When Greece defaults…

…it probably won’t be called that.  Some will note that it is a default, and those who do will be shouted at by “all the cool kids” in Frankfurt. 

Calling it default means that those investors in Greek sovereign debt who bought “credit default swaps” — in essence, insurance against the Greeks defaulting — get to collect on their policies.  But collecting on those policies will be very expensive for, um, the cool kids.  So they won’t call it that, so the insurance policies won’t pay off.  No matter what Fitch says,

“It is going to happen. Greece is insolvent so it will default,” [said] Edward Parker, Managing Director for Fitch’s Sovereign and Supranational Group in Europe…”So in that sense it shouldn’t be a surprise to anyone.”

The Fitch comments come after Moritz Kraemer, head of Standard & Poor’s rating agency’s European sovereign ratings unit, said on Monday Greece would default shortly on its debt obligations.

That was last Tuesday, and over this weekend bargaining continued, as the bondholders try to extract a little extra out of their bad Greek bonds.  In short, they have to trade 2 euros of bad bonds for 1 euro of good new ones, paid for by fresh financing from the EU which is to meet Monday.  Greece has until March to get this settled; that’s when many of the old bonds come due.

What happens if they don’t?  The Financial Times offers a nice graph describing the options.  If they work out the deal, the game continues.  There are no defaults (at least, none anyone wants to recognize), the EU ministers continue to negotiate their closer fiscal union (a/k/a, “we’re all Germans now!”) and the money shows up to back the weak periphery currencies.  It keeps hope alive.  That’s a bit of a problem for us in the US, because until the details are worked out the dollar strengthens, which is great for Ricocheteers traveling to Europe but lousy for the farmers here in central Minnesota. When the deal is finalized the euro strengthens, reversing the trend. That’s the optimistic outcome.

Suppose Greece has to leave the eurozone.  It needs to because it needs foreign exchange to pay for these bonds, and the only way it can do that, eventually, is to reduce the real value of its workers’ wages by introducing a new drachma, reduce its value versus the euro, and thus improve its ability to pay off debt with cheaper currency.  (Explanation from John Mauldin.)  The Germans don’t want this and that’s why they are helping out Greece.  But the pressure in Germany to stop this, to stop bailing out perceived Greek profligacy, will eventually force Merkel to relent and permit the Greeks to leave.  The new bonds being negotiated will have stipulations on what happens if Greece leaves the eurozone.  (I don’t know that, but it would be foolish to do otherwise.)

The part we can’t predict and must watch for 2012 is how the other periphery countries, the PIIGS-less-the-G, respond to whatever is worked out for Greece.  Because Greece is the precedent, an extralegal ad hoc workaround the Maastricht Treaty that created the euro.  Make the terms too generous to Greece, and you invite Portugal and Spain to seek similar terms.   Of course, Europe cannot afford to offer those terms to Portugal and Spain.  But make it too harsh, and Merkel will be explaining why Greece needs another bailout in the next election, one she would likely lose even if she could survive an intra-party revolt.  Her fate is tied to Athens, despite her every attempt to spin away.

Let me point to one path in that FT chart that most people ignore.  Merkel’s hole card in the negotiations over Greece and the fiscal union is the threat of leaving.  What would the eurozone be without Germany, particularly if it could take Netherlands, Austria and maybe Finland with it?  It would die.  I am not predicting it will happen, but don’t be surprised if it becomes a speculation more widely discussed in 2012.