09/18/2011 07:05 EDT | Updated 11/18/2011 05:12 EST

Like Lehman, Greek debt tragedy could spread gloom all the way to Canada

OTTAWA - Is Greece the next Lehman Brothers?

The tiny country known for sun-baked islands and historic ruins seems an unlikely candidate as the trigger for the next global economic tsunami, but three years ago few thought a New York investment bank could cause such damage.

Yet just like the startling collapse of Lehman was followed by the worst recession in six decades, Greece has the potential to send the world tumbling again.

To some, it's not a question of whether Greece's government debt tragedy becomes a problem for the rest of the world but how big a problem it will be.

Already owing about 150 per cent its annual economic output — and rising — Greece has said it has enough cash to carry its debt only to mid-October, by which time it will need about $8 billion to stave off default. It will need more billions in November and more December, as well.

Eventually, its partners in the 17-country eurozone will balk at extending more of their money.

"The lights have been out in Greece in for about a year," says Steve Hanke, professor of applied economics at Johns Hopkins University in Maryland.

"There's no way they can pay back their debts. They will either have to have a mega-bailout or they will default and have to be thrown out of the eurozone. Both those options are a very big deal (for the world economy)."

Finance Minister Jim Flaherty, meanwhile, accused Greece of not living up to its commitments.

"I think at the end of the day, it's up to Greece. Greece has to fulfil its commitments not only to the eurozone but also to the IMF," Flaherty told CTV's Question Period on Sunday.

"In countries in Europe that have gone ahead with austerity programs their governments tend to be defeated. So I understand the political reluctance to do it. That doesn't change the fact that certain steps are necessary by countries such as Greece."

As with Lehman Brothers, Canada's direct exposure to Greece is minimal. But in the end, that might not make a difference because — as the Harper government is fond of saying — Canada is not an economic island.

Hanke says Canada may get a direct impact through the devaluation of the euro relative the dollar.

But the real danger to Canada's economy is what a Greek default does to confidence and credit, and here the Lehman example is instructive, says Paul Taylor, chief investment officer with BMO Harris Private Banking.

In the fall of 2008, Lehman's collapse not only shook equity markets, but triggered a crisis of confidence among financial institutions. Banks stopped lending to banks because they didn't trust they would get reimbursed. Soon banks stopped lending altogether, depriving businesses of credit to carry on operations and invest, and households of the credit to spend.

Almost overnight, the global economy fell into a deep downward spiral that was only arrested by the injection of massive amounts of government spending — particularly in Europe, the United States and Canada — and ultra-low interest rates brought in by their central banks.

The chain of destruction this time around would likely flow from Greece to European banks that lent it massive amounts.

Then the question becomes which financial institutions outside Europe are affected by Greece's default and which other countries fall into the same debt spiral as their borrowing costs rise.

"The big effect for Canada is the economic impact associated with all that," says Taylor. "As we saw in 2008, if there's a liquidity vacuum, consumers and businesses spend less and we go into a deep economic recession, even if our domestic banking system is sound and minimally effected."

In one sense, the world is already seeing the movie trailer version of the unfolding drama. Credit is becoming harder and more expensive to access and the global economy in advanced nations has slowed.

The difference this time, say some, is that unlike 2008, governments and central bankers are alert to the dangers and experienced in heading off disaster.

But will it make a difference? Many governments and central bankers had the room to take dramatic action in response to the 2008 crisis — this time their hands may be tied.

"Governments have already fired a lot of their ammunition as far as spending goes, and it's harder for governments to do what they did in 2008," notes Grant Amyot, a Queen's University professor specializing in political economics.

"And the same with central banks. They've fired their ammunition in the sense of lowering interest rates. So it's going to be harder for policy-makers to counteract the effects of a crisis."

Some blame a failure in leadership in Europe for letting Greece dig itself into a hole too deep to escape.

The key question today, says Taylor, is whether there will a "disorderly" or "orderly" Greek default.

In the latter, banks and institutions that owe Greek debt will be issued sufficient funds to stay solvent. It amounts to writing off Greece, which will be booted out of the eurozone, and shifting the focus to protecting those institutions affected by the default to stop the contagion from spreading.

Even in the second outcome, however, the world economy and Canada will take a hit, albeit much milder than if the contagion were allowed to spread, says Taylor.

Hanke agrees that the best case scenario is one of limiting the damage to the global economy, not avoiding it.

"There is no magic bullet," he says. "If you take on too much debt, any way you play the game it's going to end badly."