NEW YORK — The Greek government’s decision this month to come clean on the true state of its finances has shaken the European Union and posed a life-and-death question for the world’s most powerful trade bloc: Can the EU allow one of its own to go bankrupt?

Greece, followed closely by at least four other EU nations, is so comprehensively over its head in debt that international markets have pounced, driving up the cost of Greece’s government borrowing to the point where default — the international financial term for going flat bust — is a very real possibility.

Read more about the EU deal with Greece. 

And if Greece goes, others may follow. Those others — derisively grouped together as Europe’s “PIIGS” by waggish traders — are Portugal, Italy, Ireland, Greece and Spain. They share a dubious distinction of having debt levels that exceed (or are on target very soon to exceed) their GDP. In simple, Main Street terms, these economies are underwater.

Playing chicken with PIIGS

The response from the EU and its capitals has bordered on denial. Officials in Germany, the EU’s largest economy, have pledged there would be no rescue of Greece and tsk-tsked that all of these piggies would have to put their straw houses in order. The German strategy — which due to the country’s heft in the EU has been adopted in Brussels, too — is the equivalent of telling financial markets, “Move along please. Nothing to see here.”

But the markets aren’t buying it, and as the well-regarded analysts at Danske Bank put it in a report earlier this month, “You can’t put lipstick on a PIIG.” Like many, the bank disregards the idea that the EU would allow any of its member-states to default, arguing that such a move would do to the EU what the Lehman Brothers bankruptcy did to investment banks in 2008. A Greek default, they wrote, “is likely to be highly contagious and would undermine the whole [European] project.”

Yet like the last days of Lehman, Greece and the other PIIGS find themselves under assault from investors seeking to capitalize on their misfortune. Yields on Greek government bonds — which rise in inverse proportion to their market value — have skyrocketed in recent months.
A similar problems is afflicting Portugal, widely viewed as the next most vulnerable, and Ireland. Spain and Italy, while also over their heads in debt, have much larger, more diversified economies and are thought to be better able to withstand the pressure.

Straw houses

That leaves the piglets — Greece, Ireland and Portugal — feeling very exposed in their houses of straw.

Ireland, whose “Celtic Tiger” economy floated earlier in the decade on a sea of real estate debt, in December passed a budget that slashed public sector payrolls, raised new taxes and cut $3.6 billion from national spending — a huge amount in such a small economy — in order to bring its annual budget deficit back down to the 3 percent limit that all countries using the euro pledge to maintain.

Greece adopted its own austerity budget around Christmas and Portugal is due to announce its own austerity budget this week, having been told by the EU that it must get its deficit down from 8 percent to 3 percent of GDP by 2013. The vultures will be watching carefully.

While Ireland’s austerity budget calmed the waves battering it, similar promises from the Greek and Portuguese governments, whose labor unions and other political realities offer them less room for maneuver, are being discounted heavily.

Greeks bearing gifts …

Greece, in particular, has had a difficult time being taken seriously. Greece’s prime minister has promised to cut his nation’s annual budget deficit — now running at 12.7 percent of GDP — down to 3 percent within four years. Last week, his finance minister, George Papaconstantinoue, denied Greece was seeking help either from Brussels or the IMF, in spite of widespread reports that his government is in desperation talks with both.

Even as euro-optimists point to a recovery in exports and industrial activity in the big EU economies of Germany and France in the last quarter of 2009, the prospect that one or more EU states could default on their international financial obligations has sent the euro into a nose dive.

Cynics feel this may suit both just fine for now — after all, the lower euro helps their export-oriented economies recover. But that’s the epitome of short-term thinking. An EU state in default — in effect, a country that goes the way of Iceland in 2008, Argentina in 2001 or Russia in 1998 — would trigger a Mediterranean tsunami as it tumbled into the sea, eventually derailing Europe’s recovery and reverberating far beyond.

The EU’s big nations surely know this and will ride to Greece’s rescue. Through the crisis, which really took root when Dubai experienced a “near death” brush with fiscal reality in late November, the EU’s top officials have refused to commit to any rescue, sticking with the German strategy in what looks like a vain hope that the errant PIIGS could be scared straight.

Time is now running out, however. In effect, regardless of what the Greek finance minister says publicly, the EU is now considering a kind of sovereign TARP program for its weakest members, and like the TARP in America, the idea of subsidizing governments which over-borrowed and make bad bets will be no more popular over there than it was here — no matter how necessary either turn out to have been.

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