Why Greek debt matters to EU, U.S.

If Greece reneges on its debt, global investors will panic. They would no longer have faith that similarly debt-challenged EU members will pay their debts, so that would raise their borrowing costs. This could mean similar defaults for Ireland and Portugal.

That series of events would be a worst-case scenario that would not only have serious implications for Europe, but the U.S. and the rest of the world.

At a minimum, a Greek default would total $485 billion, but would likely be much more when factoring credit default swaps that would be executed. Credit default swaps are investment products purchased by investors who are betting that a country will default on its obligations.

If Greece defaults, then the solvency of mainly European financial institutions would be in question. They could be on the hook for unknown multiples of that amount as they also pay up on the losing side of the credit default swap. This could easily cause a globalwide recession that would probably include the United States.

There is a feeling within the global economy that Europe realizes that Greece is too big to fail, which can create a moral hazard. The moral hazard is that this implicit guarantee of the EU, ECB, and the International Monetary Fund will result in Greece never seriously addressing its fiscal imbalances because it has faith it will be bailed out.

As a result, Greece continues to believe it can negotiate more favorable repayment terms without having to go through more painful government spending reductions and tax increases.

The downside of Greece depending on an expensive bailout is the inherently bad political fallout for Germany, France and other European countries. Any bailout would eventually come from the taxpayers — a very difficult sell for German Chancellor Angela Merkel and French President Nicolas Sarkozy. Their political fate limits their flexibility in dealing with Greece, so it is uncertain how far they will go in working with their poor southern neighbor.

As for the bond holders of Greek debt, history tells us that bond investors are very reticent to provide significant debt relief. That places more pressure on European authorities to funnel more funding to them.

But even if the bond investors were willing to accept huge losses, this would impact future financing of other activities. Many of the bond holders are financial institutions and large institutional investors, so any losses that they accept will negatively affect their liquidity. Less liquidity will mean less credit available for businesses and consumers, driving up interest rates while driving down economic activity.

There are not too many attractive options here. The best option is for the EU, ECB and the IMF to step in and pay off the bond holders, but that would create a precedent that could involve bailing out Ireland and Portugal, along with possibly Italy. That is potentially a very expensive solution that would severely impact the economic performance of Europe into the future.

Yet even with that awful scenario, allowing Greece to default could set off even more cataclysmic results.

Aaron Johnson is an assistant professor of economics at Darton College in Albany.