THERE comes a moment in many debt crises when events spiral out of control. As panic sets in, bond yields lurch sickeningly upwards and fear spreads to shares and currencies. In September 2008 the failure of once-stellar Lehman Brothers almost brought down the world’s banking system. A decade earlier, Russia’s chaotic default on its sovereign debt rocked the credit markets, felling Long Term Capital Management, a hugely profitable American hedge fund. When the unthinkable suddenly becomes the inevitable, without pausing in the realm of the improbable, then you have contagion.
The Greek crisis—or more properly Europe’s sovereign-debt crisis—looks dangerously close to that (see article). Even as negotiators from the European Union and the IMF are haggling with the Greek government over an ever-growing bail-out package, the yield on Greek debt has ballooned: two-year bonds soared towards 20% this week. Portugal’s borrowing costs jumped. Spain’s debt was downgraded, along with Portugal’s and Greece’s, and Italy came worryingly close to a failed debt auction. European stockmarkets have slumped and the euro itself fell to its lowest level in a year against the dollar.
The road into Hades…
It will strike some as mystifying that a small, peripheral economy should suddenly threaten the world’s biggest economic area. Yet, though it is only 2.6% of euro-zone GDP, Greece sounds three warnings that reach far beyond its borders.
The first is economic. Greece has become a symbol of government indebtedness. This crisis began last October when its new government admitted that its predecessor had falsified the national accounts. It is labouring under a budget deficit of 13.6% and a stock of debt equal to 115% of GDP. It cannot grow out of trouble because of fiscal retrenchment and its lack of export prowess. It cannot devalue, because it is in the euro zone. And yet its people seem unwilling to endure the cuts in wages and services needed to make the economy competitive. In short, Greece looks bust.
Few, if any, European countries suffer from all of Greece’s ills, but many scare investors. Portugal has a high budget deficit and is chronically uncompetitive. Spain has a low stock of debt, but it seems unable to restructure its economy. So too Italy, which is heavily indebted to boot. Non-euro-zone Britain has let its currency fall, but its budget deficit is unnerving.
The second lesson is political. Two weeks ago, having concluded that an eventual Greek restructuring was all but inevitable, we said Europe’s leaders had “three years to save the euro”. We presumed that they would quickly get a proposed €45 billion ($60 billion) deal to stave off an imminent and chaotic Greek default, buying time for an orderly rescheduling and for the other weak economies to begin overdue structural reforms. We overestimated their common sense.
The chief culprit is Germany. All along, it has tried to have it every way—to back Greece, but to punish it for its mistakes; to support the Greek economy, but not to spend any money doing so; to treat this as just a Greek problem, when German banks and German citizens, who lend to Greece, stand to lose money too. German voters do not favour aiding Greece. But rather than explain to them why it is in Germany’s interest, the chancellor, Angela Merkel, has run scared of upsetting them before a big regional election on May 9th.
Playing for time has backfired. Now the mooted rescue plan has climbed above €100 billion because no private money is available. The longer euro-zone governments dither, the more lenders doubt whether their promises to save Greece are worth anything. Each time politicians blame “speculators” (see article), investors wonder if they understand how bad things are (or indeed that investors have a choice). Euro-zone leaders initially refused to seek IMF help because it would be humiliating. Their ineptitude has done far more than their eventual decision to call in the IMF to damage the euro.
This political and economic failure leads to the third Greek warning: that contagion can spread through a large number of routes. A run on Greek banks is possible. So is a “sudden stop” of capital to other weaker euro-zone countries. Firms and banks in Spain and Portugal could find themselves shut out of global capital markets, as investors’ jitters spread from sovereign debt. Europe’s inter-bank market could seize up, unsure which banks would be hit by sovereign defaults. Even Britain could suffer, especially if the May 6th election is indecisive.
What then is to be done? The mounting crisis—and the fact that Greece will almost certainly not pay everybody back on time—will renew some calls to abandon it. That would spell chaos for Greece, European banks and other European countries: the effect would indeed be Lehman-like. Hence the necessity, even at this stage, of a show of financial force, linked to the construction of a stronger firewall between Greece and Europe’s other shaky countries. The priority for European policymakers is to do the same as governments eventually did with the banks: to get ahead of the crisis and to convince investors that they will spend whatever is necessary.
…and the expensive way back
The economics starts with the politics. Europe will not stem this crisis unless its decision-making apparatus is overhauled and Germany radically changes its tune. Mrs Merkel needs to go on German television and explain to her people what is at stake—laying out how much Germany has gained from the euro and what it has to lose from a cascade of chaotic sovereign defaults. Germans need to understand the risks to their banking system and their prosperity. They need to understand that stemming Greece’s debt crisis is less an act of charity than of self-interest. However unfair it seems—and the frugal Germans are as furious about the profligate Greeks as the rest of the world was about bankers—a bail-out is justifiable on the same logic: doing nothing would cost them even more.
The resolve cannot stop at Germany’s borders. Financial markets have no idea who is in charge. Europe’s Byzantine decision-making structure does not help but Germany needs to ensure that decisions are reached fast, that Europe speaks with one voice—and that co-ordination with the IMF is smooth. As a way to convince financial markets that the political weather has changed, the euro zone should set up a single crisis-management committee, with the power to take decisions.
Political resolve won’t work unless the underlying economics make sense. The first test of this is the Greek package. In return for fiscal and structural adjustments that give the economy a hope of stabilising its debts, this must provide enough money to prevent a forced default. Up to €150 billion may be needed over the next three years—better to err by offering too much. But the firebreak between Greece and the other embattled sovereigns of the euro zone is even more important. In economic terms, that should not be too hard to justify. Despite their problems, no country other than Greece is manifestly bust. Portugal is in the greatest danger, but it has a better history of fiscal adjustment which, under plausible assumptions, could allow its debt to stabilise at a manageable level. Spain and Italy could be made insolvent by a long period of high interest rates. But none has the near-inevitability of Greece.
Europe’s policymakers must make those distinctions clearer. The vulnerable economies must step up the reforms they need to rein in deficits and boost growth. Portugal, especially, needs action. The European Central Bank should demonstrate that it has the tools to maintain liquidity even if there is panic. Euro-zone governments should pre-emptively create inter-governmental liquidity lines. Thanks to extraordinary incompetence, Europe’s leaders have almost ensured that the Greek rescue failed before it began. They are paying for that today.
