By Marc Chandler
RealMoney Contributor

Greece lies at the center of the Europe maelstrom. The proximate trigger was the election of a new government last October that had the audacity to reveal a deep, dark secret — that Greece’s deficit was close to three times larger than it had previously acknowledged.

Prime Minister George Papandreou was contrite and has cobbled together a general plan (effectively reversing many of his campaign promises) that claims to reduce the deficit from 12.7% in 2009 to 3% in 2012 — a herculean labor if there ever was one.

There Will Be Blood

Things have turned ugly in recent days. Interest rates have soared in Greece; the premium over Germany widened sharply; the cost of insurance skyrocketed — it is now roughly twice what it was at the start of December. Eurozone officials have condemned Papandreou proposals with faint praise. The Dutch finance minister suggested that it was a nice first step but not sufficient and said more substantive measures were needed.

Others claimed it relied too much on one-off measures, like asset sales and a public-sector hiring freeze and wage cap for some civil service workers. Even Moody’s, which seems to be genetically predisposed to be optimistic, said that while the proposals were “relatively well designed,” it would keep its negative outlook for its sovereign credit rating on the country.

The market is not waiting for the formal EU process. It smells blood. Even if Greece’s economic forecasts were credible — which they are not — it is inconceivable that Greece will achieve its stated objectives. The combination of tax increases and spending cuts that would be necessary is simply not politically or socially acceptable.

Papandreou proposes cutting spending and raising revenue by 10 billion euro, or nearly 4% of GDP this year, which would reduce the deficit to about 8.7% of GDP. Such a move is going to exacerbate the recession from which Greece has yet to emerge. The deeper and more prolonged economic contraction will boost some countercyclical spending and in turn offset some of the fiscal consolidation. As counterintuitive as it may seem, addressing the structural deficit could very well exacerbate the cyclical shortfall.

Moreover, Greece needs to raise around 53 billion euro this year, a quarter of which (about 13 billion euro) is simply to service the debt (i.e., interest payments). Some debt was placed privately this month, without an auction, and this exercise could at least in part be repeated next month.

But the real crunch comes in the second quarter, when the government projects bond maturities of some 16 billion euro and the intention of raising around 26 billion euro. Greece is exploring tapping the global capital markets with dollar and perhaps other foreign currency issues. And of course Greece is not the only country that will be issuing bonds; in fact, the competition is rather fierce.

Return of the Repressed

Greece’s woes are to a large extent of its own making. With an economy among the smallest in the eurozone at roughly one-tenth of Germany’s, it needn’t trigger a crisis. However, it has exposed a fatal flaw at the heart of EMU: monetary union without political union.

With monetary sovereignty surrendered, members found the creative use of fiscal policy as a politically expedient way to disguise the loss of competitiveness — and that’s not limited to Greece. The incompleteness of European unification allowed the evasion of the structural problems. The global financial crisis and the policy response, the euro’s persistent strength (which has been one of the strongest currencies in inflation-adjusted terms since its advent in 1999) and ineptitude of Greece’s political elite are finally forcing a painful confrontation of precisely these challenges.

Many European officials and economists warn that for Greece to be bailed out would create a moral hazard writ large. Some express concern that a bailout would undermine the credibility of the Economic and Monetary Union (EMU), but letting Greece hang (even if it supplied the rope) would also poses significant risks.

In the post-Lehman era, policymakers must be aware of various channels of contagion. If Greece is allowed to default, which under some political calculus may be less painful than structural reforms, interest rates through the region will likely rise sharply. Such an event risks exacerbating the economic downturns and could even reignite an acute financial crisis.

It is not just the periphery of the eurozone, countries such as Portugal and Spain, that could become tarred with the same brush as Greece — some core members could be at risk. Belgium’s debt-to-GDP is around 90% (the Stability and Growth Pact limits it to 60%) and alongside Austria has banks most exposed to the fragile Eastern and Central European countries.

Greece’s political elite remains committed to EMU. The cost of unceremonious unilateral exit would not necessarily solve Greece’s problems and could very well risk a sharper economic downturn even if it recoups some competitiveness, which in turn may be quickly eroded by inflation, high interest rates and a fiscal policy that still needs to be brought under control.

Even if the other members wanted to, there does not seem to be a mechanism by which they can eject Greece from the monetary union.

It may take European officials a little while to get their heads around the fact that they are damned if they do and damned if they don’t, but they don’t have much time. By midyear, the challenges Greece will encounter placing its debt could lead to a downgrade; this downgrade is so important because it would mean that next year the ECB will not accept Greece’s sovereign bonds as collateral for its monetary operations. Needless to say, such an event would spark a banking crisis that might make the 2007-2009 crisis seem like a tea party.

If a European institution (such as the EU, European Central Bank or European Bank for Reconstruction and Development (EBRD)) or some coalition of willing countries cannot find a way to lend Greece funds, the International Monetary Fund has demonstrated a willingness and ability to step into the breach. The IMF would likely demand various concessions from Greece which could include an erosion of sovereignty in terms of budget issues. Fiscal stimulus would be verboten. The country’s statistics office may be manned by non-Greek professionals. There may be scope for political concessions too in terms of Cyprus and Greece’s refusal to let Macedonia join the EU and NATO.

The eurozone cannot evade its structural problem anymore than Greece can. To avoid the moral hazard problem, proactive measures have to be taken. Even if a small horse has left the barn, it is not too late to bar the door and prevent future end-runs. New institutional mechanisms are needed. The union needs to broaden to include fiscal policy, and this appears to require the completion of the historic ambition of the political unification of Europe.

**** Marc Chandler has been covering the global capital markets in one fashion or another for nearly 20 years, working at economic consulting firms and global investment banks. Currently, he is the chief foreign exchange strategist at Brown Brothers Harriman. Recently, Chandler was the chief currency strategist for HSBC Bank USA. He is a prolific writer and speaker and appears regularly on CNBC. In addition to being quoted in the financial press, Chandler is often a guest writer for the Financial Times. He also teaches at New York University, where he is an associate professor in the School of Continuing and Professional Studies. While Chandler cannot provide investment advice or recommendations, he appreciates your feedback; click here to send him an email.