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What will happen if Greece defaults?

If Greece’s economy collapses, it could easily lead to a breakdown of civil order. AAP

Global markets look set for a rough week amid new concerns that Greece could default on its massive debt.

The Australian share market has spent most of the day down 3% after reports that Germany could push the European Central Bank to withhold 8 billion euros worth of bailout funds unless Athens implements tougher austerity measures.

Melbourne Business School Associate Professor Sam Wylie explains the potential impact on a default on Greece’s economic and political stability, and the implications for European unity and the global economy.

Is it inevitable that Greece will default on its debt?

Until recently I thought it was very unlikely, but just in the last two weeks the probability has gone up a lot.

You can observe this in what has happened in the yield on Greek bonds, which is now nearly 20%. That is an expression of the probability that the market is assigning to a Greek default.

I don’t think it is inevitable, but I agree with the market’s assessment of the heightened risk of a default.

I don’t think anybody wants to see that happen, apart from investors who have taken a bet against Greek bonds. Nobody in Greece wants to see that happen, nor does anybody in Germany and the European Central bank.

The other thing that has changed in recent weeks has been the political situation in Germany. It has become unacceptable for that country’s government to advocate large German support for the ongoing Greek rescue package, unless Greece takes more stringent measures to cut back on spending and improve productivity.

Apart from the anger in Germany that Greece has failed to fully implement changes, there is an evolving feeling that it is better to cut Greece loose than to go on.

Germany’s leaders will have to face up to that.

Germany’s Angela Merkel uses the slogan “to make change” as she faces pressure to allow a Greek default. AAP

There is a threat that Germany will move to withhold the next tranche of bailout funding from the ECB. Do you think that will happen?

No, I don’t think anything precipitous like that will happen.

The only precipitous thing that could happen would be for Greece to exit the Eurozone. There’s no way that the Greek government could say, “well we might exit or we might not”.

As soon as people who have euro deposits in Greek banks come to believe that the government will convert their money into drachma, they will withdraw it instantly.

So as soon Greece moves to leave the Eurozone, the banking system will collapse. When their banking system collapses, their economy will collapse.

This might not appear to be Germany’s problem, even though its banks would suffer and the government would be forced to recapitalise them. That is true, and such a crisis would probably be manageable for the German government.

But the problem is that Greece is not a stable political unit. It had a civil war that ran until 1974.

Unlike Ireland, where no matter what happens with the banking crisis it will never lead to civil violence, there is a real threat of a breakdown of civil order in Greece.

When the Europeans look at Greece and Ireland, they’re looking at two very different things.

Ireland is stable economic unit and no amount of economic trouble is going to make it come apart at the seams. That not true of Greece.

It is not a stable political unit and it could quite easily come apart.

How would this potentially disastrous situation unfold?

The first thing that would happen is that Greece’s banking sector would collapse. If investors thought Greece was going to default slowly, they would withdraw all of their deposits and the sector would collapse.

If people just wake up one morning and the government has converted all deposits into drachma, which would still represent a default against the depositors, people who have loans from the banks will stop paying interest.

They will say that these are no longer solvent banks, we don’t know who we are paying money to, so we will just stop paying interest.

The biggest holders of Greek debt are Greek banks, so if the government goes into default then they will become insolvent and people will just stop transacting with them.

This will lead to a broader economic collapse, and a crisis of confidence about what will happen to Ireland, Portugal and Spain.

The potential for a breakdown in civic order will take Greece out of the financial domain, and into the domain of Europe as a political and military unit. Greece is, of course, a member of NATO.

That danger, and the fear of not knowing what will happen, will prevent Europe from allowing Greece to go into default any time soon.

If Greece does default despite all this, what will the global impact be?

There would be immediate financial losses from investors and the banking sector. The biggest impact will be the effect that it has on confidence. In Europe and in the United States, business confidence is pretty bad, but it’s not terrible.

Consumer confidence, however, is way down – especially in the US. A Greek default would just be another hit to consumer and business confidence.

Capitalism is a confidence game. If everybody is confidently spending and investing, then all the capital moves around smoothly.

When confidence is lost, everybody freezes up and stops spending and investing.

A Greek default would be to the sovereign debt crisis what the Lehman Brothers collapse was to the global financial crisis. The Lehman collapse turned a financial problem into an economic problem because it trashed consumer and business confidence.

The feeling that Greece could not be saved, and other countries could not be saved either, would trash confidence and potentially drive the world economy into a steep recession, such as happened after Lehman’s collapse.

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