Domino Theory: Greece's Default Could Topple Global Economy

(MoneyWatch)  Look out, below: Greece is on the brink of defaulting on its debt. Greek Prime Minister George Papandreou is making what looks like a last-ditch effort to convince the country to accept another round of deep spending cuts in exchange for a bailout by the other eurozone nations. If he fails -- a real possibility given the level of public anger over the latest austerity measures -- all bets are off.

When panic is in the air, it's important not to overstate the risks. Many investors remain sanguine that Greece will avoid a full-blown sovereign debt crisis, or at least contain the damage if the nation is forced into restructuring. For instance, U.S. money-market funds have been preparing for catastrophe in Europe in recent weeks by moving their money out of eurozone banks into Scandinavian institutions.

But as the housing crisis showed, when financial markets in September 2008 largely discounted the risk of a Lehman Brothers collapse, danger shouldn't be understated, either. You can't measure the shock waves until the earthquake hits.

Infectious disease
The "quake," in this case, is contagion. Ground zero would be Greek banks, which would essentially implode. More seriously, a default would shake confidence in the financial stability not only of ailing Portugal, Ireland and Spain, but also of larger European economies. Moody's (MCO) yesterday threatened to downgrade the credit of BNP Paribas, Société Générale and Crédit Agricole, three of France's largest banks. A default could gravely wound the companies, which have a total exposure of $65 billion in Greece.

That could ricochet into American banks, which as of the end of 2010 had some $41 billion on the line in Greece, not factoring in the value of hedges such institutions may have to offset possible losses there. Bank analyst Chris Whalen of Institutional Risk Analytics notes that big U.S. banks have written credit default swap protection on roughly one-half their total outstanding debt of all the so-called PIIGS nations (Portugal, Italy, Ireland, Greece, Spain) combined, a total he says is "many times their capital."

Such losses could in turn slam into the U.S. economy at large:

"The concern is that a default by Greece would not only hurt European banks but could also spread to U.S. banks," said Bernard Baumohl, an economist at the Economic Outlook Group in Princeton, N.J. "Should there be a default, it can only have a delaying effect on the recovery, hurting American exports and the banks' ability to lend."

Back to the future
If Greece's default could gouge financial firms' balance sheets, the greater danger for the global economy could be the impact on overall market psychology. In a sovereign debt crisis, fear is contagious. The implications for financial firms, bondholders, currencies and trade are hard to predict. Credit can disappear overnight. The key question is how far the virus spreads.

In some ways, the threat of a Greek default is less like Lehman's demise than the "Asian flu" crisis that swept the global economy in 1997-98. Then, as now, the disease started in a small country, Thailand, where a meltdown of the baht caused investors to bail out of similarly vulnerable economies in the region.

While Asia's so-called tiger economies at the time had grown unsustainably fast, of course, Greece and other distressed European nations have the opposite problem. But the result could be the same -- a sharp downturn in global economic growth, worsened in the U.S. by our own faltering recovery.

Many investors and analysts are still betting that Greece swallows its medicine, clearing the way for an EU and IMF rescue. And if the country does blow, the aggressive action by countries like Ireland and Spain to improve their fiscal stability could still avoid an economic chain reaction. For now, though, the environment in Europe is frighteningly opaque. The only certainty is that Greece is closer to the edge than ever.

Thumbnail and George Papandreou image from Wikimedia Commons, CC 2.0
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