Casino Royale

In the Cold War, public sensibilities about imminent threats were partly shaped by pop culture offerings, such as the spy thriller. For a modern version, imagine the following scene:

The camera captures the late afternoon sunlight glittering off the Aegean Sea as music thrums and hints of action to come. A yacht coasts across the screen, sporting a languid beauty sunning herself on its prow. Eventually, the cabin comes into view. Within, we see a dapper gentleman in a tuxedo. The voiceover intones:

"The fate of Europe rests with one figure: Bond. Greek Bond."

Zoom in on gentleman’s laptop spreadsheet.

Greek government bonds have been sinking, and they threaten to take the grand European integration project down with them. The crisis has tapped into deep-seated feelings about Europe and its history: Greek politicians claimed they would not have these problems if not for the residual effects of Nazi plunder; German politicians responded that if the Greeks were really hard up, why didn’t they go ahead and sell a few islands?

Greece is deeply in debt and borrowing heavily, its economy is contracting, and since joining the euro in 2001 it no longer has its own currency. A bailout would be nice, but the European Union has rules forbidding it. If we run down the standard list of palatable economic remedies, that leaves Greece with…

Nothing. A currency depreciation is a standard remedy when prices and consumption have risen too high, but that’s not possible within the euro. Austerity can bring down borrowing, slow the economy, and induce deflation, but it would be extraordinarily painful in Greece’s case. Greece has a budget deficit above 12 percent of GDP. Draconian budget cuts could slam the brakes on an economy in which unemployment crested 10 percent — before adoption of serious austerity measures.

So Greece is left only with unpalatable options. It could tough it out with cuts and contractions, it could look to renegotiate its debts, or it could leave the euro. The last option is seen as nearly unthinkable. FP‘s Annie Lowrey has explained that a withdrawal from the euro would necessitate a departure from the European Union at the same time. Since Greece has been borrowing in euros, a departure and depreciation would make its massive debts harder still to pay, thus almost ensuring default. A default would have its precedents; University of Maryland economist and debt expert Carmen Reinhart notes that since its independence in the 1830s, Greece has been in default roughly half the time. 

Bond investors would normally cast a wary eye on such a history, but they relaxed when countries joined the euro and accepted its strictures. Since it was hard to imagine a scenario in which a euro country would be allowed to default, there was no reason to charge much of a risk premium.

This brings us back to Greece’s sinking bonds. Default is becoming steadily more imaginable, and investors are demanding higher and higher rates to lend Greece money (rates rise as bond prices fall). Yesterday, investors demanded 3.52 percentage points more to hold Greek 10-year bonds than their German equivalents.

For countries with large debts, each rise in interest rates translates directly into economic pain. In public remarks after meeting with Secretary of State Clinton last month, Greek Prime Minister Papandreou addressed this:

What, of course, would be a problem would be if we continued to borrow at very high rates, beyond those that most of the European Union countries and the Eurozone countries certainly borrow at — twice, for example, the rates of Germany — that would be unsustainable, and that would be unsustainable within a common currency."

The continued high rates also call into question the backstop plan that major European nations negotiated with the IMF last week. The usual purpose of such a plan is to reassure investors so they will step in and the plan becomes unnecessary. The plan itself calls for a mix of IMF and European bilateral loans at market rates. It is not clear how this would help if Greece feels market rates are unsustainable.

While this saga has yet to conclude, it is possible to extract a moral or two. First, the European Union is in big trouble. My AEI colleague Desmond Lachman has argued that it is very hard to see how Greece survives this crisis within the euro, and other vulnerable European countries like Portugal, Ireland, Italy, and Spain could topple soon after Greece fell. This looming domino effect gives the big Euro powers enormous incentives to provide Greece with aid. The flip side of that argument, though, is that a bailout of Greece could look particularly costly if it sets a precedent for rescuing others. Such European economic turmoil would not bode well for the world economy.

The other moral is that there is a limit to how much countries can borrow and get away with it. In the recent era of the Keynesian Revival, many countries borrowed with a passion and continue to rack up impressive debts. This approach often assumes that interest rates are stuck at zero; in the real world, they are not. The borrowing environment may remain tame for a time, but Greek bonds show how such situations can blow up — in a way that would make a Bond villain proud.