Is Greece Really Too Small to Threaten the EU?

| About: iPath EUR/USD (ERO)

We all now know much more about sovereign debt solvency than we did a couple of years ago. We now understand some of the dynamics of insuring sovereign debt, and we know a lot more about the debt loads of numerous countries than we maybe ever even thought about previously. The most recent concern would seem to be Greece and, of course, the rest of the PIGS (or PIIGS as some prefer to think of them, that second "I" being Italy). The folks at Zero Hedge would also point us to the STUUPID countries as well.

One line of thinking that I have read and heard repeatedly, getting back to Greece, is that it is too small to really threaten the EU. At two point whatever percent of the EU economy, it is hard to argue against that point but it is incorrect in my opinion.

People are worried that Greece will default on its debt. It has a large budget deficit of around 13% and public sector debt is around 115% of GDP (eyeballing Bill Gross's Ring of Fire Chart). Ken Rogoff has taught us all that 90% is a Mendoza line of sorts (as in Mario Mendoza). Either Greece will default or not, and if not it will be because the EU bailed it out or not (please note the phrasing of that last sentence is such that I make no attempt to guess the outcome).

The thing is not the outcome for Greece, the thing is what comes next. If Greece is bailed out somehow because it did not have the will to do what it had to do, then where does that leave Ireland, which appears to be taking the difficult steps to heal on its own? If they bail out Greece, what will they do if Portugal and Spain end up needing bailouts? It is possible for members of the EU to default because they cannot print their own currency.

Sweden and Austria had some real trouble due to their loan exposure to other countries (talking mostly small countries in Eastern Europe)--a contagion of sorts. Things on the ground in Sweden were never terrible but Latvia almost became a huge problem. So, in thinking about Greece we should be thinking not just about what happens there but what could happen elsewhere as a result.

Think about how the financial crisis unfolded in the US. It was one thing after another and then another. Contagion happens and while a default in Greece (a low probability, in my opinion) might not have a domino effect, assuming there would be no domino effect is either an incomplete study or an overly optimistic assessment.