How Greece Pushed All of Europe to the Brink

From Left: France's President Nicolas Sarkozy, Slovenia'a Prime Minister Barut Pahor, Portugal's Prime Minister Pedro Passos Coelho, and Germany's Chancellor Angela Merkel at the European Union Leader's Summit in Brussels. Yves Herman / Reuters-Landov

The European Union proudly claims to be more than the sum of its 27 parts, with a collective wealth and influence that gives it elephant status in the global zoo. Its common currency, the euro, used by 17 of its governments (but not, importantly, Britain), ranks second only to the dollar as a reserve currency. But it only took a hungry Greek mouse running up the elephant's trunk to send the beast into an intensifying panic.

The ghastly mess generated by the follies of Greece, a marginal, profligate and congenitally ill-governed Tammany Hall of a Mediterranean nation, is greater by far than Ireland's banking difficulties or even Portugal's debts. It has spooked markets worldwide. If it continues to be mishandled, it could derail Western growth.

Yet how could this be? How on earth could the watchdogs in Brussels have allowed Greece, a mere bit-part player, to get near the point of rocking the world economy on its hinges?

By letting politics trump economics, that's how. Repeatedly, and for 30 years, the Greeks have played Europe like a harp. June's EU summit illustrated the chaos perfectly: a last-minute deal with Athens to raise the Greek income-tax threshold and increase levies on heating oil was hailed as a breakthrough even though everyone involved knows that this will buy, at best, a few months' respite from Greece's creditors. Thus are deck chairs rearranged, as the Greek pleasure yacht (classified, of course, as a fishing boat to escape taxes) sinks below the waves. The markets duly marked up the five-year probability of a Greek default to 80 percent.

The advice to Margaret Thatcher from the Foreign Office mandarin charged with European policy was as clear as it was intended to be confidential: Greece was unfit to join the European Community. The backward, chaotic archipelago would be an enduring drain on European coffers, David Hannay predicted. Not only that: once through the door, Athens would bring nothing but trouble, thwarting a Cyprus settlement and generally bedeviling Europe's relations with Turkey.

The leaking of Hannay's prophetic memorandum in the early 1980s was an embarrassment for Downing Street. The Iron Lady, new to the European game, had already locked horns with France and Germany demanding a cut in Britain's unfairly large EC membership dues. She was not going to pick another fight over Greece.

Besides, the case against it would be hard to make. The "cradle of democracy" had recently cast off six years of military dictatorship. Spain and Portugal had been invited to join the club specifically to help consolidate their emerging democracies; how, then, could the brave Greeks be denied?

That deliberate, understandable, and foolish decision to waive the rules for Greece in 1981 lies at the root of the crisis engulfing the euro zone and lapping America's shores. Consciously, among its pampered political elite—and subliminally in society at large—Greeks got the idea that being Europe's backward, indulged delinquent was a highly profitable game.

So it proved. "Structural" and regional aid poured in from Brussels to help Greece "catch up" with the rest of Europe, with wholly inadequate checks on what Greece actually did with the money—or why successive governments could now afford to expand the public-sector payroll to the absurd point where it employed half the workforce, all without attempting to collect more than half the taxes owed. Greek blackmail worked at the political level, too, even securing the admission of Cyprus without the EU's first requiring its Greek majority to come to terms with the Cypriot Turks—thus perpetuating a dispute the U.N. had for decades been attempting to resolve.

Even so, Greece would still be a marginal, localized European problem had the Europeans not, 10 years ago, made the further, fox-and-henhouse mistake of letting it trade in its drachma for the euro.

The creation of a stand-alone European Monetary Union was a calculated risk. Without the unifying disciplines of a common fiscal policy, profligate governments could, in effect, tap into the savings of the more prudent. To avert such free riding, the Maastricht Treaty had imposed firm entrance criteria: low inflation, manageable public debt, and small budget deficits.

In 1999 Greece conspicuously failed the entrance exam. Yet two years later, after fiddling the national books, it squeaked through the door despite the manifest weakness of its economic institutions and fiscal management. Able now to tap markets as cheaply as Germany, Athens embarked on the mother of spending sprees. The wildly overbudget Athens Olympics alone, organized, if that is the word, by none other than Greece's just-appointed finance minister, Evangelos Venizelos, should have raised eyebrows. Europe's watchdogs slumbered on.

Greece could borrow almost without limit, because although the Maastricht Treaty expressly barred bailouts of indebted members, financial markets judged that euro-zone governments would do anything to prevent a sovereign default. And no one told the Greeks that they could not live forever on the never-never. As late as October 2009, Prime Minister George Papandreou won election by promising to boost wages and halt cuts, famously declaring that "the money is out there." It was not, and he knew it.

When the music stopped a year ago, German Chancellor Angela Merkel proved the markets right. Even as Athens erupted in violent protests against tax rises and spending cuts, she urged German M.P.s to support a €110 billion bailout for Greece because "quite simply, Europe's future is at stake." The tough conditions that went with the loan would, she pledged, restore Greece to economic health. Can she conceivably have believed that?

Greece's public debt then stood at €300 billion. A year later it is €340 billion (160 percent of GDP) and climbing, while Greece's capacity to pay even the interest it owes shrinks by the day. Austerity measures have bitten hard, shrinking the economy by about 8 percent below pre-crisis levels and sending youth unemployment soaring to more than 42 percent. Those in work have seen their incomes fall by at least 20 percent—except politicians, who with typical chutzpah have refused to trim a cent off their own fat paychecks.

Yet with all these cuts, Greece failed to meet the fiscal targets set by the EU and International Monetary Fund. The next €12 billion tranche is on hold until the newly reshuffled government passes legislation, due in late June, imposing a further €28 billion in cuts on its furious, bitter, despairing voters. Plus a €50 billion privatization program that has at least given Greeks something to laugh about. "Anyone want to buy a once-only-used Olympic stadium?" asks a Greek-banker chum, adding: "Would you buy the Greek state lottery?"

In Brussels, it's back to the drawing board. EU governments are wrangling over the terms of yet another €100 billion loan to fend off a Greek default. Ostensibly to spread the pain, Merkel wants banks that hold Greek bonds due to be repaid "voluntarily" to lend the money straight back to Greece, on long maturities. The scheme is modeled on the Vienna Agreement of 2008 that helped to keep Eastern European economies afloat. But there is one crucial difference: the Eastern Europeans needed cash to see them past the post-Lehman credit crunch, but they were not broke. Greece is broke, bankrupt, kaput. Even if the tottering Papandreou government passes the legislation demanded of it, anyone who thinks it will actually implement such cuts is delusional (laws in Greece tend to be honored in the breach, not the observance). Even if they were implemented, along with other reforms needed to open up the Greek economy, the gap between present pain and long-term gain looks politically unbridgeable. The economy would contract still further, leaving Greeks, as the song goes, "one day older and deeper in debt."

Merkel is really asking the banks to pocket their repaid cash and then chuck it out the window. Call it what you will, that would look to the markets like debt restructuring—the very thing Europe has wasted a year trying to avoid. That, oddly, is the plan's merit. Continued infusions of other taxpayers' money make sense only if they enable Greece to get its finances in shape to raise money on financial markets again. But that is not going to happen any time soon.

That leaves two choices: Keep pumping northern taxpayers' money in to defer the inevitable, at least until Ireland, Portugal, and Spain look less at risk from financial contagion—if the taxpayers will stand for it, and they may not. Or accept the inevitability of an "orderly" write-down of Greek debt, before a disorderly default becomes unstoppable.

What then? The going would be rough. If Greece stayed in the euro zone, and even if it did not, borrowing costs would soar for other indebted euro-zone countries. Not only that: the banks holding Greek bonds would need extensive recapitalization—not just in France and Germany, but in the United States. President Obama recently declared that American recovery depends on successful containment of the Greek crisis. The Bank for International Settlements puts the potential exposure of American banks to Greece, including instruments such as credit derivatives as well as loans, at $41 billion, second only to France. Add in their total exposure to Portugal ($46 billion), Ireland ($105 billion), and Spain ($175 billion), and you are starting to talk about real money.

Even so, economic confidence would be unlikely to be hit as badly as it was by the Lehman collapse, because banks have had a full year to digest the grim truth that, whatever the politicians say, Greek bonds are as flimsy as cobwebs.

The political fallout would, however, be huge. It might not cause the euro to collapse; but it could force a radical redesign. Timeo Danaos et dona ferentes—fear Greeks bearing gifts. But Greece's Ponzi-scheme approach to public finance has, by exposing the risks in a one-size-fits-all monetary policy, done Europe a good turn. To save the euro, the euro zone may have to shrink to a small core of financially sound members. That is not yet on the agenda. But its time will come.

Righter is associate editor at the Times of London.

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