Alternative scenarios . . .

Financial Times
June 22, 2011

Bond investors are already pricing Greece’s government debt as though it has defaulted. Writing for today’s Financial Times, Professor Martin Feldstein of Harvard argues that “a default by Greece is inevitable” – this view is increasingly shared. But how might this occur and what are the likely consequences? None of the possible scenarios makes comfortable reading.

DISORDERLY DEFAULT

The Greek parliament rejects the government’s new austerity package next week, leading the International Monetary Fund and the European Union to refuse to hand over the next €12bn tranche of the original rescue loans. As a result, the Greek government simply runs out of money. It cannot pay its bills, public sector wages, or interest. It begs for more lenient loans from Europe and the IMF, but patience in other capitals has run out and they cut their southern neighbour loose.

Because the country has defaulted, the European Central Bank carries out its threat not to accept Greek sovereign debt as collateral in operations to fund Greek banks. A mass run on Greek banks occurs and, shorn of funds, they implode and shut up shop. Households cannot withdraw funds from banks, spending stops, companies cannot pay bills and unemployment soars. The Greek economy enters a tailspin.

Contagion is feared around the world. But having learnt the Lehman lesson, central banks, including the ECB, provide unlimited liquidity to other banks suffering runs, limiting the damage. But confidence worldwide has been knocked. Growth suffers.

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