The situation in Europe is deteriorating quickly. The reason is quite simple; it’s Greece. Greece is insolvent, but it has secured financing from Europe and the IMF to keep it going for the next two years. The problem is that to get its money, it must keep its budget position within specified bounds – but with GDP plummeting, so too are tax revenues. This means that the government must cut spending by more than currently budgeted. Voters are unlikely to agree to that and the next election re-run could very well return a government (if it returns a government) that chooses not to meet the IMF-EU lending conditions. If that happens, Greece defaults, and the only way that it could finance the budget is by leaving the euro and printing money. It’s a recipe for disaster.
Markets are working through this and safeguarding their positions now. They know what it means. It could be that “Lehman moment”, when no-one knows which bank is holding the outstanding stock of Greek debts, so banks stop lending to each other (the lemon’s problem as James Haley notes. That could trigger bank failures in big European economies such as Spain and Italy. Since it may be difficult for the IMF or the rest of Europe to bail these economies out, these countries could be forced to default too, pushing them to leave the euro. Contagion and a rapid breakup of the Eurozone, will not be good.
There are really only two options to deal with this situation. One is to figure out some way for Greece to leave while minimising collateral damaged. The other is to make a large transfer to Greece – essentially give them the money so that Greece can avoid the debilitating austerity that is driving the economy to ruin. This is kind of what would happen in a federalist system like Australia or Canada. Or like the Marshall plan that was received by post war Germany
Apart from the fact that politically it is exceptionally unlikely to happen, the trouble with the second option is that it may induce other countries such as Portugal or Ireland to hold out on taking the necessary measures to rebuild fiscal sustainability in hope of also receiving a transfer. There is also a third option, which is to just maintain the status quo and hope that somehow it all gets better. But in reality, it’s likely to get worse.
So that leaves just option one. Euro exit and default could be a disaster, which makes it all the more important to figure out how to put Greece (and other economies that need may need it) on to an exit ramp (that leads to a smooth exit from the euro. Time for that is short and the less time the less likely that an exit will be smooth.