I suspect the eurozone will soon collapse and trigger global financial contagion. This will be not remotely as bad as 2008, but painful nevertheless. A double-dip recession is not certain, but looks likely.
I have been obliged to abandon my earlier optimism that eurozone politicians would find ways of postponing Greek default, and the global economy would grow slowly but avoid recession. European politicians have poured much political capital into creating the eurozone, and will go to extraordinary lengths to prevent a rupture.
A month ago, there was support for Eurobonds – guaranteed by all member-states – that would enable weaker countries to access credit at low interest rates. But the ruling of a German constitutional court last week has cast doubt on the legality of Eurobonds. Hence attempts to save Greece and other weak states have been swamped by scepticism in financial markets.
On Monday, the credit-default swap rate in Europe indicated a 98 % chance of Greek default. The yield on some Greek bonds skyrocketed to 60%, a clear indication that bondholders expect to get back only a fraction of their principal. The European Financial Stability Facility can prop up Greek, Portuguese and Irish bonds for some time, but it lacks the firepower to prop up Spanish and Italian bonds, which are coming under pressure. Italy has asked China to buy its bonds, but that looks a very long shot.
That leaves the European Central Bank (ECB) as the last line of defence. The ECB could print euros to finance unlimited purchases of dodgy gilts. But it was created as an independent institution to fight inflation, so will oppose monetising unlimited tainted gilts, despite high political pressure to do so. After a point, it will surely refuse further gilts purchases.
The Eurobond option looked promising earlier, but is in trouble. Eurobonds would in effect provide guarantees from solvent northern Europeans to loans of improvident southern Europeans. Some analysts thought such financial engineering might avoid raising the hackles of northern voters angry about handouts to irresponsible southerners. The big blow, however, came from the German Constitutional Court.
While upholding the constitutionality of the EFSF, it placed stringent curbs on rescues that entailed permanent transfers to others, caused large losses to German taxpayers, or offered guarantees that could be triggered by other European governments. Financial engineers will seek ways round this ruling, but will probably fail.
Alternatively, all eurozone countries could engineer a speedy fiscal union, in which a eurozone finance minister will be empowered to impose taxes and spending guidelines on errant governments. However, Greece and other weak countries will resist surrendering their sovereignty over taxes and spending. Besides, a fiscal union will require referendums in European countries, whose voters have grown increasingly sceptical about the eurozone.
If Greece defaults, it can stay in the EU but will have to leave the eurozone. On joining the eurozone, Greek gave up its currency (the drachma) and adopted the euro, issued by an independent ECB. The ECB provided euros to Greek banks against gilts as collateral: that is how Greece got its money supply. But if it defaults, surely the ECB will reject its gilts as collateral and stop supplying it with euros. Absent euro supplies, Greece will have to exit the eurozone and create drachmas again.
Growth is an easier way to restore a country’s finances than austerity. Greece is not competitive but can’t devalue while stuck to the euro. So, it has failed to grow in GDP or tax revenue. It needs to admit that the eurozone was a bad idea from the start- a monetary union of so many dissimilar countries was a recipe for disaster. Greece and Portugal will be better off defaulting quickly, devaluing after withdrawing from the eurozone, and then restoring their finances through growth rather than austerity.
Financiers always claim that the cost of default is too horrendous to contemplate. This claim was thoroughly discredited by Russia and Argentina, which defaulted after running up unpayable debts in the 1990s. Default led to a few difficult years and ostracism from international financiers. But after that both economies grew at record rates. Commercial lenders came back within a few years.
This time too, some financiers claim that the cost of Greek default can be 50% of GDP. But Britain is outside the eurozone while staying within the EU common market, and surely this has not cost it 50% of its GDP. This is surely the way for Greece and Portugal to go too.
However, a Greek/Portuguese default will mean massive losses for all European banks holding Greek/Portuguese bonds. If Spain also chooses to default, European banks will be in the soup: almost all will need rescue and recapitalisation. But this can be done at the national level, and voters will be happier spending taxpayer money on a one-time rescue of their own banks than on repeated rescues of southern Europeans.
There will be global consequences. Financial markets will freeze up, and push at least some countries into recession. The blow will not be as bad as in 2008, but will hurt nevertheless. The US and Japanese banks also hold large quantities of European gilts, and will suffer too. Indeed, this is why politicians have tried so long to avoid Greek default. However, this now looks inescapable. The choice now is between orderly and disorderly default. The former is obviously preferable.