Like a financial souvlaki,
Greece is being skewered by the bond markets. Bond yields above 10 per
cent are impossible for the country to pay, and since May it has been
living on €110bn ($147bn) of soft loans from Europe and the IMF. Pretty
much everyone believes Greece cannot survive
without defaulting on its debts eventually – yields indicate a 90 per
cent likelihood of default within a decade, according to the US Council
on Foreign Relations.

Not surprisingly, this does not sit well
with George Papaconstantinou, the Greek finance minister. The slick
British-educated economist has been trying to charm both his eurozone
counterparts and potential investors, and insists there is no risk of a
default. Apart from anything else, he says, it would spark another
crisis and could take down Portugal and Ireland, doing irreparable harm
to the eurozone.

His
implied threat would be more worrying if Portugal and Ireland were not
losing credibility all on their own. Investors are demanding yields on
their bonds higher than before a €750bn European rescue fund was
announced in May. Credit default swaps (CDS) rank Ireland as riskier
than Dubai or Lebanon.

Bond losses have left deep scars in the
psyche of local investors. But for now, at least, neither global
investors nor regulators seem to have understood the full implications.

True,
there has been much talk of what nonsense it is to consider high-grade
sovereign bonds risk free. Yet, financial theories that rely on
risk-free yields continue to underlie much portfolio construction.

Regulators seem to have learned even less than investors. First came the farce of Europe’s bank stress tests,
which tested the effect of a Greek panic only on bonds held in the
mark-to-market trading book, not the far greater volume of bonds in the
banking book.

Then regulators failed to take away one of the worst
incentives for investors to treat double A-rated and above government
bonds as risk-free: the fact that banks have to hold no capital against
them.

It has become such a commonplace that it no longer shocks,
but it should. Banks can be as leveraged as they like, as long as they
put the money into government bonds (proposed new rules will cap
leverage at 33 times, but do not address the flawed incentive to hold
sovereign debt).

It is easy to accept the mindset which says
default is unlikely: no developed nation has reneged on its obligations
since just after the second world war. Back in the 19th century, though,
default was frequent and sovereigns were often seen as riskier than the
best private borrowers. Spain, for example, defaulted eight times in the 1800s, while Greece defaulted at least four times.

Should
we see the post-war experience as a break with the past, or a temporary
aberration? One could argue it is neither: developed countries have
merrily defaulted in the past 60 years, just invisibly, through
inflation and devaluation.

This is why the focus is on the
eurozone, where individual members cannot resort to either devaluation
or printing money to solve their problems.

Investors have this
year begun to differentiate within the eurozone; even France has seen
the amount it must pay on its bonds rise relative to Germany.

Globally,
the pricing of developed market sovereign risk remains obscure, to say
the least. Jerome Booth, chief economist of fund manager Ashmore,
has a pithy definition of emerging markets: they are where risk is
priced properly. It is questionable whether this is correct right now
(CDS suggest Colombia is safer than Belgium, for example), but it is
true that risk is not priced at all in the safest developed markets.

Even
in the eurozone, where investors are keenly aware of the dangers that
the Irish banking crisis could sink the country or the Greek deficit
force a default, bonds are priced on the notion that Germany is risk
free.

This all matters because it allows countries regarded as
safe – as Greece was until late last year – to borrow far too cheaply.
It should not need a subprime crisis to remind us that underpriced loans
lead to unsustainable spending.

Developed nations have already
begun to renege on their promises as they struggle to bring spending
back under control. So far, though, they have chosen to default on
spending pledges – particularly pensions – rather than imposing pain on
creditors. As Willem Buiter, Citigroup chief
economist, points out, this is only sustainable if the pain taken by
voters is less than the costs that would follow a default.

In recent years, those costs have been negligible, with defaulters often borrowing again within months.

With
Greece facing the prospect of using at least 7 per cent of tax revenue
to service debt pretty much forever, default is bound to look attractive
at some point.

Luckily, that point does not come before the
EU/IMF funding runs out in 2013. By then, hopefully, Greek debt will
have been switched from vulnerable banks to those willing to bet on
recovery, meaning default will not have the knock-on effects Mr
Papaconstantinou believes.

When Athens finally defaults, the bond
markets may start to treat sovereigns as Zorba the Greek recommended
treating everyone. “Man is a brute,” he said. “If you’re cruel to him,
he respects and fears you. If you’re kind to him, he plucks your eyes
out.”