Greece: The Worst-Case Scenario

By Stephen D. Simpson, CFA | May 04, 2010 AAA

While there has been a great deal of attention paid over the last few months to the nascent recovery in the United States, the ongoing Greek sovereign debt crisis in Europe is a reminder that there are often long-tail effects to recessions and global economic shake-ups.

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How Did This Happen?
What has happened is the result of a long series of bad decisions. The establishment of the euro effectively gave Greece access to a huge amount of relatively cheap debt, but Greek officials did not put the proceeds of this debt to good use. Since the euro came into existence, Greece's ratio of debt to GDP has stayed above 100% and the country ran persistent deficits in excess of 10% of GDP. Ultimately, when investors (and, belatedly, the ratings agencies) realized that the emperor had no clothes, rates on Greek debt began to creep up, and matters culminated in the S&P downgrade of Greek debt to "junk" status on April 27 of 2010.

What will happen next will not be pretty. A bailout package will give Greece up to 110 billion euros in total. That is intended to buy Greece time to get their house in order, but that means a tremendous austerity program - including major cuts in public wages and pensions and a host of new taxes.

Can Countries Go Bankrupt?
Sovereign nations like Greece cannot go bankrupt. What happens instead is a process called sovereign default whereby a nation renegotiates the terms of the debt (including the interest rate, the length of the loan, the schedule of repayments, etc.) and/or replaces it with new debt. This process generally leaves the original creditors with about 25-50% of the amount they originally loaned.

Greece is not the first country to contemplate default; there were a breathtaking number of sovereign defaults across the world in the 1980s. More recently, we saw Russia default on its internal debt (GKOs) in 1998 and Argentina default on its external debt in 2002. In most cases, the causes were similar - too much debt relative to GDP, debt spent on nonproductive assets (or outright stolen through corruption) and persistently high deficits as a percentage of GDP. (For more, see Government Bailouts Around The World.)

What Does This Mean?
For Greece, this crisis is going to mean a major change in the standard of living over the next few years, with wages and economic activity likely to be down for a number of years. Ultimately, the hope is that Greece can reduce its deficits and debts to a more sustainable level and rejoin the public financial markets. In plain(er) English, Greece is basically going to be in a severe recession (if not depression) for several years.

Europe is clearly going to see the biggest short-term effects from this Greek meltdown, as roughly 70% of Greece's sovereign debt is held outside the country - much of that in France and Germany. That, in turn, is going to significant hurt those banks holding the debt and could force them to raise capital and curtail lending to rebuild their solvency. As that happens, there will be less money to loan to companies and individuals. The bottom line? Less growth across the continent.

On a more positive, if cynical, note, the bailout being offered to Greece should help protect the banks. In effect, the governments of Europe are choosing to have all of their taxpayers chip in to keep its banks and large financial institutions on firmer footing. So, while this is called a "Greek bailout", it is in effect just as much about bailing out the foolish lenders in France and Germany.

There is also a very real risk of follow-on effects. Spain, Portugal, Ireland and Italy also have high debt burdens and deficits. Unlike Greece, which is about 2% of the Eurozone economy, Spain, Portugal and Ireland make up a far larger component, and many of these nations have banks with significant international lending operations. If Spain falls into crisis, the entire credit system in Europe could grind to a halt and that would send tremors throughout the world's financial system.

What About Us?
In the U.S., the direct effect of the Greek crisis is not likely to be all that large, as American banks have not loaned that much to Greece and American institutions do not hold large amounts of Greek debt. That said, if the troubles in Greece lead to a slowdown across Europe, it could choke off our economic recovery as Europe as a whole is a major trading partner.

The Worst Case
For the Greeks, the worst case could be even worse, and may include ongoing unrest and government instability. Also part of the worst case scenario is a messy collapse of the euro and a Europe-wide credit freeze. Should that happen, growth in Europe would almost certainly drop and there would be instability across the system. Given that professional investors hate instability more than anything, it would be fair to assume that equity markets would plunge, rates would increase, and gold would probably shine. (To learn more, see When And Why Did The Euro Make Its Debut As A Currency?)

What You Can Do
Unfortunately, there is little for the average investor to do about any of this. Owning some gold could offer a hedge to a truly dire scenario.

Clearly, this crisis serves as another reminder about the benefits of diversification. If you own a Greek bond, you are in trouble. But if you own a diversified portfolio of bonds (through an ETF or mutual fund), then the impact is not so severe. Speaking even more broadly, there is little to do but continue to make sound investing decisions - diversify your portfolio, buy quality assets, and make sure that no one mistake would be devastating.

Going Forward
Beyond that, we should all hope for the best and perhaps consider pressuring our Congressmen and political leaders to run our country according to sound fiscal principles. (To learn more about the Greek crisis, check out EU Economics? It's All Greek To Me!)

Catch up the Greek situation and other financial news highlights in Water Cooler Finance: Buffett's Armed and Greece Keeps Falling.

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