Why letting Greece default would be cheaper than a bailout

German Chancellor Angela Merkel Merkel pushed to get the German parliament to approve last month's nearly $1 trillion bailout for Greece. Some economists argue that it would have been cheaper to let Greece default and then bailout European bank bondholders.

David R. Francis

Year after year, relatively well-to-do New Yorkers subsidize the poorer citizens of Mississippi through the federal system of taxes and disbursement. There's little complaining. No "tea party" protests.

Citizens of both states see themselves as brother Americans.

In Europe, by contrast, prosperous and productive Germans are loath to lend more aid to the Greeks because they're, well, Greeks, whom they regard as profligate.

German Chancellor Angela Merkel had to push hard to get the German parliament to approve last month's 750 billion euros (nearly $1 trillion) rescue package for Greece and other weaker members of the 16-nation eurozone. She did it because she and other European heads of state worry that a default by Greece, Portugal, or Spain would destroy the credibility of the euro.

As she put it: "If the euro fails, then Europe, too, will fail."

Maybe not. Some economists on the left and the right hold that European unity could still progress without its weak southern sister – and that Greece would be better off leaving the eurozone and defaulting on some of its debt.

In any case, the Greek rescue plan looks sufficiently iffy that worried currency traders have pushed down the value of the euro.

Should Greece follow through on its extreme austerity plan, it will put its citizens through a deep recession that will probably take at least eight or nine years to recover from, figures Mark Weisbrot, co-director of the Center for Economic and Policy Research in Washington. And that is if the plan works.

His model for comparison is Latvia, an Eastern European nation struggling mightily to reduce its fiscal deficit and keep its currency pegged to the euro in the hope of soon joining the currency union. But Mr. Weisbrot points out that its severe austerity plan has caused an economic collapse on the scale of the Great Depression: a 25 percent decline in its gross domestic product (GDP), its output of goods and services, and unemployment at 22 percent. It will take Latvia years to recover.

How much would Greece suffer if it opted for default instead? One model is Argentina, which failed to keep its currency pegged to the US dollar at the end of 2001, leading to an economic and financial collapse and, eventually, default on its international debt. Its economy shrank for a few months in 2002 and then grew an inflation-adjusted 63 percent in the next six years.

There are other costs associated with default. Argentina's reputation – its credit rating, as it were – remains in shreds. It can't tap international credit markets, and capital is scarce. It is battling one of the highest inflation rates in the world.

In the case of Greece, default would also be a blow to European banks, which hold $65 billion in Greek government bonds, with the largest chunks in French and German institutions.

Still, Europeans would have found it cheaper to force Greece to default and then, if needed, bail out European bank bondholders, argues Edward Yardeni, a consulting US economist. That move would have had the added benefit of demonstrating the commitment of the European Monetary Union (sponsors of the euro) to their treaty, which specifically bans bailouts, he maintains.

Mr. Yardeni sees lessons for the US. He wants Congress to take an equally tough stand in the "Greek crises" in individual states. Presumably, that means letting California, New York, New Jersey, and Illinois default, if it comes to that.

•David R. Francis writes a weekly column.