David Rudes/Bloomberg BusinessWeek

Greece: How the Bond Vigilantes Left It in Ruins

The European Union's experiment with a single currency is deep in crisis because Europe failed to learn from the Greeks. Not today's Greeks—the ancient Greeks, specifically Odysseus, the hero of Homer's epic poem. Odysseus knew his limitations. Realizing he was vulnerable to temptation, he ordered his sailors to tie him to the mast of his ship. That way he could listen to the bewitching song of the Sirens without obeying their call to steer the ship onto the rocks.

Today's Sirens are the investors and traders of the global bond market, who lure nations into tapping abundant credit at low rates when times are good. If a nation borrows too much, those open-handed investors abruptly turn into vigilantes who punish the country by making new loans scarce and expensive. Greece has fallen into precisely that trap. It got low-interest loans by promising to behave responsibly and keep its budget deficit low. That gained it admission to the single-currency zone in 2001. But because Greece was never tied to the mast, it kept spending. Its debt is now about 125% of gross domestic product, more than double the supposed EU ceiling. Eventually, all that debt brought down the wrath of the bond-market vigilantes, who drove up yields by betting against Greek debt, precipitating what has become the worst mess for the euro since the single currency's launch on Jan. 1, 1999.At this point, Greece and the European Union have no good choices left. It's hard to see how Greece can muddle through on its own. On Feb. 10, striking labor unions shut down schools, hospitals, and air travel in a challenge to Prime Minister George Papandreou's austerity plan, which is intended to win back investors' confidence. Yiannis Kelekis, 68, a retired construction worker who joined a demonstration in rainy Athens, complained: "The people that caused the crisis are now asking for others to make sacrifices."

Noting the range of opposition, investors have concluded that Greece needs outside assistance to avoid default. If the European Union refuses aid, the government could find itself unable to issue $26 billion worth of debt as scheduled this spring. A Greek default—still considered highly unlikely—might trigger a run on the debt of Portugal and Spain. Like Greece, they belong to the PIGS—a name coined to describe Portugal, Ireland (and sometimes Italy), Greece, and Spain as the financial weaklings of Europe. "If Greece were alone in this, then possibly they would have been kicked out of the euro zone," says Diego Iscaro, economist at IHS Global Insight in London. "But they can't do that, because Greece is not alone." Stephen L. Jen, portfolio manager of BlueGold Capital Management, a London-based hedge fund manager, says German banks' exposure to debt of the five PIGS equals 19% of German GDP.Trouble is, extending aid isn't a great choice, either. If the European Union helps Greece, then Portugal and Spain, whose finances are only slightly stronger, could demand similar help. That would stir resentment in the richer nations such as Germany and France. Worse, it would undercut the EU's credibility as an enforcer of fiscal rigor.As of Feb. 10, European officials seemed to be angling for a compromise plan to aid Greece but on such harsh terms that no one else would want such a deal. Germany and France were leading talks to help Greece under "tough preconditions," said Markus Ferber, a member of German Chancellor Angela Merkel's bloc in the European Parliament, citing discussions his group had with the federal officials in Berlin.

LESSON FOR THE U.S.

While Greece is uniquely dysfunctional, there's a lesson here for any country with a heavy debt load, including Britain, Japan, and the U.S.: The bond market is treacherous. For now, investors are pouring money into the U.S. Treasury market as a safe refuge. But the U.S.'s ratio of total debt to GDP is likely to exceed 90% this year, making it more indebted even than Spain and Portugal. If global investors began to demand higher yields to compensate them for the risk of a U.S. default, that would vastly increase U.S. borrowing costs. Higher debt service would worsen the nation's budget imbalance and possibly precipitate the very crisis that investors fear most. A long shot, to be sure, but not impossible