Peter Jones: Inherent dangers of a 'lend and pretend' solution

HAIRCUTS? Re-profiling? Soft restructuring? Do these words mean anything to you? If they do, then award yourself a gold star, for you are clearly up to speed with the latest financial crisis rumbling away across continental Europe. You can tell it is bad. According to Jones' Law of Bank Disasters, the worse a crisis is, the greater is the number of nice-sounding words used to describe possible solutions.

My favourite is "extend and pretend", a phrase used by financial wiseacres in many contexts. But in the current Eurozone troubles, it means to keep on extending loans to the Greeks and pretend that everything is all right. As you might guess, those who think the Eurozone authorities are extending and pretending, also think that it is not going to work. And there they have a much tougher word to describe what they think will work - default. But that means another recession might just engulf us all.

You will recall that a year ago, the Greek economy was in such an awful mess that the Greek government needed a 95 billion loan from the European Union and the International Monetary Fund. That was because things were reckoned to be so parlous that international investors - banks, pension and hedge funds - would not buy Greek government bonds without charging interest rates the Greeks could not afford. So that it could carry on paying its bills, the EU and IMF stepped in with a loan.

Well, the Greek economy is in no better shape a year on. So interest rates have shot up again. If the Greeks want a 10-year loan, it will cost them nearly 17 per cent a year, a rate which would make the government insolvent. Another EU/IMF loan? That is what hardline cynics call extend and pretend, for they think that the Greeks won't get out of the hole they are in if they keep getting their sweaty heads sponged with more cool money.

The alternative is to default, or simply to not pay the bondholders what they expected to get. They could get a lower interest rate (taking a haircut), or be paid back the capital over a longer period (re-profiling), or face a combination of both (re-structuring), perhaps under-pinned by some EU guarantees on maintaining the face value of bonds (soft restructuring).

There are good reasons for doing this. Any investment is a risk, so why should investors escape all the risks of investing in Greece? And why should Greek citizens bear all the pain of their previous governments' follies? With strikes and street protests at tax increases, falling wages, and rising unemployment, they are reaching the end of their tether. The size of Greece's national debt is enormous - about 285bn, or a stonking 150 per cent of Greek GDP.And that's why a default will cause problems to other countries, because a write-down of Greek bonds will hit European banks, mainly French, Swiss, and German banks, perhaps causing another banking crisis. And if there is a Greek default, attention will then switch to Ireland and the likelihood of an Irish default (its 10-year bond interest rate is nearly 11 per cent), closely followed by Portugal (10-year rate of 10 per cent).

If the default option ripples through these countries, then the chances of another major banking crisis, closely followed by another recession, are high. And that of course, even though Britain is not judged to be at risk with a 10-year bond rate of 3.3 per cent, would be a big disaster for our economy.

Although British banks have about 25bn of loans in Greece and Portugal, their balance sheets look strong enough now to cope with some of that turning into losses. But the big problem is Ireland, where about 140bn has been invested, most of it by RBS and Lloyds. And if the Eurozone crisis spreads to Spain, as some are predicting it will, then British banks with about 75bn invested there, will suffer some serious damage. Could we afford yet another bank bail-out? I rather doubt it. Therefore, although it seems a bit much to carry on bailing out the Greeks from the mess they created themselves, it looks as though it will have to be done. That's why there is lots of feverish activity this week in Brussels as representatives of the EU government try to thrash out a package of assistance.

Minds have been concentrated by a threat from the IMF that unless the EU sort something out which will stabilise Greece, the Fund will not hand over the next slice of the loan agreed last May, due at the end of June. Reports from Brussels yesterday suggested that officials were working on a loan package of about 56bn.

This package is certainly not going to be a free lunch. The money, however, will come, not with strings but with damn great ropes attached. The talk is that it will see unprecedented external intrusion into a domestic European economy. Quite apart from demands for further public spending cuts and tax increases, there also seems to be an intention to crack down on tax evasion, one of the main reasons that Greece has failed to balance the government books. The loans also look likely to be attached to Greek government property, using that as security. Greece has already announced that it will attempt to raise about 40bn by privatising state assets.These don't just include things like state-owned telecoms and electricity companies, but also many of the sports facilities built for the Athens Olympics and even yacht marinas.

This extent of state ownership is one reason why there is a lot of corruption in public life, and why also the EU, pushed especially by the German government, wants the privatisation to become not just much bigger, but also to be run by an independent agency led by non-Greeks and not by the government.

It will be an utter humiliation. And I suspect that Greek citizens will not take it well, the only question being whether it is their own government or interfering foreigners that become the target for their rage. Sympathise if you will, but remember that the alternative is that we take the pain. As the smart-asses in the City say, the time to delay and pray is over.