The relatively positive outlook from Europe of recent weeks is now turning dark again, courtesy of our old friends the Greeks, and it’s not just the burning buildings in Athens.

Greece has to pay a €14.5 billion loan by March 20. Overnight, eurozone finance ministers postponed a meeting tonight to consider the Greek response to austerity measures demanded by the IMF and EU, and will instead hold a phone hook-up. In other words, the eurozone finance ministers don’t expect anything concrete from Greece for a while. The ministers say they will meet next Monday night, Australian time, as planned to see what Greece’s response is to the measures demanded so the country can get the huge €130 billion second bailout.

The key problem is, in response to the riots that accompanied parliamentary approval of the latest austerity package, an election that will now be held in April, in effect making any agreement now problematic. The EU and IMF want all political parties to sign up to any agreement: the far left parties (and maybe the far right ones as well), seem to be trying to avoid such a commitment because they can see the chance to make gains at the election by portraying themselves as being against the cuts and for Greece’s independence. At least one party leader has said Greece should sign up now and simply renege on its commitments after the elections.

Another problem is that the Greek economy is shrinking rapidly, driving its debt:GDP ratio up as fast as austerity can reduce it. It’s only a more extreme example of the same forces now at work across Europe as economies don the hairshirt while unemployment rises and economic growth slumps, slicing into tax revenue. It’s a vicious circle locked in by the Berlin-Paris-Brussels axis of austerity, for all the talk of “pro-growth austerity” coming glibly from commentators and some politicians.

The economy had shrunk by 17% in the past four years. Greek unemployment is now more than 20%; youth unemployment is just shy of 50%, and growth is set to contract significantly again this year, some say by as much as 7%. Yes the Greeks have been lazy and profligate in the past, but the country’s economy is in a nosedive and Europe is in effect demanding they find ways to fall faster.

There’s speculation now that eurozone leaders would be content to let Greece default and abandon the euro. The transition would be difficult, but it might be better for the rest of Europe and the Greeks themselves to let them return to the drachma, which could belatedly provide a cushion for the economic freefall under way. The difference between this and Europe simply chucking the Greeks overboard, however, is a little hard to discern, and likely impossible from Athens through the pall of smoke.

It would however send another shock through the European banking sector, which has started to unthaw courtesy of the ECB’s injection of liquidity late last year, a key step in avoiding further disaster in Europe.

Regardless of what happens, the Reserve Bank has made clear that that it will cut rates further if it sees the eurozone worsening and again becoming the big unknown threat that it was from October through December of last year. The RBA cut the cash rate twice to give our economy some leeway then.

If Greece’s problems do continue or deepen, then our big banks will be in a bigger pickle than many understand.  A rise in worries about Greece will mean offshore funding costs won’t ease any further (they have come down noticeably in the past few days, especially within Australia, as RBA Assistant Governor, Guy Debelle explained in a speech in Sydney yesterday). Funding costs will likely rise, putting the big banks under further pressure to boost home mortgage rates, again.

The problem for the big banks is that while 52% of their funding now comes from local deposits, domestic and offshore wholesale borrowings are still expensive and will stay that way. Should Greece default, we could see another freeze in euromarkets while the impact is assessed, or at best a sharp rise in borrowing costs for high rated banks like our big four. Fortunately, the RBA still has plenty of ammunition left, courtesy of its prudence last week.

Peter Fray

Save 50% on a year of Crikey and The Atlantic.

The US election is in a little over a month. It seems that there’s a ridiculous twist in the story, almost every day.

Luckily for new Crikey subscribers, we’ve teamed up with one of America’s best publications, The Atlantic for the election race. Subscribe now to make sense of it all, and you’ll get a year of Crikey (usually $199) and a year’s digital subscription to The Atlantic (usually $70AUD), BOTH for just $129.

Peter Fray
Editor-in-chief of Crikey

JOIN NOW