Could Greece Default?

Greece is in big, big, trouble:

Most blatantly, Greece misled the world about the acuteness of its fiscal plight. Back in March, the situation looked bad – but manageable. The European Commission forecast that the Greek public sector deficit this year would be above the 3 per cent limit set under EU rules and “exceed 4 per cent in 2010”. At the time, officials were concerned the actual numbers would be higher. Nobody, however, was prepared for the shock unveiled by the Socialist government elected in October. Statistical revisions showed the public finances so much worse that the Commission changed its projections to a deficit of 12.7 per cent this year and 12.2 per cent in 2010. ...

On almost every measure, Greeks have been living beyond their means. The current account deficit reached almost 15 per cent of gross domestic product last year, making the US deficit of 5 per cent look modest. External public debt now exceeds GDP. ...

Since joining the euro, Greece has regularly flouted the deficit and debt limits set in the zone’s “stability and growth pact” that is meant to correct for the lack of a single eurozone fiscal authority. Scant progress has been made in reforming the country’s public sector, which added 50,000 mostly low-skilled employees in 2004-09.

Greece has been playing a game of chicken with the E.U., and it looks like the E.U. is not going to back down. This could force Greece to turn to the IMF and accept stiff conditionality, or... what? Can the E.U. let Greece default on its debt? It would be very difficult (perhaps impossible) for the E.U. to kick Greece out of the monetary union, and it is mostly inconceivable that the E.U. would let a member country default on its debt, as that would have an impact on the borrowing costs of the rest of the Eurozone countries. In any case, Greece seems to believe that the E.U. will bail them out and thus avoid the iron fist of the IMF. But E.U. is sending signals in the opposite direction:

The eurozone has a “no bail-out” clause, which prevents collective liability for debts incurred by a member. In February – when the crisis was at its most intense – Peer Steinbrück, then Germany’s finance minister, admitted that in the worst case “we would have to take action”. That eased pressure on the weakest members, including Ireland. But Mr Steinbrück has since been replaced and his promise now carries little weight; in the eyes of conservative European policymakers, it increased the risk of “moral hazard” – rewarding bad behaviour.

“It is one thing if you are in the middle of a systemic crisis. Then you can’t allow anyone to fail and don’t worry about moral hazard,” says Mr Gros at Ceps in Brussels. “Now we are out of the woods and it may be a good time to reduce moral hazard.” In a research note last week, Deutsche Bank economists wrote that Greece’s continuing violation of the rules “may have changed the minds of EU authorities ... We believe that they may have to set an example for other countries in trouble”.

Greece is not a terribly important part of the greater E.U. economy, so worries about systemic reverberations from punishing Greece would be somewhat slight.

I don't know what's going to happen -- it's not even clear to me what the options are at this point -- but this story certainly bears watching.