A specter is haunting Europe - the specter of default in the eurozone. At the core of the problem is Greece - one of the smallest yet most heavily indebted economies in Europe. The country desperately needs a next aid payment of $11 billion to avoid running out of cash within weeks, but negotiations between the Greek government and the "troika" of the European Union, European Central Bank, and International Monetary Fund have stalled. Considered unthinkable not too long ago, a Greek default now seems imminent - a subsequent exit from the eurozone no longer improbable.
Some politicians have begun speaking of a potential "orderly default" of Greece. Others are suggesting that a Greek exit from the eurozone can no longer be ruled out. While uncertainties remain over the if, how, and when of a default, one thing seems certain: Europe's days of "muddling through" are over. The fundamental decisions over the direction of the monetary union will be politically tough, and they will be costly. The costs of not acting decisively now, however, are going to be even higher.
The weekend meeting of the 17 eurozone finance ministers in Poland only heightened market concerns. It produced little in the way of concrete proposals to deal with Greece's acute funding issues and the risks of financial contagion. Only two months after a second bailout was agreed to by European leaders, and amid new numbers indicating that the Greek economy is shrinking at a faster rate than expected, the size of current rescue packages seems to be inadequate. Furthermore, a number of indicators suggest the markets have already begun to discount a default - yields on Greek bonds have soared to record highs, while the price for credit-default swaps to insure Greek debt has rocketed.
Despite these punishing moves by investors, markets may be under-pricing the cost of a Greek default. A default on this scale is unprecedented, and its potentially widespread ramifications are unknown. Markets can limit some of their risk, but it is far from certain that an actual default would not lead to further panic and turmoil.
Scenarios for a Greek default could include a run on the country's banks. Capital, people, goods, and other transportable assets would likely leave the country. Hoarding of physical cash and delays in payments among banks and corporations could be expected. A Greek exit from the monetary zone might become an unavoidable next step. The risk of redenomination of government debt and currency depreciation would then result in higher borrowing costs. With the cost of capital very high over the medium term, and the new/old currency likely being relatively weak and thus highly inflationary, a painful and prolonged period of no or weak economic growth for Greece seems probable.
The pain would also be felt elsewhere in the eurozone as suspicion and mistrust among banks would curtail lending. Other perceived weaker countries, such as Portugal, Ireland, or even Spain and Italy would swiftly be "tested" by financial markets. Despite what some in the creditor countries might hope for, Greece's default and/or exit from the common currency would thus not signal the end of the crisis, but instead would add even more pressure on stronger countries to come up with a "Big Bang" solution.
For the United States, developments in Europe should be reason for great concern. While not as heavily invested in Greek debt, U.S. banks are somewhat more exposed in Ireland and Spain. The United States would have to try to insulate its financial system from shocks in Europe in order to protect its own economy. To avoid a potential default-induced financial crisis, the U.S. Federal Reserve has already expanded its swap operations with the European Central Bank, and it may have to do more. It might also need to provide Federal Reserve money for U.S. branches of European banks and jawbone U.S. banks and money market funds to not withdraw their funds from Europe.
However, even if the U.S. financial sector somehow managed to insulate itself from the risk of financial contagion, the impact on corporate America would be severe. Europe accounts for over one-fifth of world GDP and one-quarter of global personal consumption. Just over half of corporate America's non-U.S. revenue comes from Europe.
Against this backdrop, it is no wonder that U.S. Treasury Secretary Timothy Geithner warned this weekend of "catastrophic risks" if Europe failed to rise to this challenge. Indeed, the time to find a "good" outcome for Europe's crisis has passed. It is time to acknowledge that any solution now will be costly. In the short term, this includes strengthening European banks and extending further support to distressed countries. Another failure to act decisively contains unforeseeable risk and is likely to come at a much higher price - and not only for Europe. Secretary Geithner did not mince words. The fallout from a Greek default, the risks of the eurozone disintegrating, the systemic risks of a European banking crisis, the aftershocks to the U.S. economy - any or all of these events could ultimately prove catastrophic for an already fragile transatlantic economy and transatlantic partnership.
