With Greece Near Default, Wider Impact Feared

Protesters in Athens gather in front of the Greek Parliament as riot police stand guard Wednesday. i i

hide captionProtesters in Athens gather in front of the Greek Parliament as riot police stand guard Wednesday.

Aris Messinis/AFP/Getty Images
Protesters in Athens gather in front of the Greek Parliament as riot police stand guard Wednesday.

Protesters in Athens gather in front of the Greek Parliament as riot police stand guard Wednesday.

Aris Messinis/AFP/Getty Images

With Greece in political and economic turmoil, financial market participants worry what effect it will have on the rest of the world. Eurozone countries helped fund a previous rescue package for Greece. But French and German banks are still highly exposed to potential losses in Greece.

And that has investors in the U.S. and elsewhere worried about potential fallout.

If Greece is unable to pass austerity measures and cannot secure more international aid, it will start defaulting on $165 billion worth of debt this summer.

At that point, its financial problems become like an infection.

"It starts obviously in Greece, and then it infects other countries," says Jacob Kirkegaard, a research fellow with the Peterson Institute for International Economics.

A Greek default will scare investors away from buying government bonds of other European countries, he says. That will make it much more expensive for countries like Ireland and Portugal to borrow money. And if that happens, the problems could spread to still larger countries like Italy or Spain.

"But when you get to Spain, they're like a big bank," he says. "They're not only too big to fail, but they're also too big to bail out."

Already some European banks — especially in France and Germany — are considered vulnerable to losses because of big investments in Greece. On Wednesday, the Moody's rating agency downgraded three major French banks.

Jack Ablin, chief investment officer for Harris Private Bank, an asset management firm, is quick to say the prospect of a Greek default or restructuring alone is no lethal blow to Europe's banks. However he points out that often, perception can be reality.

"So to the extent that investors believe that the French banks are infected, they could all of a sudden swoop in and try to redeem all of their holdings at once," he says. "So it's effectively a run on the bank."

Investors in U.S. money markets, for example, could pull their European investments, which would further destabilize the financial system.

Possible Solutions

In short, Europe wants to and needs to quarantine the problem.

But the question is how? One school of thought is to continue to treat the patient. In other words, make Greece swallow a bitter pill of additional budget cuts and tax hikes, and try to nurse it back to financial health through some combination of private and public rescue money.

The other school of thought is to let Greece fail. Ablin thinks this wouldn't have to be catastrophic.

"I would argue the best-case scenario is that Greece either defaults or restructures and dominoes don't fall," he says.

Kirkegaard agrees that ultimately Greece will, at some point, have to default or restructure its debt. But he argues delaying that process — stretching it out — by continuing to bail out the country in the short term will buy the European economy and its banking system some time to recover.

It may be counterintuitive, Kirkegaard says, but ultimately this could end up being a very restorative process.

"I think in many ways the illness, or the crisis that Europe is going through right now, is one of the best things that have happened," he says.

Kirkegaard does not mean that all this turmoil is good. But he says it should give countries the political cover they need to push through serious financial reforms and spending cuts.

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