Don’t bet that the latest financial rescue of Greece — with some aid also for Ireland and Portugal — will end Europe’s debt crisis. Almost certainly, it won’t.
The reason: contagion. That’s a fancy word meaning that the European Union’s efforts to contain the crisis may ultimately spread it to other countries. Spain and Italy are likely candidates.
If Greece’s debt problems — and those of Ireland and Portugal — were isolated, the latest rescue might work. Together these small countries represent about 4.5 percent of the economy (gross domestic product) of the 27-nation European Union. All have heavy debt loads. Greece’s government debt is now reckoned at about 166 percent of its gross domestic product. Greece can’t borrow in financial markets to roll over maturing debt and cover its existing budget deficit.
The classic solution to this sort of debt problem is simple, if harsh. Governments embrace austerity, reduce spending and raise taxes to curb budget deficits. Meanwhile, they get new loans from other countries or the International Monetary Fund to prevent an economic collapse. If none of this works, they default on debts or negotiate writedowns.
What the European Union has done is to provide a new 109 billion euro loan to Greece (that’s $153 billion at $1.40 to the euro). In addition, some of Greece’s private lenders “voluntarily” agreed to swap existing debt for longer-maturity bonds, up to 30 years, at altered interest rates. Presumably, the debt exchanges would provide Greece added breathing room.
The trouble is that Greece’s debt problems are not isolated. They are shared in some way by most European countries. In 2010, government debt for all the European Union averaged 80 percent of GDP, up from 59 percent in 2007. Italy’s debt was 119 percent of GDP, Belgium’s 97 percent. Worse, European banks hold much of this debt. Writedowns or defaults would weaken the banks, making it harder for them to support a recovery and — at worst — triggering a financial panic.
Unfortunately, the latest Greek rescue makes all European government debt riskier. The “voluntary” debt writedowns by private lenders, apparently demanded by German Chancellor Angela Merkel, constitutes a partial Greek default, whether or not rating agencies declare one. Lenders had been assured that no country using the euro would default, write economists Peter Boone and Simon Johnson of the Peterson Institute for International Economics. Other euro countries would protect the lenders; now, the so-called voluntary write-down undermines that guarantee.
Without it, lenders face greater possible losses. As a result, investors are already “demanding higher interest rates to hold these debts,” say Boone and Johnson in a new paper. There’s a specter of a vicious circle. Higher interest rates expand budget deficits, requiring more austerity to offset greater interest payments. Countries (Spain, Italy?) find it harder to satisfy both their electorates and the financial markets.
Boone and Johnson speculate that there could be a “disorderly series of financial sector (i.e., banking) and sovereign defaults” or even “large-scale capital flight into ‘safe countries.’ ” European leaders understand the risks, and in announcing the Greek rescue, emphasized that the voluntary debt writedowns are “exceptional and unique,” applying only to Greece. These are brave words. But then, words are cheap.