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Yesterday Standard & Poor’s warned that even if Greece’s private sector creditors agreed to a 70 percent reduction in the value of their bonds, Greek debt will still be unsustainable.

The problem is that so much of Greece's debt has left the private sector. The European Central Bank owns a substantial portion of the bonds—and so far has insisted that it will not accept anything less than full payment at maturity.

"But because only a small subcomponent of investors are actually taking the haircut and the official sector is not, or only partially, then the reduction... is probably not sufficient to make the debt sustainable, given the outlook for GDP itself," an S&P analyst explained.

It’s more than a bit ironic that the ECB’s bond purchases may make it more difficult for Greece to bring its debt down to sustainable levels.

You can expect that there will be a lot of pressure on the ECB to accept some haircut on its Greek assets. As I’ve explained here before, repaying the ECB at par for bonds it bought at a discount is actually a monetary contraction. The ECB will be taking more euros out of circulation than it injected by purchasing the bonds.

But an ECB haircut may be even more dangerous than the effective monetary tightening. Warren Mosler points out that letting Greece off the hook for its debt will immediately prompt other debtor nations to ask: “If Greece doesn’t have to pay, why do I?”

This, Mosler warns, would trigger a “financial crisis rivaling anything yet seen.”

More specifically:

… the catastrophic risk I’d highly recommend immediately hedging is the risk that Greek bonds are formally discounted, rapidly followed by a global discussion of ‘so why should we have to pay?’ Possible immediate consequences of that discussion include a sharp spike in gold, silver, and other commodities in a flight from currency, falling equity and debt valuations, a banking crisis, and a tightening of ‘financial conditions’ in general from portfolio shifting, even as it’s fundamentally highly deflationary. And while it probably won’t last all that long, it will be long enough to seriously shake things up.

This is not a figment of Mosler’s imagination. Earlier this week, Reuters was reporting that “Ireland would see any European Central Bank contribution to the restructuring of Greek debt as a precedent that would boost Dublin's efforts to ease the burden of its own sovereign debt.”

We’ve had lots of warnings about a possible domino effect of a disorderly Greek default. But we should also be worried about the domino effect of an orderly discounting of Greek debt.

Greece will likely fail to achieve sustainable debt levels if it only resorts to a 70 percent reduction in the value of bonds held by private creditors, Standard & Poor's warned on Wednesday, putting pressure on the ECB to also take losses. The deal with private sector bond holders is part of a reform package Athens needs to forge in return for a new international rescue to avoid a chaotic default.

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