With Greece just weeks away from running out of cash, the European Union is fast running out of options to save the currency union and head off another global recession.
The focus is now shifting to once-unthinkable scenarios that await Europe if the Greek government defaults on its debt.
Petros Giannakouris / APInternational Monetary Fund representative Bob Traa speaks at a conference in Athens Monday. The IMF, European Central Bank and European Union are trying to work out a plan to avoid a Greek debt default.
Hopes were raised that a weekend meeting of European Union leaders – aided by an unprecedented visit from U.S. Treasury Secretary Timothy Geithner – could break a downward spiral of confidence that has engulfed the European banking system.
But on Monday, after giving Geithner a chilly reception, European officials remained deadlock after nearly two years of failed efforts to head off a Greek default.
"A Greek default looks to be imminent,” Gluskin Sheff chief economist David Rosenberg write in a note to clients Monday. “The EU finance meeting was a colossal waste of time. Nothing concrete came out of it.”
There were fresh signs Monday that Greece has run out of time. Greece's prime minister abruptly canceled a trip to the U.S. to remain in Athens to deal with the crisis. European officials have delayed payment of the next $8 billion of financial assistance until Greece meets budget-balancing targets imposed as a condition for help. Without the money, Greece will be unable to pay government worker salaries and pensions by the middle of next month.
In a last-ditch effort to balance its budget, Greek officials last week announced a new $2 billion property tax – to be collected by the state electricity company. Workers there have threatened to refuse to collect the tax, and European officials Monday said the new tax would raise only half as much as Greek officials are projecting.
The revolt in Greece is echoing throughout Europe, as voters in wealthier “core” countries like Germany and France harden their opposition to bailing out weaker southern economies including Greece, Portugal, Spain and Italy. It’s part of a growing “revolt against Brussels,” according to Nicolas Burns, a former U.S. ambassador and now professor at Harvard's Kennedy School of Government.
“It’s reminiscent of the revolt by Americans against their own government in Washington, but it’s much more serious and deeply rooted in Europe,” he told CNBC. “People want to reclaim some control and ownership that used to reside in nation-states that now reside in this huge bureaucracy. It's difficult for politicians to overcome that depth of public sentiment."
The rising prospect of Greek default leaves European leaders with several unappealing scenarios.
Even if German officials relent and ease their insistence that Greece meet strict budget targets, the country faces a grim future. Spending cuts and higher taxes have sent the Greek economy in reverse, forcing bigger cuts, which only deepens the recession. That’s prompted some observers to call for an “orderly default.”
Such a default would wipe billions of dollars of capital from the books of Europe’s banks, which is making it harder for the banks to borrow.
Banks holding large chunks of Greek debt face the biggest losses, but it’s not clear which banks would be hit hardest. That’s sparked fears of another Lehman-like financial panic, when bankers grew increasingly skittish about lending to anyone holding shaky mortgage bonds. Only this time the “toxic” bonds are debt issued by Greece and Italy.
“What bank would want to lend to another if it felt that other bank’s solvency was threatened by exposure to defaulted government debt?” said John Higgins, a market economist at Capitol Economics.
In the Panic of 2008, U.S. bankers could turn to a single central bank and the U.S. Treasury for help. But Europe’s central bank is deeply divided over how aggressively to respond to the crisis. A senior German ECB official resigned last week over a proposal to have the central bank buy up more Greek and Italian debt. Europe has no national Treasury, which could force individual countries to bail out their own banks.
“(If Greece defaults), it's unknown which of these national governments can underwrite their banking sectors and which ones can't,” said Philippa Malmgren, an investment consultant and former economic adviser to President George W. Bush. "But you will have bank failures.”
A default by Greece also would raise the prospect of Athens leaving the euro zone and returning to its former currency, the drachma. German officials have already reportedly begun preparing for such an outcome.
Doing so would avoid a “vicious cycle of insolvency, low competitiveness and ever-deepening depression,” economist Nouriel Roubini said in a column published in the Financial Times Monday.
In the short term, reviving the drachma would inflict even more hardship on Greece: Its banking system would still need to raise fresh capital, while the cost of imports from Europe would soar. The hope is that over the long term it could repair the financial damage and restore economic growth.
A Greek default also would add to pressure on Italy, Portugal, Ireland and Spain. The risk is that these countries would be forced deeper into the same downward spiral. As nervous investors and creditors demand higher interest rates to offset the risk of a default, they would be forced to cut spending and raise taxes to pay the higher cost of borrowing. That would further reduce growth, making bond buyers even more nervous, raising borrowing costs higher – the same vicious circle that has engulfed Greece.
If additional countries were forced to follow Greece’s footsteps, Europe could be reduced to its “core” economies, led by Germany and France. It remains to be seen whether those countries could weather such a sharp contraction of the eurozone – even if it were engineered in an orderly fashion.
With time running out, and European leaders facing increasing voter resistance to forging a consensus, some have begun contemplating the prospect of a breakup of European Union. Such an outcome could have dire long-term consequences, according to Poland’s Financial Minister, Jacek Rostowski.
“In the absence of the key elements of our security system on the key elements of our political system that insures that we deal with problem in this peaceful democratic way that we’ve developed - if that were not there then the risk of all sorts of authoritarian political movements, and therefore the risk of even war, in the long horizon, rises,” he told CNBC.
CNBC's Michelle Caruseo-Cabrera has the latest from Athens:
CNBC's Michelle Caruso-Cabrera has the details on the finance minister to conference with Euro Zone and IMF officials.
