27 Sep 2011

Stopping a Greek drama from becoming an economic tragedy

What happens if Europe’s politicians fail to resolve Greece’s debt problems? Channel 4 News looks at the repercussions.

Anti-austerity protests in Greece (Getty)

The stakes are high: in our inter-dependent world, we really are all in this together. Greece’s difficulties are our difficulties, and if a solution is not found, the consequences could be extremely serious. Serious, but eerily familiar.

Dawn Holland, an economist at the National Institute of Economic and Social Research, told Channel 4 News: “The worst that can happen is a return to what we saw in 2007-08 in the banking sector. The banks ceased to lend because they were on the brink of bankruptcy. This brought the investment cycle to a standstill.”

This tipped several economies, including Britain, into recession – and it would be the same story if Greece is not dealt with and market confidence restored, she said.

Politicians have to get a handle on Greece. Paul Kavanagh, Killik and Co

Channel 4 News asked Paul Kavanagh, a partner at stockbrokers Killik and Co, to imagine the worst. He said the markets needed clarity on what Europe’s politicians were planning to do.

If it became apparent to them that they could not sort out Greece’s problems, there would be “panic”, with financial institutions selling government bonds of other heavily indebted countries, such as Spain and Italy. This would make it more expensive for these countries to borrow.

‘Collapse of society’

“What started in Greece has ended up bringing down other countries that are too big to save,” he said.

The result would be “the collapse of society in many southern European states, with a significant drop in standards of living”.

As the EU was Britain’s biggest trading partner, Britain would not be immune, with its banking sector and housing market hit and the country plunging back into negative growth. As in 2008, the banks would need to be bailed out.

Read more on the Greek debt crisis 

“The UK’s banks aren’t capitalised sufficiently to cope with further material shocks,” he said.

Mr Kavanagh said this scenario explained why politicians “have to get a handle on Greece”.

On Thursday, the German parliament votes on plans to extend the powers of Europe’s bailout fund, the European Financial Stability Facility.

The German government has voiced misgivings about increasing the size of the 440bn euro (£384bn) fund, but Ms Holland believes Germany is the only eurozone country that is “strong enough to bail everyone out”.

Germany’s role

Berlin needed to make a “strong commitment to do whatever it takes to support other members of the euro area and raise contributions to the rescue fund”. That was likely to “calm the markets”, and Germany had to be aware that the alternative was “dire”: the collapse of the euro and a resulting recession.

“I don’t think you could have the dissolution of the euro without recession, which is the thing we all want to avoid,” she said.

Ms Holland added: “I don’t think it is going to get better quickly, but it doesn’t have to get worse if there’s a turnaround in market confidence. It’s down to Germany showing a strong commitment to the bailout programme. That ultimately leaves them more exposed. The Germans must show they’re willing to do what it takes to ensure the euro does not collapse.”

I don’t think it is going to get better quickly, but it doesn’t have to get worse if there’s a turnaround in market confidence. Economist Dawn Holland

Mr Kavanagh said the markets were expecting the size of the bailout fund to be increased to 3-4tr euros, with Germany the ultimate guarantor.

Ms Holland said the architects of the European single currency had drawn up rules stipulating that members kept their budget deficits and debts under control, but recession had wreaked havoc in their balance sheets.

“They hadn’t expected the banking crisis that led to big increases in government debt. Banking crises don’t happen very often, but they do happen and they are very costly.”

The answer, said Ms Holland, was for member states to move towards fiscal union, where levels of taxation and public spending were more closely aligned.

Government debt

Greece’s problems were caused by the plummeting value of government debt held by financial institutions in the form of bonds, she said. This made it ruinously expensive for the Greek government to borrow money.

Mr Kavanagh said when the British government wanted to borrow money, the markets set an interest rate of 2.5 per cent, half of what Italy had to pay.

While that is a sign that Britain is not as exposed as some countries, it would not be able to escape the shockwaves from a crisis overseas.