The issue of sovereign debt is quickly exploding into front page news, as it should. Sovereign debt is essentially the "sub-prime" crisis on steroids, and Greece gives us a glimpse of our future if we don't implement fiscally conservative policies.

The U.S. media seems to be completely preoccupied with the last financial crisis and with Arizona enforcing immigration laws. Meanwhile, we have a potential meltdown erupting in Europe. And depending on how it plays out, this could make the financial crisis of 2008 look like child's play. Instead of banks going bankrupt, entire countries are teetering on the edge.

The potential consequences are enormous.

Update 5/6/2010 2:30pm: A few hours after posting this article the stock market had an incredible intraday 1000-point loss. An article at the Wall Street Journal included the following quote which touches on exactly what I wrote about above--that the potential risk with a sovereign debt crisis could make the sub-prime/housing crisis look trivial in comparison.



Investors said they were worried about potential contagion from Greece's ongoing problems, and whether eventual losses could even exceed those of the U.S. housing collapse.

"You worry about the a domino effect, from Greece to Portugal to Ireland and Spain," said Richard Schottenfeld, general partner of Schottenfeld Associates, a New York hedge fund. "Pretty soon, those kinds of losses are bigger than housing."

The Greek Crisis: A Brief Background

The problem is essentially a repeat of our housing crisis, but instead of too many sub-prime homeowners borrowing money they couldn't afford, entire countries have borrowed far too much money and now can't pay it back.

The current problem is Greece.

Greece owes at least 120% of its Gross Domestic Product. . Like many countries, Greece is suffering a tough economy. And, like many other countries, Greece has made far too many spending promises--including to its civil servants. It's no longer able to balance its budget without draconian spending cuts or tax hikes. Attempts to reduce spending in March led to street protests that shut down transportation, and an attempt was made to storm the Greek parliament. Crowds were dispersed with tear gas.

Greece simply cannot meet its obligations. So, as a member of the European Union, it has appealed to other EU states to bail it out. The problem is that Germany hasn't been all that eager to spend its money bailing out Greece. In the absence of a concerted response from the European Union, the International Monetary Fund (IMF) eventually got into the picture.

In the meantime, the markets became increasingly doubtful that Greece would be able to get through this without defaulting or restructuring its debt--either of which means investors lose money. So, not surprisingly, investors are demanding that Greece pay far higher interest rates in order to lend it money since they demand higher reward for the higher risk. The higher borrowing costs make Greece's financial situation even worse, and the cycle continues.

In the face of all of this, S&P lowered Greece's bonds to junk status. This caused interest rates charged for Greek debt to spike even higher.

But not only did S&P downgrade Greece, it downgraded Portugal's bond rating as well. Portugal has a debt of 80% of GDP and its interest rates also spiked. The next day, S&P downgraded Spain's debt.

Although the European Union and the IMF finally got together and bailed out Greece with a $145 billion aid package, the value of the Euro continues to drop against the dollar as investors worry about Greece's ability to implement the conservative economic policies demanded by the agreement (Especially in the face of growing Greek protests opposed to the massive spending cuts ) and the risk of the debt problem spreading further throughout Europe.

Europe at Risk

Greece originally was looking for something along the lines of $30 billion to solve its current-year problems. The EU and IMF decided that only a larger, three-year package would give Greece time to get its financial house in order and calm the markets. So Greece was given a $145 billion, three-year package. The bailout of Greece was at least as much about giving markets confidence in the Euro--and Europe's willingness to defend it--as it was about saving Greece. By supporting Greece, Europe demonstrated that it was willing and able to address a major financial crisis in the Eurozone.

Nevertheless, the value of the Euro against the dollar continues to plummet and markets continue to be very nervous. The day after the Greece bailout details were announced, article headlines included "Financials Weaken On European Debt Fears" and "Global Economic Concerns Dent Retail Stocks" and stock markets around the world fell--the DJIA by more than 2%.

Despite a monumental bailout of a sovereign nation, the markets remain very nervous. The fact that a bailout of this size--four times larger than was originally requested by Greece--has not calmed the markets is, in itself, disconcerting.

Consequences of Sovereign Debt Crisis

As it stands, the value of the Euro is dropping which is causing the dollar to rise. Investors with money in Europe are selling their investments and taking them to the U.S. Of course, investors in the United States are spooked so they're selling their investments, too--witness the large drops in the stock market over the last two weeks.

So where does all this money go? Most likely to U.S. Government Bonds. That's perfect from President Obama's point of view since the U.S. Government still needs to borrow trillions of dollars per year to finance his spending. This also has the side-effect of putting downward pressure on interest rates, including mortgage rates. Indeed, since Greek's debt rating was reduced two weeks ago, the interest on 10-year U.S. Treasury bonds has dropped from 3.82 to 3.46.

However, the long-term situation is much less attractive.

In a "best case" scenario, the lower rates allow the U.S. Government to more easily borrow trillions and trillions of dollars that will be added to our national debt. That will exacerbate our current fiscal trajectory such that we will, one day, be facing the same problems Greece is facing today.

The worst case scenario is that the markets continue to be nervous about sovereign debt, starting with Portugal, Spain, and Italy. At that point Europe would be under extreme pressure. It would either have to bail out those countries at enormous cost, or the Euro itself may collapse and be abandoned by the strongest economic powers of Europe.

Regardless of whether or not the Euro collapses, the "contagion" effect of concerns about sovereign debt could get to the point where investors realize that even the United States really isn't a flight to quality. If investors are concerned about loaning money to Greece, with a debt of 120% of GDP, why shouldn't they be concerned about loaning money to the U.S. with a debt approaching 100% of GDP--and expectations for our debt-GDP ratio to continue to increase.

If investors get spooked to the point that they're afraid to loan money to the U.S., things would get "interesting" really quick. And not in a good way.

The United States would either be forced to immediately cut spending on a massive scale, or the Federal Reserve would have to rev up the printing presses. Such massive and sudden spending cuts (exactly what Greece is going through now) would cause unemployment to go up and we'd be looking at an extended, painful recession that would dwarf what we're already going through. Or, if the Federal Reserve just starts printing money, we'd essentially become a banana republic--inflation would go through the roof and there'd be extreme pressure for the world to abandon the dollar as its reserve currency which would bring its own new set of problems.

The Problem Is Spending and Debt

As has been the story now for years, the problem is spending and debt.

The debt problems of the 2008 financial crisis were sub-prime homeowners, banks, and investment firms. With bailout after bailout--both in the U.S. and abroad--many of these bad loans were essentially transferred to the national governments. The bad loans didn't go away, their negative impact have just been absorbed by governments.

But the governments don't have any money, either. Countries around the world have been running insane levels of deficit spending for years, and it's only getting worse. Years of spending on things countries cannot afford have created national debts that are unmanageable. And investors are getting to the point where they no longer trust sovereign governments to pay back the money they're borrowing.

This is more than just esoteric economic theory. We've already seen rioting and protests in Greece that have led to deaths. This could get worse, and spread. There are security implications to any financial meltdown.

The potential impact of what's going on in Europe right now is hard to overstate. No-one knows exactly what's going to happen and when, but it's hard to imagine a pretty ending.

The situation in Greece gives us a glimpse of our future. If we continue on our current course of excessive spending, it's just a matter of time until we face the exact same challenges as Greece. Yes, we can get away with it longer because we have the world's reserve currency. But that doesn't make us immune to the same economic realities that are sinking Greece and threatening Europe. It just lets us first get even further in debt so that the eventual impact with reality will be even worse.

It's not too late. We could start making the tough choices today. We could start reducing spending rather than increasing it. We could start reducing the federal government's workforce. We could start tackling the problem of entitlement spending in an honest and serious way. And we could immediately stop our misguided Keynesian-based deficit spending and make an about-face towards fiscal sustainability.

Doing this will not be easy. It will, unfortunately, require bold and gutsy politicians that are more concerned about the future of our country--and of future generations--than they are about their own political careers. It will require politicians that will stand firm in the face of riots in the street such as what is happening in Greece. In fact, it won't just require politicians: it will require statesmen, leaders, and true patriots at all levels of government.

I hope we elect those leaders because nothing less will be required for us to avoid Greece's fate.

Update 5/7/2010: The day after publishing this article, the following article was posted at Fox.



Some lawmakers and analysts are sounding the alarms over America's fiscal policies and deficits, warning that Greece's financial crisis could be coming to a neighborhood near you... It helps that the world's reserve currency is the dollar, he said. But he added that if bond investors lost trust in the U.S. like they did with Greece, the dollar will not save the country.