Also 98% chance seems pretty high especially when Germany and France are going to do everything to avoid this because their banks are heavily invested in Greek bonds.
P.S. The Germans may, at some point, prefer to bail out their banks, as there they have some capacity to draw a line and call a halt.
The _real_ question is the implications of a Greek default / euro withdrawal on European political integration. The Germans care a great deal more about that, and are probably prepared to pay a very high price for it. The question comes down to, how much of others' welfare states must they underwrite, and how much will they underwrite.
I think Germany is loving this crisis. The number it's doing on the Euro has been incredible for their export economy. I suspect they'll do whatever they need to to keep this going as long as possible.
Of course, Greece could just turn its back on the treaties, ditch the euro, re-instate the drachma, convert all debt obligations to drachmas and go on its merry way devaluing the drachma against the euro. But they would no doubt face retaliation from an angry EU and will likely get hit with stiff trade barriers on Greece exports as punishment (in which case devaluing the drachma would have limited effect).
I think the more likely outcome will be some kind of debt restructuring, a situation where the foreign bondholders (who own almost 60% of the debt) will have to finally face up to their losses.
That's probably fine as a one-off event, but of course this situation is basically writing the rules going forward. And a default / restructuring would also force reconsideration of the "risk-free" status afforded euro sovereign debt by the EBC and national regulators. Actually reflecting risk would introduce yield and liquidity differentials among euro sovereigns, with Germany essentially becoming the benchmark. Ignoring that risk would perpetuate the moral hazard temptations, and under a precedent of Germany underwriting the risks.
So either the euro becomes the deutchesmark, or Germany underwrites the deficit risks of the euro countries. Not easy to see how that gets resolved.
http://krugman.blogs.nytimes.com/2011/08/07/a-self-fulfillin...
http://krugman.blogs.nytimes.com/2011/09/11/the-spanish-pris...
and what is the alternative? To pay back with 74% of interest? In real money (ie. euro/dollar)? The only possible non-default way is several times inflation of Greek currency.
This escape route from a towering debt burden was tried by German post-WW1 governments, and lets just say it didn't go very well. It's the reason the Bundesbank is the way it is now.
Say inflation is 2% interest rate is 2% over inflation (or 4%) and the bond is for 10 years. 1.04^10/1.02^10 = 1.2143. Now compare that to 3% and major assumption you still need to pay out 2% over inflation well you get 1.212 which is a lower cost. At the same time your debt servicing costs drop. Now it's true that you may need to pay a fraction more than 2% in interest but for small positive increases in inflation it can reduce debt servicing costs significantly. For this to really work well your new debt needs to be well below your debt servicing costs AND you need to hold mostly long term bonds is rarely the case for country’s with debt issues.
Unfortunately, few nations are trying to pay off their national debts and are more focused on maximizing their ability to borrow which is another story.
The moderate, potentially politically feasible inflation would have served to overcome nominal price stickiness and helped Greece transition to a slightly lower standard of living gracefully, one they could actually sustain without borrowing based on their production.
The unfeasible inflation would just be a backdoor default, and not really any worse than a real default except to the extent that the EU laws prevent Greece from actually defaulting. This would also entail adjustment in living standards.
The horrible option that would result in hyperinflation would be continuing to live beyond their means and using inflation to pay off the debts they were continuing to accumulate. I totally agree that that wouldn't end up solving anything.