PIIGS Basics

Marty Feldstein, my favorite mainstream economist, in today's FT writes that a default by Greece is inevitable and does a great job of explaining the basics of the PIIGS crisis:

Even though the Greek parliament has given the government some breathing space with its vote of confidence late on Tuesday, a default by Greece is inevitable. With a debt to gross domestic product ratio of more than 150 per cent, large annual deficits and interest rates more than 25 per cent, the only question is when the default will occur. The current negotiations are really about postponing the inevitable default.

If Greece were the only insolvent European country, it would be best if its default occurred now. Cutting its debt in half and replacing the existing debt with low interest rate bonds would allow Greece to service its debt without the excruciating pain that would be involved if it tried to service its current debt.

But Greece is not alone in its insolvency and a default by Athens could trigger defaults by Portugal, Ireland and possibly Spain. The resulting losses would destroy large amounts of the capital of banks and other creditors in Germany, France and other countries. There would be a drying up of credit available to businesses throughout Europe and there could be a collapse of major European banks.

This inevitable contagion and its potential consequences for the European financial system is the reason the European Central Bank is determined to avoid a default at this time. The challenge, therefore, is to find a way to postpone the defaults long enough for the banks and other creditors to withstand the write-downs of bond values if Greece, Portugal and Ireland default simultaneously.

This, btw, is why the EU-IMF will not allow Greece to default at the current time regardless of what austerity program Greece does, or does not, adopt. The next payment due is only 12 billion euro. The EU-IMF is not going to risk contagion involving Portugal, Ireland and Spain because of a lousy 12 billion. Down the road the numbers to keep Greece afloat become much larger and that's when the EU-IMF members start to balk at making the payments.