It is ironic that Greece, whose gross domestic product is just two per cent of that of the European Union, should hold the latter to ransom. It is not just its high trade deficits or the high public debt at 115 per cent of the GDP, but its lies about these that are responsible for Greece’s predicament. The country had fudged its accounts on the ‘expert’ advice of the American firm, Goldman Sachs, and had showed a budget deficit of below three per cent to join the euro club in 1999. In 2004, it admitted its crime, but went on fudging its accounts. In October 2009, a new government came to power which made the startling disclosure that the deficit was 12.7 per cent. Afterwards came the bombshell — the actual deficit was 13.6 per cent. Greece lost its credibility and its bonds were downgraded to junk status.

On April 9, 2010, EU and the International Monetary Fund jointly pledged a package of 45 billion euro for Greece on condition that it reduces its budget deficit to below three per cent over three years. On May 10, the EU-IMF raised this to 750 billion euro ($1 trillion) for Greece and other distressed nations of the EU. This step was taken to save the euro-zone banks that had invested heavily in Greek sovereign bonds. Otherwise, the EU leaders felt, the very credibility of the euro would be lost. Euro did rise by three per cent against dollar and the Greek bond rates did fall from 22 per cent to 8.7 per cent. But the euro soon crashed to its four-year low of $1.20 on June 4.

Greece can neither devalue to boost exports, nor can it cut interest rates to spur investments because of its euro membership. So the EU-IMF prescription for Greece is cutting wages and pensions and a rise in VAT. This will reduce its income and consumption, and worsen its debt burden. Growth will be slower, making it even harder to reduce the budget deficit. It could be a death spiral and Greece may default unless the surplus nations open an aid channel for it.

Till September 2008, foreign funds poured in freely, and Spain, Portugal, Greece, Ireland and others prospered. Thereafter, the cash inflow stopped and these countries were left with low growth and high costs, rendering them uncompetitive against stronger European nations like Germany. After September 2008, many EU-countries had to increase public spending sharply to ward off the impending recession. This raised their budget deficits and public debts. All these countries face the music now, since they have to follow deflationary policies to get the EU-IMF loan, which will pay off their sovereign debt. If any of these countries default, the euro’s credibility to the private banks will be at stake.

However, the euro is far too important for the global financial system. According to the Bank for International Settlements, outstanding derivative contracts worth over $180 trillion stand transacted in euro that is 30 per cent of the total global outstanding derivatives. So one way out is to devise a mechanism that will transfer resources from the surplus to the deficit regions. Of course, this will be politically difficult. The alternative is to let the banks face the losses.

The entire episode exposes the vulnerability of the global financial system, which is highly leveraged and hinges on a chain of credibility. The world’s total outstanding derivatives of $600 trillion is backed by just $25 trillion of real money. At the moment, Greece happens to be the weakest link in the chain.