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But there are more issues that arise in the scenario in which Greece is given a second chance and kept inside the EMU. The slippery slope is that if the bond haircut is high, then Portugal, Ireland, Spain and Italy see that Greece has been given a second chance with much of its debt forgiven, they will want the same treatment. After all, why should these countries institute austerity to pay the private sector and often foreign debt holders when Greece doesn't have to.
In order to avoid the contagion that the others will want the same deal as Greece, there will have to be a consequence that dissuades them. The only consequence I can think of that is serious enough to dissuade them is expulsion from the EMU. Therefore, in order to avoid contagion under a scenario of an 80% bond haircut, it is essential that Greece leave the monetary union, and that the EU set up and strictly enforce expulsion criteria.
Ultimately, though, because the four problem countries all have the same entitlement mentality, they will never be able to maintain the required fiscal discipline, and will ultimately be expelled. Apparently, the European politicians recognize this. So, the 22.5% haircut deal currently on the table simply kicks the can further down the road. The deal on the table cannot ultimately work.
European Bank Capital Issues
No matter how it is sliced or diced, Europe's major banks are undercapitalized, and that is being kind. If the sovereign debt they hold is marked to market, they are all insolvent. As we know from America's S&L crisis in the '80s and from the recent '09 meltdown experience, a financial institution can operate in an insolvent condition for years, as long as it can get liquidity. In fact, there may still be such zombies in the U.S.
Enter the European Financial Stability Facility (EFSF). It's function will be to support (i.e., buy) the underwater sovereign debt held on the books of Europe's financial institutions at prices significantly above market, thus transferring the ultimate losses from the private sector to the taxpayer. The Fed did this in '09, purchasing billions of mortgage-backed securities at above market prices from U.S. financial institutions. In effect, this is equivalent to the taxpayer making a capital contribution to the banks without receiving any ownership interest. This is just a gift from taxpayers to stock and bond holders.