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As Warren Buffett famously said, "It's only when the tide goes out that you learn who's been swimming naked." At the risk of taking that metaphor too far, now that the wrath of the global recession has finally hit Greece, it almost seems like the country is doing a striptease for the rest of the world -- with the help of Goldman Sachs (NYSE: GS ) and Credit Suisse (NYSE: CS ) .
Here's the recap from The Wall Street Journal: Greece cooked its books in order to meet European Union fiscal requirements. It entered into currency swap bets that helped mask debt and deficit problems, including an off-market swap that is now raising some controversy.
Certainly, Greece's fiscal situation is in dire straits. The country has been the opposite of frugal, spending more than it received in tax revenues and taking on mountains of debt to finance the gaping hole. Problems with economic data -- late last year, Greece had to raise its previous annual deficit forecast from 3.7% of GDP to a whopping 12.5% -- have exacerbated worries.
Now, the very banks that helped Greece cover up its position are betting against the country. The New York Times reports that Goldman, JPMorgan Chase (NYSE: JPM ) , and several other banks created an index that allowed markets to bet on whether European nations would default. Investors are bidding up credit default swaps (CDS) on Greece, raising the cost of financing for its debt.
Is Greece too big to fail?
The situation illustrates how using CDS can exacerbate a situation, as we saw domestically withAIG (NYSE: AIG ) . But Andrew Busch, global currency and public policy strategist for BMO Capital Markets, told me in an interview that "Greece is a much bigger monster to play with, as opposed to an individual company."
It's tempting to try to compare Greece's situation with other credit-related problems, like the subprime mortgage debacle in the U.S., in which CDS played a large role. However, Busch says the situation isn't comparable: "The overall effect is much different. It has to do more with the fact that it's a sovereign situation versus a global scenario." Busch puts the chances of contagion at 10%.
What's the fix?
EU leaders initially quelled concerns about the threat of Greece's systemic risk to the global economy when they said they would take necessary action to backstop Greece. However, because no details were provided, investors remain skeptical of the EU's statement. Certainly, recent volatility in stocks, and especially the sell-off in Greek companies like National Bank of Greece (NYSE: NBG ) , illustrates investor anxiety.
Due to the prospect of a bailout, member countries have called on Greece to get its fiscal house in order. Reuters reports that Greece plans to cut its deficit by four percentage points this year in order to bring its deficit to less than 3% of GDP -- the level required by the EU -- by 2012. "We're currently in an uneasy environment, with Greece saying that they're going to embark upon their austerity measures and the rest of the world saying 'right,'" Busch says. "The proof is in the pudding. We'll have to see if Greece actually follows through."
Because Greece operates on the euro, though, it lacks some options open to countries with their own currencies. In particular, it can't devalue its currency to stimulate its export economy. But Busch says that for Greece to abandon the euro isn't the answer. "It would be really foolish for them to do it," he said. "Overall, the whole system loses value because of that."
Was the euro just a pipe dream?
Greece's difficulties highlight the larger problem with the euro zone's monetary union. "The global recession is when you get a better understanding, because it's really a stress test for the union," Busch says. "Going forward, I think they have to fix the structure of what allows one to remain in the eurozone and come up with rules that specifically kick people out if they don't meet them. That's really the question. It's enforcement."
That won't be easy. Eurostat, the EU's statistical authority, doesn't have the power to regulate and audit public accounts of member countries. And Greece isn't alone in bending the euro rules. According to The Wall Street Journal, France negotiated with France Telecom (NYSE: FTE ) in 1997 for a lump-sum payment of 5 billion euros in exchange for assuming the company's pension liabilities. That payment was instrumental in cutting the country's budget deficit for that year below the key 3% threshold for euro admission. Also, Italy used currency swaps to trim its reported deficit in 1997, and Portugal was forced to correct accounting misclassifications in 2001 that resulted in its deficit nearly doubling.
Some say Spain could be the elephant in the room and the real test for the EU. It's the eurozone's fourth-largest economy, comprising roughly 12% of the eurozone's GDP. Greece accounts for just 2%. Spain's budget deficit ballooned to 11.4% of GDP last year, and some want more spending to stimulate its economy. Only time will tell what other surprises this low tide will bring.