Will Greece Default on its Debt, and Take the Eurozone Down with It?

The credit ratings agency also changed its outlook on Greece to negative, saying the Greek government's long-term credit strength was "eroding materially." The deterioration of public finances also cost Spain and Ireland their top ratings last year.

That was followed by a run on Greek government bonds by traders who doubt that the country will be able to unload their bad bonds on the EU, sending yields over 6% -- about twice what Germany pays. The cost of insuring against losses on Greek government bonds last week rose to a record of 344.5, according to CMA DataVision prices.

Further downgrades by credit ratings agencies would mean Greek government bonds will no longer qualify as collateral to borrow cheap European Central Bank (ECB) funds starting in 2011. That would raise government borrowing costs, cripple hard-hit Greek banks and also hurt other holders of Greek debt.

Across Europe, there is concern that serious fiscal problems in Greece could threaten the credibility of the Eurozone and set off similar debt crises in other weak European economies.

"The Greece example is putting us under great, great pressures," German Chancellor Angela Merkel told AFP. "The euro is in a very difficult phase for the coming years."

Fiscal Discipline on Shaky Ground

Like any other major currency, support for the euro relies on fiscal responsibility. But, unlike any other major currency, the euro is issued by 16 autonomous countries largely beyond the reach of European Union rules.

In other words, if any individual member such as Greece wants to run up debts that threaten its credit rating, Eurozone members have very little recourse.

"Who is supposed to tell the Greek parliament that it needs to carry out pension reform?" Merkel said at a recent meeting, according to The Wall Street Journal.

During this week's meetings, Greece's Prime Minister George Papaconstantinou will brief his counterparts on his plans to cut the country's giant deficit. The three-year budget plan includes more than $14.4 billion (10 billion euros) in deficit-reduction measures for this year, and promises to bring the deficit down to the EU's 3% ceiling by 2012.

But financial markets and many EU officials don't believe he can achieve that based on the budget plans that have been announced so far and are pressuring Athens to make deeper spending cuts.

Papaconstantinou is afraid of the potential for social unrest if Greece were to issue huge cuts at once, a source close to Papandreou, who spoke on condition of anonymity, told Reuters.

"We're going to have to salami-slice our way into it," the source said. "The EU pressure is helpful to provide an alibi for the next round of measures, because everyone in Greece realizes that the EU is our lifeline."

Most economists view the statistics underlying the fiscal reform package that the government has proposed with skepticism, as well.

The EU last week diplomatically referred to its "statistical irregularities." For instance, the government's plan suggests that it can slash the country's budget deficit over the next year or two, while also projecting that the economy will continue growing through 2011.

Unless Athens takes swift action to slash spending and raise revenue, it risks costly EU sanctions and further downgrades by credit ratings agencies that would sharply raise its borrowing costs and deepen its economic recession.

EU officials say Greece alone is responsible for its current plight. The newly elected Socialist government stunned the EU last October when it revealed the giant deficit - announcing that the previous Conservative administration had under-reported the deficit by more than twice.

"Because of the history, there is not much sympathy out there for Greece," a European Commission official involved in the drive to enforce fiscal discipline told The Journal. "There is a very strong determination to apply the rules."

EU Has Few Options

The Greek government will submit a new three-year fiscal plan to the European Commission this month and EU finance ministers could issue an ultimatum in mid-February giving Greece four months to take corrective action or face sanctions.

One solution to resolve the whole issue would be to revoke Greece's EU membership.

But such a drastic measure could put the euro itself at risk and was quickly ruled out by ECB President Jean-Claude Trichet, who called the notion "absurd" when he was questioned on the matter last week.

However, Trichet also said that the ECB wouldn't be rushing to Greece's aid with any "special treatment."

That's not surprising since the central bank would undoubtedly come under pressure to offer similar bailouts to other debt-ridden members such as Italy, Portugal, Spain and Ireland, which have already been forced to swallow tough spending cuts to reduce their deficits.

The anti-bailout stance was reiterated last week when ECB executive board member Juergen Stark, a German deficit hawk, bluntly stated that markets were deluded if they thought other member countries would reach for their wallets to save Greece.

If the excessive deficit remains uncorrected, the EU could also punish Greece by forcing it to make a huge, nonrefundable deposit with the European Commission. But that would only reduce market confidence and multiply Greece's economic troubles.

Neither kicking Greece out of the EU or a fine makes economic sense. But letting Greece flaunt the rules could do irreparable harm to the credibility of the euro as a sustainable currency.

Olli Rehn, the newly installed European commissioner for economic and monetary affairs, expressed fears of a potential "spillover effect for the entire euro area" during his European parliamentary confirmation hearing.

The whole Greek issue also underscores the Eurozone's generally tepid recovery from the recent global recession.

Even the notion that Greece could default on its debt is not out of the realm of possibility.

But Citigroup Inc.'s (NYSE: C) Global Markets analysts said that although political pressure from the European Union "will likely remain high...we reckon that the probability of a Greek default remains very small."

Former IMF and Wall Street analyst Desmond Lachman, however, was much more pessimistic when he raised the idea of Greece defaulting in a piece for Financial Times last week.

"Much like Argentina a decade ago, Greece is approaching the final stages of its currency arrangement," he predicted, adding that "after much official money is thrown its way, Greece's euro membership will end with a bang."

News & Related Story Links:

• Money Morning:
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• The Wall Street Journal:
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• The Wall Street Journal:
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• AFP:
  Greece faces EU grilling
  
• EU Business:
  Greek shadow over euro darkens
  
• Reuters:
  Greek debt crisis tests euro zone credibility
  
• Financial Times:
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• Money Morning:
  Is Government Debt the Next Crisis to Strike?