Germany and France Will Not Let Greece Default

In 1997, the European Union established the Stability and Growth Pact. The main objective was to maintain fiscal discipline in countries adopting the Euro. However, very few envisioned that after a few years, Greece would be close to default on its debt and only a minority of EU members would be respecting the basic rules of the stability pact.
Anna Fedec, 2/10/2010 7:52:34 PM

Indeed, according to the Stability and Growth Pact, members of the Euro Area should respect two rules: an annual budget deficit no higher than 3% of GDP and a national debt lower than 60% of GDP. Yet, because each Euro Area member enjoys the benefits of having the same currency and the same level interest rates, many countries thought would be safe to leverage their economies. So many took advantage of historical low interest rates to expand their government expenditures and improve social benefits in their own countries. And as long as national economies were performing well and tax revenues were enough to cover the spending this macroeconomic strategy worked pretty well. Not surprisingly, all that spending proved to be unsustainable and the worst recession since World War II is bringing Greece, Portugal, Spain and Ireland to the brink of a very serious debt crisis.

However, we don't expect Greece to default on its debt because other EU members have too many investments in that country. Indeed, since the single currency was introduced, investors had been primarily focused on the Euro Zone economy as a whole. With  no discussion whatsoever on macroeconomic fundamentals of individual countries and in the complex relationship that exists between the EU members. For instance, Germany and France hold a sizable amount of other EU countries debt. In particular, Germany and France are the biggest holder of Greek bonds. So, the default of any European country will have immediate consequences for the EU largest economies. Having said that, we do expect a EU solution for those countries debt problems which will probably be painful and take a few years to produce any positive results.