Will Greece shock the system like Lehman?

By this summer, Greece will have to ask its bondholders to participate in a "distressed exchange" in which bonds and short-term notes are exchanged for longer-maturity and, in some cases, lower coupon bonds. Something on the order of 10-year bonds with a 4.0 or 4.5% coupon (which, in classic Argentine style, will undoubtedly be subsequently defaulted upon). The question is not whether or even when it will happen (this year).

The question is market impact: Will this be an exogenous, asymmetric shock like Lehman, or will it be an anticipated non-event like Argentina? I have little doubt that it will be the former: another myocardial thrombosis like Lehman. This is because Greece (which is not a big deal) will reveal the spectre of something truly worrisome: countries that are not only too big to fail but also too big to rescue, like Austria and Germany in 1931. 

Since WWII we have faced the default of countries which were not TBTF such as all of Latin America. But now we have a set of countries which are TBTF but also too big to be rescued, which we haven't seen since the Great Depression. 

If the credit markets withdraw confidence from Portugal, it will also default. Default has pretty dire consequences with respect to fiscal balance and growth. Default results in an instantaneous and automatic budget balancing due to loss of external market access (and no national printing press). There is a minor benefit in the reduction of debt service, but this is a minor cushion against the massive and instantaneous fiscal consolidation required by the need to balance revenue and expenditure. Budgets have to be balanced in the face of national recession and declining tax revenue. 

Such draconian adjustments have not been witnessed in Europe in modern memory. Such adjustments can ony occur at the expense of state dependents: public sector employees and all pensioners (i.e., most Greeks). Fragile political regimes with recent legitimacy are at risk of rudderlessness or chaos. Postwar Greek and Portuguese history have not been characterized by stability or legitimacy. Once subject to these pressures, we should expect a reversion to these countries' political history of the sixties and seventies. 

To what extent can Italy and Spain escape this contagion, in the fall of 2010? Only to the extent that, by then, they will have successfully demonstrated their ability to substantially reduce their fiscal deficits in the face of Eurozone contraction, a tall order.