By forcing further "austerity" on the Greek economy in order to give them enough aid to pay the upcoming round of bond maturities at par, and therefore "saving" those particular bondholders, they are just prolonging the whole issue. Even more austerity will further undermine the Greek economy causing ever widening deficits. So, why are the bondholders so sacred? The answer, of course, is that the European banks hold huge positions in the sovereign debt of Greece and the other high-debt European Monetary Union (EMU) nations.

Kick the Can: Liquefy European Banks

With huge volumes of such debt on their books, each financial institution has become leery of its brethren, and interbank lending has begun to dry up. As a result, The Fed, the European Central Bank (ECB), the Swiss national Bank, the Bank of England, and the Bank of Japan, in a coordinated effort in mid-September, began making dollar swap lines available to the European banks. It appears that the Fed is involved because of Bernanke's view of the Fed as the world's central bank, and because of the fact that the vast majority of America's money market funds hold large amounts of European bank commercial paper or other debt as assets. Thus, instability of the European banking system could potentially touch off another credit market freeze in the U.S. and worldwide. Yet, despite these interventions, within a week those very same liquidity strains have begun to re-emerge.

Kick the Can: Greek Default Inevitable

In the end, a Greek default is inevitable. The math on this is too compelling. Even if Greece could balance their budget pre-debt service, the debt service cost alone, even at reasonable interest rates, doom them to years of depression. For Greece, default is really the best road.

Default is also better for the rest of the EMU. Better to use the funds that are now going to pay off bondholders of Greek debt at par to help recapitalize Europe's banks. In the long run, this is cheaper and it addresses the underlying issue -- European bank capital.

As for Greece, they, and even the other weaker EMU countries, can go back to their own currencies, and, if they so choose, peg them to the euro. If they run large fiscal deficits, the pegs can always be adjusted.

Dealing with Greek Default

A Greek default, of course, risks a financial panic in the markets. To deal with such contagion, the ECB or the EFSF (European Financial Stability Fund) or some pan-European or international entity with credibility, should specify which countries are Tier I EMU countries, which are Tier II (Italy and Spain),and which are Tier III (Greece, Portugal, Ireland). Tier III countries should be planning an imminent, but orderly, exit from the EMU with ECB and EFSF support of their bonds at some price well below par. Tier II countries should be given some time and support (in the form of an ECB or the EFSF bond purchase program at par) to get their fiscal houses in order.

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