Greece's neighbors are the bigger problem

(MoneyWatch) COMMENTARY Yesterday we discussed the fact that the Greek election doesn't revolve Europe's financial crisis. Today, we'll offer some further perspective on the situation, such as the following:
Since its independence in 1829, Greece has spent about 50 percent of the time in default, with five prior episodes.

In other words, there's nothing new here. It's just the history you don't know. Markets have survived prior defaults and will likely survive this one.

It's also important to understand that in relative terms, Greece is a small economy, ranking NO. 42 on the IMF's list of economies, just below Chile. Greece's problem is that its public debt is around 160 percent of GDP and growing. Because Greece is relatively small, what the market is really worried about is the possibility of "contagion," with the crisis spreading to the much larger economies of Spain and Italy. Both have high levels of debt that need to be refinanced by selling government bonds.

The problem is that investors are pulling money out of both countries, worried that the risk of not being repaid is growing. That concern recently has pushed up borrowing costs in Spain through the 7 percent mark -- compared with 4.8 percent in early February -- a level considered unsustainable because of the added costs of paying off the debt. Bond yields soared in Italy this week to more than 6 percent, from about 5 percent in March.

What's perhaps the most surprising development is that while the Chicago Board Options Exchange Market Volatility Index (VIX) broached the 80 level during the height of the crisis in 2008, it closed yesterday at just 18.4, which is down about 30 percent from the level at the start of the June.

Making matters worse is that because there's no eurozone equivalent to our FDIC insurance for bank deposits, European banks are rapidly losing deposits and interbank lending is drying up. As we mentioned yesterday, this creates the potential for a Lehman Brothers-type liquidity crisis.

The solution to the problem is clear. For the euro to succeed in the long run, there must be more than monetary integration. Europe needs to also integrate fiscal policy and banking systems. The question is: Do the Europeans have the political will to take the necessary measures?

I certainly don't have the answer to that one. However, while it may seem unlikely that a solution can be reached, history provides us with examples that demonstrate that it often takes a crisis to create the necessary sense of urgency (and thus the will) to take the tough measures required. Just consider what happened last year as we reached the deadline for action to prevent the U.S. government from being unable to meet its obligation because the debt ceiling was about to be reached. President Barack Obama and Speaker of the House John Boehner announced on July 31 that an agreement had been achieved. After the legislation was passed by both the House and Senate, President Obama signed the Budget Control Act of 2011 into law on August 2, the date estimated by the Department of the Treasury that the borrowing authority of the U.S. would be exhausted.

What we do know is that while Greece is small, Spain and Italy are both considered "too big to fail." As we discussed yesterday, we might just be at the point that resolution will happen one way or the other, as investors force the issue through capital flight.

The road to salvation has been made difficult, with the the austerity programs imposed in several countries as conditions for bailouts from the European Union and the IMF sparking social and political unrest. Elected governments are torn between their responsibilities to creditors and the anger of some of their taxpayers. The bottom line appears to be that either the Eurozone countries will find the will to make the tough decisions or Greece will be forced to return to its former currency, the drachma, and devalue it.

That could lead to bank runs, with deposits flowing out of Southern Europe and into the safe havens of Germany and the U.S. And no one wants to even contemplate the risks that would create, as "dominoes could start to fall." Indeed, we could have a full blown liquidity crisis. You should be prepared for either eventuality.

While selling now may seem a prudent decision, remember that's what investors who sold stocks in March 2009 thought. And once you sell, it will be very difficult to know when it will again be safe to buy. History teaches us that successful investors deal with crises with equanimity, having been well prepared for them. How are you doing?