have enough industry to increase exports quickly. It is difficult to see how Greece will ever be able to repay foreign lenders. Western financial institutions that hold Greek bonds will have to look to their own governments for bailouts.

What's Coming

With this in mind, we see inflation and public finance as the next crisis arenas. The global financial crisis has saddled major governments around the world with large fiscal deficits that are unlikely to fall in the near future. Government spending had increased during the bubble years due to high tax revenues, which actually reflected an asset inflation tax. Now that the asset bubble has burst, revenues are too low to support spending. Moreover, aging populations continue to increase their expenditures.

Without painful cutbacks, governments are heading toward bankruptcy. As long as they can borrow, inflation won't be too high. And when governments can't borrow any more from financial markets, they can print money. Countries such as Japan and the United States can do this. But printing money is a way to inflate away debts, and it's technically a form of bankruptcy.

Hence, the sovereign debt crisis is ultimately an inflation crisis. What occurred in Germany in the 1920s could be repeated in Japan and the United States in the future, possibly within a decade.

Small economies that borrow in foreign currencies are facing stress now because the market knows they have less wiggle room. Their financial situation isn't black and white; there is a vast gray area between solvency and bankruptcy.