Financial markets should brace themselves for a restructuringof Greek debt in September, Barry Eichengreen, Professor of Economics at the University of California, Berkeley said on Thursday, but a default will not necessarily be a "Lehman-like" event.
"History suggests that things will quiet down in August because all the traders will go to Tuscany and they'll be drinking Chianti through the month and relaxing," Eichengreen told CNBC.com.
"But everybody knows that when they come back in September it will blow up. And at that time the Greek government will not have the capacity to go back to the well," he added.
Eichengreen believes the European Unionand the International Monetary Fund know that a restructuring is inevitable.
"I don't think they've known until recently how quickly it's coming upon us but the point is Europe doesn't have two years until 2013 to sort this out. At most two months," Eichengreen said.
The alternatives now are "bad" and "worse", according to Eichengreen.
"I think it's important to swallow and and opt for the bad in order to avoid the worst. The worst solution would be a collapse of the Greek government, loss of control of the streets, a disorderly default with unpredictable consequences that would spread widely to other EUropean countries and destabilize the financial system," he said.
"Bad would be to have to restructure the Greek debt, with a plan as opposed to without one. I am confident that the EU and ECB are figuring out how exactly to do this," he added.
But "this doesn't have to be a Lehman-style credit event," Eichengreen said.
"The CDS written on Greek debt are small," Eichengreen pointed out, and are written by American firms, not by European firms. In addition, Lehman was so devastating because people were unprepared, Eichengreen said.
"There has been tremendous time to hedge your position, buy insurance. I think it can be managed," he said.
Point of No Return?
Calls for Greece to leave the euro may be intensifying and the creation of the single currency without fiscal union might have come under scrutiny, but Eichengreeen said there was no turning back.
"People who don't understand the difference between a single currency and a fixed exchange rate imagine that Greece would benefit from reintroducing a new drachma," he said. "The fact of the matter is that some historical processes are irreversible."
"The euro - like it or not - is one of those so Greece is going to have to figure out other ways, with the help of Europe, to restore its competitiveness," Eichengreen said.
With the Greek government on the verge of losing control of the streets, there is no time to waste, he said.
"I think it's a big problem for Athens but it's not one that Athens and Greece can solve by itself. That is what European leaders in their wisdom should be thinking about this week," said Eichengreen.
"Step number one is going to have to be debt restructuring that will require a very substantial writedown or haircut on the existing Greek debt. Greek debt/GDP ratio is on the order of 150-160 percent. That will have to come down by half," he said.
Greece will also have to introduce macro policy reform and politically difficult privatization of state assets.
"It's embarrassing for a country to sell off its national patrimony," Eichengreen said.
He was critical of the way the ECB had handled the situation, saying it should have ring-fenced other countries such as Portugal and Ireland.
"The (European) council and the ECB especially have done a very bad job at distinguishing between Greece - which is insolvent and everybody knows it - versus the other crisis countries, Ireland and Spain in particular which in my view have liquidity problems but can grow their way out of them," he said.