Athens defaulting: Direct and indirect effects

Greece, requesting another bailout of 120bn Euros to solve their notorious government debt problems, have been ordered to draft up plausible austerity plans before they receive any funding. But what if Greece, with government debts of around 150% of its Gross Domestic Product had to restructure its debt or default altogether? What if the EU or IMF denied them further bailouts and wanted them out of the Eurozone?

It has been said that the effects of Greece default would be bigger than the collapse of Lehman in 2008! Governments may just be too big to fail.

Soaring Cost of Public Borrowing Worldwide

Say Greece was denied further bailouts and had to default. Now this would send out a huge message to bondholders of EU nations who are heavily indebted that their securities are less secure than they thought, just as interbank offered rates ballooned just after the US let Lehman go down.

Higher risk government debt spikes after defaults i.e. Brazil 1998 and 2002 above

If they had to borrow, governments could now only do so at greater liability to themselves, affecting economies around the world, especially those not in full control of their own monetary policy (thus cannot print their way out of debt).

The likes of Ireland, Portugal, Belgium, Spain would really feel it, so would the more powerful Germany and France; already relying on refinancing their own debt with new bonds, debt interest payments will mount severely, encouraging contraction. Payment on their bonds will tend towards the massive current 28-30% of 2 year Greek debt.

The Financial System and Contraction in the Money Supply

As  the cost of borrowing rises for bonds worldwide, and significantly in the UK, the prices of existing outstanding debt moves inversely, a fall in total value. As government debt of certain maturities and high grade private debt make up part of the M3 (EU measure) money supply, Greece defaulting leads to a fall in the money supply, directly (less Greece bonds) and indirectly (above).

Money substitutes, making up ‘broad money’ (M3-M1) is becoming more significant

Bank Balance Sheets

Already under a little strain to meet Basle 3 requirements, the banking system will face write downs of its securities and may incur further losses, forcing them to downsize their balance sheets even further.

This can only mean another credit crunch, tighter lending standards and prudence. Private, as well as public interest rates will rise.

Macroeconomic Collapse: IS/LM Model

The Neo Keynesian model first drawn up by Hicks and Hansen can show, in theory what this is thought to do (learn about ISLM here):

As understood, market interest rates on average will rise due to the higher cost of borrowing in the private and public sector. Economic activity can be seriously hurt too, implying another potential recession in many of the G20.

Negative wealth effects (falls in stock market, asset prices as well as bonds), governments forced to be austere (due to higher borrowing costs) and a credit crunch apparently the main factors to drive the economy downward.

Return to the Drachma and Euro Disintegration

The troubles with Greece and the continuous support it needs from the Eurozone may lead it to do what a business does to a loss making venture, cut it off. In this case, the Greek independent currency will devalue to a large extent due to a capital flight (like Thailand etc in 1997) and the country may encounter an inflationary crisis, much like Germany in the 1920’s.

As above, escalating government debt costs may lead already fragile economies (Ireland, Italy etc) into a Greece like situation. If it manifests itself into a handful of the EU27 more may need to be severed, possibly leading into a massive downsizing or break up of the European Monetary Union.

Notable Government Defaults

To see the effects of a government debt default in the past, it might be worth it to see

Argentina 2002:

1998 Russia:


Leave a Reply

Fill in your details below or click an icon to log in: Logo

You are commenting using your account. Log Out /  Change )

Google+ photo

You are commenting using your Google+ account. Log Out /  Change )

Twitter picture

You are commenting using your Twitter account. Log Out /  Change )

Facebook photo

You are commenting using your Facebook account. Log Out /  Change )


Connecting to %s

%d bloggers like this: