BUSINESS
06/16/2011 05:35 pm ET Updated Aug 16, 2011

As Greek Default Becomes Increasingly Likely, Investors Flee To Safer Investments

Stock prices around the world have fallen sharply in response to the growing likelihood that the Greek government could default on its debt and plunge the European economy into a recession, endangering the euro and infecting the global economy.

Greek stocks plummeted Thursday, dragging down stocks across Europe. Greece's ASE index declined 2.8 percent Thursday, and the Stoxx Europe 600 index closed down 0.5 percent. Meanwhile, the value of the euro fell to a record low, and the yield on bonds of more indebted European countries rose, according to Bloomberg and Reuters.

Markets far outside of Europe reacted negatively to the news. Latin American currencies fell against the dollar, since the dollar generally is viewed as a safe investment during uncertain times. In Asia, Hong Kong's Hang Seng index fell 1.7 percent Thursday, Japan's Nikkei Stock Average ended down 1.7 percent, and Australia's S&P/ASX 200 fell 1.9 percent, according to Dow Jones Newswires.

U.S. stock market shares fell sharply on Wednesday, though the fall softened on Thursday as investors viewed the United States as an increasingly safer gamble than Europe.

The Dow Jones Industrial Average rose 63 points on Thursday after tumbling more than 200 points, or 1.5 percent, Wednesday.

U.S. banks have minimized their exposure to the Greek debt crisis during the past year, according to Reuters, and the value of the dollar has risen substantially against the euro. Overall, investors have been moving away from stocks into less risky investments, such as the dollar.

With Greece locked in a political crisis over whether to impose new budget cuts, investors increasingly are betting that the country will default. The cost of insuring a Greek default has reached an all-time high, as investors wager that Greece does not have the political will to agree on debt reduction measures in time to qualify for another round of bailouts from the European Union. If that happens, Greece likely would default by mid-July.

After failing to establish a unity government to address Greece’s debt crisis, George Papandreou, the prime minister of Greece, offered to step aside as long as the center-right opposition party could agree to a new bailout plan to Greece, which it still opposes. The Socialist Party, which he leads, has become increasingly fractured as the Parliament and Greece remain similarly divided.

Adding to the sense of turmoil, the ratings agency Moody's Investors Service threatened on Wednesday to downgrade the rating of major French banks because of their exposure to Greek debt: a move that could cause a crisis in confidence across Europe. French bank shares have fallen in response. In the only sliver of good news from Europe, the European Union said it would be willing to give Greece an emergency $17 billion bailout by early July so that Greece does not run out of cash right away to pay its creditors.

Greece’s political crisis has raised questions about whether the euro, and the European Union with it, can survive. If Greece defaults, it could cripple market confidence like the collapse of Lehman Brothers did in the fall of 2008. A Greek default would cause interest rates to escalate, which in turn could pressure European countries with larger debt burdens into default, send European banks into failure, freeze lending, dry up the cycle of buying and producing that keeps people employed and put the European Union in danger of dissolving. As a result, many investors around the world are hedging their bets and selling their stocks.

A default by the Greek government would start a negative chain reaction forcing lenders to suffer serious losses, according to the Associated Press, and it would scare away lenders "for a very long time," European Central Bank Governing Council member Christian Noyer said on Wednesday.

Michael T. Darda, chief economist at the investment research firm MKM Partners, wrote in a report today that as interest rates spike, Greece is becoming more likely to default, an event that would make it much more likely for Portugal, Ireland, Italy and Spain to declare bankruptcy as interest rates rise even higher. Defaults in Spain and Italy then would trigger a credit crisis, causing major European banks to fail, and contracts written insuring against European countries’ defaults would endanger the financial institutions that wrote the insurance. Bank runs could ripple across European Union, as frightened investors rush to cash both their stocks and bank deposits, causing banks to fail and stock values to fall. The value of the euro would decline.

"If deposits begin to flee and a ‘bank run’ ensues, it will be difficult for the ECB to stop," Darda wrote, emphasizing that the European Central Bank’s current policy to decrease the supply of cash in the economy, in order to prevent the possibility of inflation, “makes no sense” in the current crisis.

If enough countries and banks fail as a result of a European bank run, the euro itself would be in danger of dissolving -- and the European Union with it. If Europe enters another recession, it would weigh down to some extent on the global economy, since Europeans would be buying fewer imports, producing fewer exports, hiring fewer people, inventing fewer technological breakthroughs and lending less. Such a contraction could spread to the United States and around the world.