3 Scenarios for the Greek Debt Crisis

Greece's debt is quickly becoming everybody's problem. After the Dow crashed last week, Europe and the IMF joined hands to create a trillion-dollar fund to defend Greece -- and by extension, the euro. Will it be enough to contain the crisis?

Three scenarios seem likely in the next six months: (1) Greece plods along under the protective shield of Europe's emergency fund; (2) the Greek government tells foreign banks that it cannot pay back its loans on time and restructures its debt; and (3) Greece drops the euro and moves to a separate currency that it can control. Here is what each scenario would mean for Greece, Europe, and us.

1. Greece plods along
The massive emergency fund designed to stem the Greek debt crisis has a good shot at delaying the hardship for Greece, but almost no chance to actually resolve the crisis. The reason is arithmetic. This year, Greece's budget deficit is 14% of GDP. The IMF wants Greece to stabilize its debt by cutting the deficit from 14% to 3% of GDP in next three years. If Greece controlled its own currency, the solution would be simple: depreciate your currency to make your products more affordable to international consumers, and boost your exports. But Greece doesn't control its own currency, so it can't rely on higher exports. The solution is all pain: small tax increases and major spending cuts.

What comes next? Greece would slash spending just after a recession, and the economy would shrink. A down economy generates fewer tax dollars for the government. Fewer taxes pay for even less spending, so in order to reach the deficit goals, Greece would have to cut spending again, further weakening the economy. Under optimistic assumptions, the IMF expects Greece's economy to contract by 6% next year. Countries like Latvia and Argentina have found that drastic deficit reduction can contract the economy by up to 25%. That kind of contraction could lead to an even deeper banking crisis in Greece and could force the government to take on the banks' debt, growing their public debt-to-GDP ratio to 180% -- about three times what the IMF considers safe for most developed countries.

2. Greece restructures its debt
Most economic experts expect that a restructuring of Greece's debt is inevitable. But what would it mean, exactly? Restructuring means agreeing to pay your creditors less than you owe them. Most of Greece's debt is held abroad by banks throughout Europe. Greece would approach these banks and work out a deal to pay only a portion of the money they owe on their bonds. This will force big losses on fragile international banks, which could require additional rounds of bail outs from European governments.

But even restructuring isn't a panacea for Greece. Remember, Greece's current deficit is 14% of GDP. Interest payment on the debt make up about 6% of GDP. So even if Greece restructures to pay 50 cents on the dollar, slashing its interest burden in half, they're still left with a deficit equal to (14 - [6/2] =) 11% of GDP. That's an enormous deficit! Write down the debt by 2/3rds, and you've still got a budget deficit equal to 10%. Greece would need to make a huge fiscal adjustments, without the key weapon of currency depreciation to boost exports.

What does a Greek default mean for Europe? You could get what economists call a "contagion" effect. Greece's default makes investors nervous about investing in countries in similar financial distress: early contenders include Portugal, Spain and Ireland. Nervous investors demand higher interest rates on government debt, which in turn makes it more expensive for those countries to finance their debt, which in turn makes it more attractive for those countries to restructure and force enormous spending cuts. The cycle is self-fulfilling.

3. Greece leaves the euro
Greece has some good economic reasons to leave the euro zone. Remember, if it can devalue its currency, exports can rise, bringing in some much needed cash. But being the first country to leave the euro zone could also lead to a massive bank run. After all, who wants their stable euro-denominated deposit turned in rapidly depreciated drachmas?

All bets are off if the euro zone splinters. For Europe, it would almost certainly lead to a second economic crisis. Desmond Lachman of the American Enterprise Institute says he can see a future where the euro zone shrinks to include only the richer northern countries like France and Germany. But in the short term the entire continent would be lucky to experience a small recession.

What would the collapse of the euro zone mean for the United States? The dollar would strengthen again the euro, meaning our exports would suffer. "Essentially all of the interest rates spreads on mortgages would blow out so the US economy would be shocked by banks not wanting to lend," Lachman says. "It will be a financial shock."