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How Greece could go down like Lehman Brothers

Eurozone Finance Ministers Demand Greater Scrutiny Of Greek Budget CutsEurozone Finance Ministers Demand Greater Scrutiny Of Greek Budget Cuts

After bailout talks broke down with Greece’s creditors over the weekend, the government on Monday closed all banks, the stock market and put restrictions on cash withdrawals as the Mediterranean nation teeters on the verge of a financial meltdown.

Greece’s creditors are playing hardball, which is understandable. The country is due to repay $1.7 billion to the International Monetary Fund on Tuesday, but the European Central Bank has refused to extend emergency funding unless Greece promises to institute meaningful reforms to its economy. While the Greek government has unveiled a plan to increase taxes to raise more money, the European Union and the IMF are skeptical — mainly because higher taxes could impede economic growth in the future. They would rather see sharp spending cuts.

The problem is that Greece has already gone past the point of no return. Implementing severe austerity measures won’t stabilize its economy; it would actually choke off the economy. At this point, the EU and IMF need to decide whether making an example of Greece to Europe’s other debt-trouble nations is worth risking the immense economic turmoil that will surely infect most of Europe if Greece collapses.

Today’s situation brings to mind an argument that some economists have posed over the past few years: Greece’s financial disaster could be as bad, if not worse, than Lehman Brothers, the storied investment bank that collapsed in 2008 and sparked a market panic that quickly spread through the entire U.S. financial system. In that case, the government was unwilling to bail out Lehman because it had just saved Bear Stearns and was wary of setting a bad precedent. But it failed to foresee the chain of dominos that the bank was a part of and would inevitably bring down.

The lesson there was that it wasn’t just the exposure that other market players had to Lehman, but the erosion of confidence in the financial system that led to a full-blown crisis. Banks, after witnessing the abandonment of Lehman, felt they could not rely on the help of the U.S. government to weather their brewing subprime mortgage storms. As a result, they stopped lending to each other and to other businesses, which led to an instant credit freeze and a dangerous increase in borrowing rates.

The aftermath, as the world remembers, was very bad. It necessitated an unprecedented bailout of nearly every large financial institution, including Bank of America (BAC), Citigroup (C), Goldman Sachs (GS), and Morgan Stanley (MS), as well as insurance giant AIG (AIG) and automaker General Motors (GM). It can be argued that had the government saved Lehman, thereby preventing market panic and giving other banks time to unwind their exposure to toxic subprime mortgages, the fallout might have been somewhat contained and a softer economic landing achieved.

In addition, a bailout, as The New York Times points out, could have been easily structured to protect taxpayers, as the U.S. government’s rescue of AIG illustrates. At the time, though, Washington was more worried about excusing bad behavior than following the prudent plan of action. In the end, Congress and the White House would have no choice but to do what they didn’t want to. Greece’s detractors should learn from this experience. The real threat from a Greek economic collapse is not just the default on its debt or its exit from the euro, but a larger panic that could ripple across broader European markets, according to The LA Times.

That, in turn, could encourage investors to flee their positions regardless of merit; creditors demanding their money overnight, borrowing costs skyrocketing, and ordinary depositors withdrawing their cash in hordes – bleeding banks dry and sending already weak nations, such as Italy, Spain, and Portugal, into a death spiral. And neither would this disease remain contained to a few pockets since a crisis of confidence in the euro would impact the entire EU business establishment. A broad market sell-off and widespread bank runs are not out of the question.

During the Lehman crisis, government regulators fretted about condoning Too-Big-to-Fail, and rightfully so. But in the process they only created many more instances of Too-Big-to-Fail. Greece is small compared with many other more developed European economies, but the potential impact of its collapse on the rest of the region is not. As such, it is exactly like Lehman, and the EU and IMF should realize that before allowing it to collapse.

Kumar is a tech and business commentator. He has worked in technology, media, and telecom investment banking. Kumar does not own shares of the companies mentioned in this article.