05/22/2011 07:27 pm ET | Updated Jul 22, 2011

Beware Greeks Bearing Banks

After every financial debacle or war, there is a huge political struggle over whether creditors and financial speculators get to stand in the way of an economic recovery. When the creditors win, ordinary people who had nothing to do with the crisis are typically the victims. Today, the entire political elite is in the austerity camp, and those who argue that creditors should take some losses so that the rest of the economy can grow are mostly ignored.

This is the common theme to the issue of mortgage relief to spare American homeowners millions of foreclosures, the question of whether the US should sacrifice Medicare and Social Security on the altar of deficit reduction, and the punishment being visited upon small European economies such as Greece, Portugal and Ireland.

(Though Dominique Strauss-Kahn was evidently a sexual predator, he was not a financial rapist when it came to vulnerable nations. He was a rare member of the ruling financial club who gave some attention to economic recovery over austerity.)

Greece is the poster child for this dilemma, and the Greek story reveals the real villain of the piece -- the big banks. In February 2010, it was revealed that Goldman Sachs had been complicit in allowing previous Greek governments to cook their books and hide the size of the Greek deficit by creating a special kind of currency swap that was really a disguised loan.

In the aftermath of the financial crisis, Greece's national debt is unsustainable, and only credits from the European Central Bank and the International Monetary Fund are keeping Greece from defaulting.

The bankers want Greece to languish in debtor's prison, cutting wages and social benefits, increasing taxes, and otherwise sandbagging its own economy in order to pay back creditors at 100 cents on the Euro. Greece, however, is now in a vicious circle: the more the Greeks practice the austerity demanded by the money markets and the European Central Bank, the more the Greek economy predictably slumps and the more that money markets lose confidence that Greece will ever recover enough to pay back its bondholders.

In this crisis, bankers are culpable in three different and reinforcing respects. First, we have the case of Goldman's complicity in helping the Greek previous government to get Greece in over its head. Secondly, the European Central Bank and the big German banks are opposed to a restructuring of the Greek debt -- trading short term bonds for longer term securities with reduced interest and principal -- because big banks are the major bondholders and resist taking any losses.

Recently, a third concern came to light -- our old nemesis, credit default swaps (CDS). These are the very same toxic securities that were so implicated in the 2007-2009 financial crash. CDS are a form of insurance against default of securities. But unlike, say, underwriters of life insurance or fire insurance, the issuers of swaps seldom have adequate reserves against losses because they assume that defaults will hardly ever occur. Rather, CDS have become a favorite vehicle for speculation by hedge funds and investment banks.

According a Friday Wall Street Journal report from Brussels, even a partial a restructuring of the Greek government debt could trigger payouts of credit default swaps. A group of European finance ministers raised the possibility of a "soft" restructuring of the Greek debt, so as not to reward speculators who were betting on a Greek default, but officials of the European Central Bank threw a fit, warning that the ECB would pull the plug on funding for Greek banks if such a restructuring were discussed.

From the view of the ECB, the sheer complexity of financial markets is now such that any form of restructuring that would benefit Greece could set off ripples that might destabilize the system, so the ECB is dead set against it. Better for the Greeks just to suffer.

It's clear that Greece can't pay its debts. The practical question is whether an adjustment will be accompanied by more pain or less, and whether the financial sector will be permitted to keep bleeding Greece dry.

There is an instructive historical parallel. When American banks found themselves in big trouble in the 1980s because several third world countries could not pay back their loans, Nicholas Brady, Bush I's Treasury Secretary, came up with an ingenious plan. The debts would be stretched out, and the creditors would take a hit averaging about 30 percent.

The banks were compelled to take their feet off the oxygen hoses of more than a dozen nations, and recovery of their real economies ensued. Worry about triggering payouts of credit default swaps was not an obstacle because, mercifully, credit default swaps had not been invented yet.

The more we learn about these toxic securities and their abuse, the more wisdom we see in Paul Volcker's comment that the last useful innovation created by the financial industry was the ATM machine.

The stakes are somehow clearer after wars than after financial busts. Bonds issued by defeated countries are worthless, so debts do not sandbag recoveries. Victorious countries typically restructure their own war debt, so that it doesn't cripple the postwar economy. (America's first treasury secretary, Alexander Hamilton, was a hero for devising a plan for the new federal government to assume the war debts.)

We also remember the fatal lesson of the First World War, where the British and French tried to squeeze defeated Germany dry to pay off their own war debts -- and destroyed Germany's economy, thus creating grievances that led to World War II. After the second war, we didn't make the same mistake twice.

But somehow, it's harder to win general support for debt relief after a financial collapse because details are more murky and the banks are so bloody powerful. The fact is that throughout modern history, governments have defaulted on debts dozens of times. It's more important for real economies to realize their productive potential than for bankers to get their pound of flesh.

The choice doesn't have to be default or debtor's prison. A middle ground is debt restructuring of the sort being proposed for Greece, but the banks and their toadies in government are too greedy and short sighted to appreciate it.

In the context of today's debt politics, Nick Brady, who faithfully served George H.W. Bush, is a dangerous radical.

Robert Kuttner is co-editor of The American Prospect and a senior fellow at Demos. His latest book is A Presidency in Peril.