Why Europe Will Negotiate a Greek Default

As another Euro summit takes place today, with another bailout package for Greece on the table, it's important to realize that what we're talking about is not whether to "rescue" Greece. Rather, we're discussing how the Germans, other rescuing countries, and bondholders and other private investors are going to have to pay the bill and perhaps how big the bill will be. To see why that's so, just look broadly at some possible outcomes to the Greek crisis

If a haircut for bondholders and other investors is required as part of an agreed bailout package, everyone with investments in Greece participates in the hit. The share of the package borne by the public sector in Germany and other strong Euro countries will presumably have some impact on their public finances. A deal of this sort, however, would be attractive because it would allow for some management of the scale and timing of default.

If Greece gets bailed out through a loan package and there is no haircut on bondholders and other investors, the interest burden on the Greek economy would continue, and with Greek debt to GDP at current levels, the Greek economy would be forced into a sustained depression, probably requiring subsidies and aid to fix. The pressure to bail out other struggling companies in a similar way would be intense. The continued bailouts would have to be funded by more taxes or more debt in the rescuing countries. This solution would defer the reckoning but not for long and it would almost certainly increase the scale of the losses for all concerned.

If there is no bailout and investors refuse to take a haircut, Greece can just declare a default, and other investors will take the hit. This would take control of the size of the bill out of investors' hands. That might be good for Greece, but it would involve sacrificing Greece's ability to raise funds on a large scale abroad for the foreseeable future. Greece would have to be perceived as a potential Asian tiger to get investors to come back in. This is not an attractive option for anyone except maybe in the very short term for Greece.

Greece could also simply leave the Euro, converting its obligations back to drachmas. But other investors would still end up footing a bill (through the devaluation of their assets once the drachma went into free float and got marked down in the forex markets) and they'd have no control over the size of it (that would be the markets). This would seem to be an attractive option for Greece, because it could perhaps technically be dressed up as something other than a default, but it's probably not good for creditors in the rest of Europe.

Whichever way you look at the evolution of the Greek crisis, there seems little doubt that a bill has to be paid. Greece is in no condition to grow its way out of its debts unless the debts are reduced. Since Greece has one unilateral option that's arguably economically attractive from its perspective (dropping out of the Euro) it would seem that everyone else has a stake in arriving at a bailout package that includes a haircut before Greece starts to se the economically attractive as politically attractive too. Negotiations about a lot of money always involve a certain amount of bluff and brinkmanship, so we can expect a rocky ride to get there, but we should, in a rational world, expect to arrive. Watch this space