Greece Rattles the Euro Zone

As the global financial crisis rocks Greece, Europe faces a question as basic as they come: What do you do when a one-size-fits-all currency no longer fits all? On Dec. 8, Fitch Ratings downgraded Greek government debt, based on new estimates that the country's budget deficit was out of control. The rating revision spooked Europe's markets as investors fretted that Athens might soon default on its bonds.

Greece and other European countries that use the euro lack the options the U.S. has in fighting a recession. To combat sinking demand, Washington can run huge budget deficits while cutting interest rates to near zero and allowing the dollar to depreciate. Under EU rules, Greece's deficit isn't supposed to top 3% of gross domestic product (though it has almost always done so, and the level today is 12.7% of GDP). And it can't devalue its currency to ramp up exports because it gave up the drachma for the euro in 2001.

The strains on the euro zone are emboldening those who question whether it makes sense to lock such disparate nations into a single monetary policy. "The current situation in Greece shows the problems created by a single currency," says Martin Feldstein, a Harvard University economist who is perhaps the euro's most prominent skeptic. For much of the past five years, the European Central Bank pursued a relatively loose monetary policy to keep France, Germany, and other large northern economies growing. But the likes of Spain, Ireland, and Greece needed tighter policy to keep from overheating. "The single currency enabled Greece to issue enormous amounts of government debt until it reached the current crisis level," Feldstein said in an e-mail interview.

THE EU'S QUANDARYFitch cut Greece's rating to BBB+. That's a problem because the European Central Bank isn't supposed to accept sovereign debt as collateral for loans to commercial banks unless the debt is rated A- or higher. Although those rules have been relaxed during the financial crisis, they're slated to go back into effect in 2011. If the ECB doesn't make an exception for Greece, Greek banks that hold lots of bonds issued by Athens will be cut off from an important source of funds.

Europe is in a quandary over how to cope with Greece's crisis. Sticking to the budgetary rules could deepen the pain for ordinary Greeks. But not enforcing the regulations will make the EU look like a pushover and invite weaklings such as Spain, Italy, and Ireland to demand similar treatment—which would increase the risk of inflation across Europe and undermine the integrity of the euro.

Although the single currency is likely to make it through this crisis, it could face an even bigger one next spring when billions of euros in Greek government debt must be refinanced. Athens is already paying more to borrow because of the perceived risk, and now Standard & Poor's is also reviewing Greece's credit rating. "It's five minutes to midnight for Greece," former Bank of England policymaker Willem H. Buiter said in a Bloomberg Television interview.

To win back the confidence of investors, Greek Prime Minister George Papandreou will have to jettison campaign promises he made in the runup to October elections. He had pledged to increase state-sector salaries faster than inflation and boost stimulus spending. Now he'll be forced to rein in government outlays dramatically since the European Union fears the precedent a bailout would set, says Lena Komileva, an economist at brokerage Tullett Prebon in London. Spending cuts will hurt, but in the long run they will be better than a default, which would drive up Greek interest rates for years. Even worse, though, would be an exit from the monetary union. "That," says Komileva, "is too painful to contemplate."

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