To Default or not to Default? This is not the Question

Will Greece default or will it service its debt as agreed with creditors? This seems to be the critical question for our politicians, economists and bureaucrats. But the Greek sovereign debt crisis raises a much more important question than this one.

Greece contributes less than 0.4% to the world GDP. Nonetheless, many fear that a Greek sovereign default could result in uncontrollable chain effects that even harms the world economy. What does this tell us about the state of our financial system? The critical question is: why is our financial system so fragile, and what can we do to about that?

Why is the Financial System so Fragile?

The underlying problem of the Greek sovereign debt problem is banking. The fragility does not arise because creditors suffer losses directly. It is because Greek debt is used by Greek banks as collateral to finance their balance sheet. If Greece defaults, the ECB can no longer accept Greek debt as collateral in refinancing transactions.

The remaining depositors would instantly panic and trigger a collapse of the national banking system. In turn, Greece may eventually be forced out of the Eurozone. This would enable Greece to print a national currency without restrictions from the ECB to save its banking system.

Such a course of events could spill over to other Eurozone countries. Their depositors could fear that similar events unfold in their country too and they could react by pre-emptively transferring savings into safe haven countries like Germany. This opens up a possibility for a banking panic across several Eurozone member countries.

Banking causes all these chain effects. Banking is the reason why even small countries cannot default on their debt without potentially endangering the financial system. The sovereign debt crisis once more reveals heavy weaknesses of the contemporary financial system.

An adequate response to the Euro crisis

The solution to the sovereign debt crisis is to end banking. Our proposed systemic solvency rule would ensure that banking chain effects can no longer occur. Without banking, a sovereign default would only cause direct losses for its creditors, the people who willingly lent money in the first place.

Yes, a sovereign might find it no longer possible to borrow once it defaulted. But this would forcea balanced budget financed by taxes until a government has proven it has regained creditworthyness. The market would finally impose the fiscal discipline that lacked so bitterly before the financial crisis of 2007-08.

Sometimes the obvious answer is not the right one. And sometimes, the obvious question is not even the relevant one. Let us give the right answer to the relevant question. Banking is the reason our system is so fragile that a Greek sovereign default can severely damage it. The end of banking is the best response to deal with the Euro crisis.