Should the EU Just Let Greece Fail?

Uncertainty is killing the global financial markets, but certainty could be even worse

600 greece eu flags REUTERS John Kolesidis.jpg

The biggest obstacle standing in the way of the global economic recovery is Europe. Its sovereign debt problems continue to worsen, with Greece slowly inching closer to the edge of the cliff. With each day that passes, its default looks more and more certain. If Greece's fate is essentially determined, then what is Europe waiting for? Why not just allow Greece to default immediately so that banks can take their losses and everyone can move on? While that might provide some certainty to markets, it would mark the beginning -- not the end -- of the crisis.

An Analogy: The U.S. Financial Crisis

In some ways, Europe's situation is comparable to the U.S. banking industry's crisis back in 2008. Just as banks were experiencing serious problems and nearing default, so are several European nations. And just like a few particularly toxic banks threatened to take down the entire industry with them, a few struggling nations could take down the entire European Union.

Like during the financial crisis, contagion is a serious problem. While a handful of big U.S. banks had exposure to toxic mortgage securities that rendered them insolvent (losses would overwhelm their assets), most were experiencing liquidity problems (they merely couldn't roll over their short-term funding). In Europe, solvency could be a problem with Greece, Ireland, and Portugal. But others like Italy and Spain will likely only fail if the fallout from those others triggers their collapse.

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Greece as Lehman

So to keep with this analogy, Greece is a lot like Lehman Brothers. That's the bank that the U.S. decided not to save and just allowed to fail. But as we all now know, that decision had disastrous consequences. The move resulted in even greater panic, and the crisis hit new heights.

This year, Greece's debt-to-GDP ratio is 166%. According to economist and American Enterprise Institute scholar Desmond Lachman, banks and investors holding Greek debt would probably need to take a 60% loss in a default scenario. Although that loss may be inevitable, European bank balance sheets don't reflect this possibility: they currently show their debt at par value (100%).

The EU's Philosophy: Buy Some Time

In other words, banks that hold Greek debt will sustain major losses once a default occurs. You can't just rip off Europe's band-aid here: other nations would also bleed out. Capital acts like a staunch for bank losses, and European banks don't have enough in place to sustain what they must endure if Greece defaults.

With each additional day that Greece avoids collapse, these banks can work to acquire additional capital to better sustain the losses that appear inevitable. Although this creates an awful situation for global markets, as uncertainty over Europe's stability hampers economic activity, the alternative would be worse. A default would force banks to recognize these big losses immediately, which would very likely throw the region into a financial crisis.

So Europe appears to be aware of Greece's unhappy fate, but it can't allow a speedy failure. There's no orderly resolution option here. It needs a slow demise for Greece, because its best bet to avoid a deeper crisis is for its banks to acquire enough capital to cushion the losses that are likely coming.

Image Credit: REUTERS/John Kolesidis