Europe shambles as Greek fire spreads

By J Saft
April 29, 2010

Europe desperately needs to get out in front of its solvency problem, Greek edition; not because it is right, not even because it will work in the long term, but to stem rapid and costly contagion through financial markets to other weak links in the euro zone, not least to banks.

Whether euro zone institutions will have the agility and resolve to quickly put in place out-sized measures for Greece is doubtful.

That Greece on Wednesday was paying more than 20 percent, or about double the rate of Hugo Chavez’s Venezuela, to borrow money for two years showed that investors were expecting either a default or very large burden sharing by existing creditors, and possibly a, by definition, disorderly exit from the euro by Greece. Spain joined the list of sovereign downgrades, as Standard & Poor’s cut its rating a notch to AA, a day after the debt rating agency slashed Greece to junk status and cut Portugal to AA.

The moves prompted rapid widening of Spanish and Portuguese debt, and hit financial markets world-wide. Investors, lulled by an apparently miraculous government-underwritten escape from the banking crisis, and aware of how badly things would go if Greece were not bailed out, had been operating on a cheerful if lazy assumption that this crisis too would be made to disappear, because the alternative is too horrible.

Month has followed month, meeting has piled upon meeting and even with broad consensus there is still huge lack of clarity about who in the European Union is going to do what exactly to whom.

It has, frankly, become surreal. German Chancellor Angela Merkel opined on Wednesday that, “We are on a good path now,” while in the next breath saying “I think the handling of the Greece case shows that everyone knows we cannot allow the same situation with countries as with Lehman Brothers.”

Everyone may well know it, but not everyone, including many politicians in Germany, are acting that way and dropping the L-word without already having a massive, credible plan to brandish is foolish in the extreme.

IMF Managing Director Dominique Strauss-Kahn declined to name a figure or detail how a package of aid would work, delaying until final arrangements with the Greek government are concluded. Meanwhile the problems that the IMF, Germany and the rest of us have to contend with are growing by the minute.

Markets are fast-forwarding to not just a Greek default or restructuring to there being a small probability of a very large-impact generalized crisis among the weaker euro zone countries. This would not just be a problem for Europe, but could easily spill over into a generalized funding crisis for banks. Already the cost to insure Spanish and Portuguese banks against default has risen sharply, but a generalized crisis would hit German and French banks, which are heavily exposed to peripheral European loans.

DON’T COUNT ON THE ECB
Compare the situation in the euro zone to the United States in 2008 and 2009, when it managed to get out in front of its own banking solvency crisis. Because the U.S. had a single fiscal authority it was able to quickly marshal forces for a bailout. Even then it needed the Federal Reserve to take steps that arguably took it beyond its mandate and infringed on the constitutional privileges of Congress. You can, as I do, disagree with the strategy and the way the burden was shared, but having a plan and executing it beats the alternative.

Do not count on the European Central Bank taking similarly extraordinary steps — for example by monetizing Greek debt by buying it up in the open market. The ECB has steadfastly maintained that it will not be the instrument of a bailout.

The irony, of course, is that monetization and much, much looser policy is probably going to be exactly what the euro zone needs. For Greece to get back to a position of international competitiveness while cutting budgets sharply, it will have to suffer hugely deflationary conditions, probably for years on end. A double dip is not a threat but a promise.

Spain, Ireland, Italy and Portugal face a similar fate; either a rapid disorderly exit from the constraints of euro union or years of pain.

It may be inevitable that a currency union without fiscal unity was bound to break under stress, and there is little question that, even if bailed out convincingly, Greece has a high chance of being politically unable to keep to its side of even the gentlest bargain.

Even that small chance was worth paying a very large price for. As it stands, we may end up with a big bailout for Greece that, though it would have been big enough in January, melts in the warmth of May.

(Editing by James Dalgleish)

(At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund.)

Europe desperately needs to get out in front of its solvency problem, Greek edition; not because it is right, not even because it will work in the long term, but to stem rapid and costly contagion through financial markets to other weak links in the euro zone, not least to banks.
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