Beware the Greeks: They have no Gifts to Bring to the Party

The future of the planet may hinge on the deliberations under way in Denmark, but the eyes of many Europeans will be fixed on a country rather further to the south. For the future of the eurozone may hinge on the grim developments under way in Greece, a usually delightful country that accounts for less than 3 percent of the European Union's gross domestic product.

Greece is hurting. Its two prize industries are shipping and tourism. Shipping has been badly hit by the fall in world trade, and cargo rates are currently bumping along near the bottom of a 25-year low. Tourism has been hurt by the general recession in Europe but also by Greece's misuse of the euro currency. And years of massaging the economic statistics have battered the country's credibility.

The comfort blanket of the euro tempted recent Greek governments to live and spend far beyond the country's means, while prices for tourists remain high. They are much cheaper in Turkey, its neighbor and rival for the tourist euro, because Turkey was free to devalue its currency.

So Greece this year faces a budget deficit of 12.7 percent, with its debt soaring above 100 percent of GDP and the new center-left government reluctant to slash public spending in the draconian way the Irish did last week. So Greece now has to pay 2.5 percent more interest on its euro-denominated bonds than Germany does, and the downgrade of its debt from AAA- to BBB+ status means that the European Central Bank may be unable to accept them as collateral for loans.

This should be a Greek crisis, but the euro dimension makes it start to look like a European one, because several other eurozone countries are in similar difficulties. If members of the eurozone cannot be bailed out, then the credibility of the euro is in deep trouble. The ECB is hoping that the Greeks take the bitter Irish medicine, or that Greece turns to the IMF (which could to the same thing).

The question the ECB does not want to ask is whether Germany, the backbone economy of the euro, will stand by its partners. Germany's own borrowing is set to double next year to 6 percent of GDP, after its GDP shrank this year by 5 percent. The main reason for the increased deficit is the government is trying to revive the economy with tax cuts and more labor-market subsidies.

"Public finances are in an extremely strained state due to the dramatic weakening of overall economic activity," said a joint statement of finance ministers from the country's 16 states and Finance Minister Wolfgang Schaeuble.

Germany's unemployment has remained low because of a government measure to subsidize short-term working, paying up to 67 percent of an employee's salary to prevent layoffs, even when a company has few customers. This has worked in the short term, but unless German exports revive soon it is likely to prove unsustainable, and if the subsidy stops German unemployment will soar above 10 percent. At that point, it would become politically toxic to talk of bailing out the feckless Greeks.

This brings us to the heart of the matter. Between them, governments and central banks have over the past year pumped about $5 trillion (or 10 percent of global GDP) into fending off another Great Depression. This has supplied a modest recovery, but the private economy has not yet been able to take over the heroic job of sustaining it.

"We have not yet achieved self-reinforcing recovery," former Fed Chairman Paul Volcker warned the Germans in a widely cited interview with Der Spiegel last week. "We are heavily dependent upon government support so far. We are on a government support system, both in the financial markets and in the economy."

The G7 economies are approaching the ugly moment of transition. The massive deficit spending by states and liquidity creation by central banks cannot be long maintained. They are running out of ammunition. Within the next six to 18 months, they will have to rein in the deficit spending and increase interest rates, and hope that the private economy will by then have recovered sufficiently to restore growth. It is very questionable whether the private economy is healthy enough to do this. And in the case of weak economies like Greece, governments will then face an ugly choice between depression and default.

The crisis may come sooner, because of the growing threat of a major currency crisis. Since China will not revalue its currency and alleviate the problem of chronic imbalances, the United States is letting the dollar fall against more flexible currencies. This is pushing the burden of adjustment onto the euro and the yen in a way that is becoming unsustainable for eurozone exporters.

A currency crisis would be disastrous and probably trigger a wave of populist protectionism against Chinese exports. That is the main reason why the "recovery" is so unconvincing and also why gold remains above $1,000 an ounce. The risks are ahead are as daunting in Greece as they are in Denmark.