Greece’s Overdue Default
Why the euro is unraveling and what it means for the United States


Greek prime minister George Papandreou’s announcement that the country will hold a referendum on the European rescue deal came as an unpleasant surprise to many. Jean-Claude Juncker, chairman of an informal group of European finance ministers, is dismayed that the decision was taken “without talking it through with his European colleagues.”

Well, that’s how democracy and sovereignty operate. The Greeks need to be allowed to make decisions about their future themselves. Arguably, the announcement marks the end of the deal negotiated by European leaders last week. Although it is far from obvious whether the referendum will be held or when, the ultimate outcome of the current turbulence is going to be a unilateral and unconditional default of Greece, and maybe its exit from the eurozone, regardless. And that would be a good outcome. In the end, these steps are long overdue, and the sooner they occur, the better.

Mr. Papandreou’s decision is not surprising either. With the ongoing unrest throughout the country, the prime minister is unable to carry out any of the reforms he has promised to his European counterparts. By proposing a referendum, he is trying to walk away from his promises in a face-saving way. It won’t be him — it will be the people — who will renege on the commitments that Greece has made.

Although Nicolas Sarkozy called it “a durable solution to the crisis,” last week’s deal was a sham. True, it contained a small dose of realism, as it imposed a 50 percent haircut on private lenders, thus reducing the burden of the Greek debt. If adopted, the haircut would hit the Greek banks hardest, which hold around one quarter of the total privately held debt. And under the most optimistic of scenarios, Greek debt would be at 120 percent of GDP by 2020, and hence still in sore need of further consolidation. That won’t happen if Greece can’t regain its competitiveness.

The deal also contained a commitment to help Europe’s banking sector through Greek-debt restructuring by increasing the guarantees given to the European Financial Stabilization Facility from €440 billion to €1 trillion. But the EFSF is a flawed instrument — for the simple reason that the guarantees given to it by various European countries are not credible. Italy guarantees 18 percent of the total bonds and debt instruments issued under the EFSF, but it is not clear whether the country will even be able to repay its own debt. If worst comes to worst, and the EFSF needs countries to honor their guarantees, the whole edifice will unravel.

A Greek decision to scrap last week’s deal will be a catalyst in the endgame that has been coming for some time. When Greece defaults and leaves the euro, European leaders might try to use the EFSF to save the banks from taking the full blow, or they might try to put in place a more robust bailout mechanism, perhaps with the European Central Bank acting as the lender of last resort. But that won’t make much of a difference.

In 2008, TARP might have saved the banks, but it did so only at the cost of American jobs and growth. In the same vein, regardless of how many European banks tumble, Europeans need to brace for a recession. And it is not just the Europeans. The economic contraction that is likely to occur is not going to spare America — just as in 2008, when post-Lehman events led to a deep economic slowdown in Europe.

These events might affect the U.S. presidential election. A prolonged economic malaise and high unemployment will lower the bar for whatever Republican challenges Obama in the race next year.

In January of last year, Paul Krugman was still saying that “Europe is an economic success, and that success shows that social democracy works.” In the next months and years, it will become much more difficult to make such claims. Let us hope that, in the coming years, the European-style welfare state will cease to be seen as a viable political platform — in the United States and beyond.

— Dalibor Rohac is the deputy director of economic studies at the Legatum Institute in London.