My main focus on the Greek crisis is how it will impact the global economy, and especially the United States, but nobody covering this issue can avoid the morality lessons. First, Greece borrowed too much. That’s bad. Second, Greece cooked its books to conceal the magnitude of its deficit spending. That, too, is bad. Third, other European countries knew that Greece was doing this, but ignored it so as not to embarrass them or weaken the European Monetary Union. That may have been the worst error of them all.
With the morality issues out of the way, let’s assess potential damage. Two possible channels of harm are possible: direct European recession and financial contagion.
The risk that Greece’s fiscal austerity would trigger a Greek recession is reasonable. It’s simple Keynesian economics turned from expansion to contraction. However, the potential for Greece’s downturn to spread throughout Europe is more remote. Greece constitutes about three percent of the economy of the Euro area, hardly enough to trigger a recession by itself.
The greater risk is of contagion, leading to a more widespread financial crisis, which in turn could more plausibly trigger a European recession. Greece has not been the only country running high deficits. Analysts discuss the PIIGS: Portugal, Ireland, Italy, Greece and Spain. All of these nations have been running high deficits. The prospect of a Greek default has already pushed up borrowing costs of the other PIIGS. Greek citizens are shifting their bank balances outside the country for fear of confiscation by the government. However, the chief financial officer of the National Bank of Greece calls this movement “a trickle, but nothing like a real flight.”
Should Greece’s crisis turn into a PIIGS crisis, the size of the problem scales up from three percent of European GDP to 37 percent, certainly large enough to pull the entire continent down with it, as well as North America. However, the major healthy European countries are well aware of this risk, as are other global players such as the United States and the International Monetary Fund. The problem is seen as one primarily for the Europeans to fix, but some participation by outside countries might help put a deal together.
The side issue of credit default swaps has muddied the Greek waters, but it truly is a side issue, similar to complaints about speculators such as George Soros shorting a weak country’s currency. Had there been no underlying risk in Greek bonds, there would have been no run up in the cost of insuring against a Greek bond default. Although it’s certainly possible that speculators over-bought Greek CDSs, it is even more likely that Greece was, for years, able to borrow money at interest rates that reflected her cooked books rather than her true financial condition. Think of this as a sovereign stated income mortgage. Tighter regulation of the CDS market would not have prevented Greece’s high debt or bogus accounting.
In sum, Greece poses a noticeable risk to the world and American economies, but the odds are against catastrophe. However, it would be better not to have to roll those dice at all, because the odds of losing are not trivial, and the amount of our loss could be substantial.