Europe prepares for a 'Grexit'

European stock markets were battered overnight as investors fretted that Greece's continued political stalemate made it ever more likely that the country will default on its debts, and be forced out of the eurozone.

Athens recorded the biggest decline, with its stock market closing 4.6 per cent lower. Madrid and Milan both recorded falls of 2.7 per cent, while Paris dropped 2.3 per cent and Frankfurt saw a 1.9 per cent decline. At the same time, investors flocked to assets they believe to be "safe havens”, pushing yields on German, UK, Dutch, Swedish and Finnish government bonds to record lows.

Investors are dismayed at the clumsy attempts being made by Greece's political leaders to find a solution to the country's growing political crisis. Later today, the leaders of Greece's main political parties will meet to discuss the latest compromise proposal put forward by the country's president, Karolos Papoulias, which would see the formation of a coalition government made up of technocrats. The new government would have the task of softening and renegotiating the harsh austerity conditions imposed on Greece in exchange for its latest €130 billion ($US166.7 billion) bailout.

But the leader of the Socialist Pasok party, Evangelos Venizelos has already admitted that he is "not optimistic” about the chances of forming a unity government, while Democratic Left leader Fotis Kouvelis has scorned the idea, saying that "a government consisting of technocrats is proof of a defeat of the political system."

Investors are worried that Athens will have its aid money cut off because of the country's continuing political paralysis, and could soon start defaulting on its debt payments. According to the Greek newspaper Ta Nea, Greece's outgoing prime minister Lucas Papademos has warned the country's political leaders that Greece will struggle to cover its cash payments in June unless the country receives fresh aid money.

At the same time, European leaders are increasingly canvassing the prospect of a Greek exit from the eurozone – or "Grexit” as it is now commonly known. Overnight, German Finance Minister Wolfgang Schuble warned Athens that "the price would be very high if they decided to leave the euro". |

The respected German publication der Spiegel reports that in Berlin, advisers to the German Chancellor, Angela Merkel, worry that the present situation in Athens is similar to the ill-fated Weimar Republic. "Back then, the Germans perceived the Treaty of Versailles as a supposed 'disgrace'. Now, the Greeks feel the same way about the austerity measures imposed by Brussels. And, as in the 1920s in Germany, the situation in Greece today benefits fringe parties on both the left and the right. The country's political system is unravelling, and some advisers even fear that the tense situation could lead to a military coup.”

According to der Spiegel, Schuble has set up a special task force to work out contingency plans in case of a Grexit. A big problem is that the European Central Bank owns around €35 billion in Greek government bonds. If aid to Greece is cut off, the ECB will suffer heavy losses on its Greek bond holding.

But Schuble's task force has come up with a solution, according to the der Spiegel report. Under a Grexit, the Greek government will no longer receive aid money to pay for things such as pensions, or the wages of Greek public servants. But Brussels will make sure that that part of Greece's aid money is paid into a special account, so that the ECB continues to receive interest payments on the Greek bonds it holds. In exchange for this special treatment, the ECB has promised to buy up the bonds of debt-laden eurozone countries if their yields rise after a Grexit.

Der Spiegel notes that efforts to salvage the Greek economy have failed. The country is now in the fifth year of recession and economic output has shrunk by a fifth. Unemployment is close to 22 per cent, and for young people it is at more than 53 per cent. For the first time in Greece's postwar history, there are more people out of work than employed in the country. "Only a Greek withdrawal from the eurozone will give the country a chance to get back on its feet in the long term”, it argues.

What's more, it notes, a Grexit, would demonstrate to other debt-laden eurozone countries, such as Portugal, Spain and Italy, that austerity is non-negotiable. As der Spiegel notes, Alexis Tsipras, the populist leader of the radical left Syriza party which rejects the country's austerity program, "is merely expressing views that are already widespread within large segments of the Athens establishment, namely that the Europeans will ultimately give in and pay up, because they fear a Greek bankruptcy as much as people in the Middle Ages feared the Black Death".