The Greek Tragedy continues. To try make some sense of this, let’s look at the key players.

First, Greece: The country is mired in a deep recession with rising unemployment and increased risks of social and political instability. Greece has a massive budget deficit, which needs to be financed. Taming the deficit is being made very difficult by the recession, which is reducing tax receipts and increasing expenditures for social programs, and by sharply rising interest rates, which will have to be paid on new debt issued to finance the deficit and to roll-over maturing debt.

So Greece is in a Catch-22. Any credible plan to quickly reduce its budget deficit will only exacerbate economic conditions, deepening the recession and further increasing unemployment and poverty rates. But without any such plan, interest rates will continue to climb exacerbating the budget deficit. Greece is damned if it does, and damned if it doesn’t.

By the way, in 2008 in the midst of the Great Recession, the International Monetary Fund (IMF) called upon all major governments to provide a fiscal stimulus of at least 2% of their respective GDPs. The IMF was not concerned with the effects on government budget deficits. Rather, the IMF was concerned with turning around the global economies. Yet, with Greece’s economy in far worse shape than the economies of most of the major countries in 2008, Greece is being told to tighten up its fiscal policy.

Next, the debt: There are two components to this debt – the outstanding debt, and the new debt. The outstanding debt, much of which is held by European banks, especially German-headquartered banks, has lost much value. If the banks are following mark-to-market rules, then they already have absorbed substantial losses on their holdings of Government of Greece debt. However, Greece has not benefited from these write-downs. Greece’s interest and principal payments are still based on the face, not market, values of the outstanding debt.

It would seem like a straightforward matter for the holders of the debt to convert the outstanding debt into new debt at a conversion rate equal to current market values. This would help Greece and not have any further negative consequences for the debt holders. But, of course, the debt holders prefer that they get bailed out a la Goldman et al with AIG. That is, they want someone else, the IMF for example, to “bail out” Greece so that they can be re-paid in full. If this were to happen, the banks would record substantial profits, and undoubtedly some bankers would receive enormous bonuses.

Greece probably can continue to issue new debt, but at ever increasing interest rates. Herein lies one of the problems for Greece. As I pointed out, high interest rates, together with a rapidly deteriorating economy, make it very difficult, if not impossible, for the government to reduce its deficit in a short period of time.

Finally, Germany: German politics make it difficult for Chancellor Merkel to support any package of assistance for Greece. This is just another example of the electorate not being able to handle the truth, and political leaders abdicating their role as leaders. An economic collapse of Greece would spill over to other members of the EU. This in turn would negatively impact German exports and economy. Germany is dangerously close to falling back into recession. A default by Greece also would negatively impact a number of German banks, thus possibly requiring a bail out of these banks. Germany cannot escape the repercussions of a collapse in Greece.

Is there a way out?

I have argued before that the obvious solution consists of the following: The EU collectively guarantees newly issued debt by Greece until Greece has reduced its deficit to GDP ratio to the EU limit. This would significantly reduce interest rates for Greece, and might not cost the EU anything. The debt holders take a haircut at least equal to what they have lost thus far. (I suspect that this threat alone would lead to a remarkable recovery in Greek bond prices.) And Greece commits to a path of fiscal prudence, but one that starts slowly so as to not worsen current economic conditions, and ramps up as the economy begins to improve.

The opinions expressed in this blog are personal and do not reflect the views of either Global Brief or the Glendon School of Public and International Affairs.