Greek debt crisis tests euro zone credibility

European Central Bank executive board member Juergen Stark, a German deficit hawk, said bluntly last week that markets were deluded if they thought other member states would put their hands in their wallets to save Greece.

German and French leaders have sounded less gruff, hinting that Greece could ultimately receive help from its euro zone partners — at a price — if its debt problems get out of hand.

“I am confident that with proper peer pressure and support from members of the euro zone, Greece will find its way back to where it should be,” French Finance Minister Christine Lagarde said last week.

Ireland, a fellow peripheral euro zone state hard hit by the financial crisis, and non-euro EU member Latvia have achieved similarly drastic deficit reductions by cutting public sector pay and benefits. But neither has Greece's powerful trade unions and history of civil unrest.

A source close to Papandreou, who spoke on condition of anonymity, said that if Greece were to attempt such draconian cuts at once, it would face the kind of social disorder that hit many states implementing IMF adjustment programs.

“We're going to have to salami-slice our way into it,” the source said. “The EU pressure is helpful to provide an alibi for the next round of measures, because everyone in Greece realizes that the EU is our lifeline.”

The source said Papandreou would face down leftists in his PASOK party who oppose austerity but needed to take time to persuade non-communist public sector trade unions that the pain was being shared fairly.

The two main sanctions that could hit Greece would be deeply counter-productive if applied.

The EU could force Athens to make a huge deposit with the European Commission, which would be lost as a fine if the excessive deficit was not corrected. But that would sap market confidence and deepen Greece's economic woes.

Further downgrades by credit ratings agencies would mean Greek government bonds were no longer eligible as collateral to borrow cheap ECB funds from 2011. That would raise government borrowing costs and hit Greek banks particularly hard but also hurt other holders of Greek debt and spark a chain reaction.

Neither measure makes economic sense. But failure to enforce the rules on Greece could harm the credibility of the euro area.

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