t was less than three years ago that the failure of Lehman Brothers sent tremors through the global financial system, threatening the existence of every major bank and triggering the most severe economic crisis since the Great Depression. As Europe's policy elite met for fresh crisis talks today, the dark fear that haunted everyone around the table was this: if the bankruptcy of a middling-sized Wall Street investment bank with no retail customers could have such dire consequences, what would happen if the Greeks decide they have had enough and renege on their debts?
Could Greece, in other words, be the new Lehmans? Given the structure of modern financial markets, with their chains of derivative trades and their pyramids of debt, there is only one answer. Greece could certainly be the next Lehmans. The likelihood that a Greek default would pose a threat to the future of the eurozone as well as to the health of the world economy means it has the potential to be worse than Lehmans. Much worse.
Given that gloomy prognosis, the European Union and the currently rudderless International Monetary Fund know something has to be done but are not quite sure what.
To be fair, it's a tough one. A single currency that involved a hard core of European countries that were broadly similar in terms of economic development and industrial structure might just have worked. Bolting together a group of 17 disparate economies with different levels of productivity growth, different languages and different business cultures was an accident waiting to happen, and so it has proved.
The weaker countries, on the fringes of the single currency area, have not been able to cope with the disciplines involved in giving up control of their interest rates and their currencies, with the problem going much wider than the three countries – Greece, Ireland and Portugal – that have sought bailouts. Spain's housing boom and bust was the result of the pan-European interest rate being too low; Italy's increasing lack of competitiveness stems from a lack of exchange-rate flexibility.
It was also clear from the outset that the structure of monetary union would result in struggling countries being subjected to deflationary policies. Since the eurozone is not a sovereign state there is no formal mechanism for transferring resources from rich parts of the monetary union to the poor parts. Nor, given language barriers and bureaucratic impediments, is it easy for someone made unemployed in Athens to get a job in Amsterdam. Instead those countries seeking to match Germany's hyper-competitive economy have to cut costs, through stringent curbs on wage increases and fiscal austerity.
This was the plan A that was wheeled out for Greece last spring, when it became the first eurozone country to run into trouble, and it has been repeated for Ireland and Portugal. Plan A involved providing Athens with a bridging loan so that it could continue to meet its debt obligations, while at the same time insisting on draconian steps to cut Greece's budget deficit. Pain plus procrastination: the traditional recourse for policymakers who lack imagination, as Europe's have done throughout the sovereign debt crisis. Clearly, plan A has not worked, as anyone who has piled up too much debt on their credit card could have predicted.
Just like an individual who can't stop interest charges going up and up, despite trading down to a budget supermarket, cancelling the gym membership and abandoning the holiday, Greece has found that the belt-tightening has left it with a bigger central government budget deficit in the first four months of 2011 than it had in the first four months of 2010.
It's not difficult to see why this has happened. Those who put together Greece's programme underestimated the extent to which public spending cuts and tax increases would hamper the growth potential of the economy, particularly given the lack of scope for the currency to fall. Historically the IMF's structural programmes for troubled developing countries have involved devaluation, so exports became cheaper; but Greece's membership of the single currency has meant there has been no external safety valve to compensate for the domestic squeeze.
Greece needs to have the scope to grow its way out of its debt crisis. Failing that, the rest of the eurozone has to be prepared to stomach not just a second, but a third and perhaps even a fourth bailout so Athens can keep up with its debt repayments. Hence the drumbeat of speculation that Greece would be better off defaulting, or leaving the eurozone altogether.
There is no suggestion that the Greek government is planning anything of this nature. Default and devaluation pose big risks, particularly since the debts would have to be in a redenominated currency (like thedrachma) that creditors would deem to have junk status. In the short term, Greece's economic and financial crisis would almost certainly deepen. Athens would prefer the EU to provide a second bridging loan and to reschedule its debts over a longer period so the interest payments become less onerous.
But that is at best a stopgap solution, because it does nothing to address the structural weaknesses of the eurozone. For this, there are really only two solutions. The first is to turn monetary union into political union, creating the budgetary mechanisms to transfer resources across a single fiscal space. That would fulfil the ambitions of those who designed the euro, and would recognise that the current halfway house arrangement is inherently unstable.
The second would be to admit defeat by announcing carefully crafted plans for a two-tier Europe, in which the outer part would be linked to the core through fixed but adjustable exchange rates. Neither option, it has to be said, looks remotely likely, although the collapse of Lehmans shows the limitations of the current muddling-through approach.
The eurozone's future will not be decided in Athens or Lisbon but in Paris and in Germany. Both the big beasts have invested vast stocks of political capital in "the Project", and insist that there will be no defaults and no departures from the club.
Yet German public opinion was sniffy about the Greek bailout in May 2010, kicked up a fuss at being asked to pick up the tab for Ireland last November, and is positively furious about having to sort out the mess in Portugal. Despite the strength of the German economy, Angela Merkel is facing strong political resistance to more bailouts. The political calculus is clear: cutting Greece and the other weaker euro-area economies adrift would end the dream of monetary union as a club where European countries, big and small, weak and strong, could rub along together with a single economic policy. But failing to cut them adrift could cost Merkel her job.
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