January 23, 2012

AS EUROPE GOES, so may go the U.S. and global economies. Europe’s fate, in turn, hinges on what happens in Greece, whose debt crisis triggered the broader predicament of the euro and the 17 nations that use it. Alas, the news from Athens is not bright. Not only did Greece fail to meet its deficit reduction and growth targets for 2011, with a further deep recession forecast for 2012, but negotiations to write down the $260 billion in Greek debt held by the private sector have bogged down.

Back in July, Europe’s leaders pledged more bailout funds for Greece, conditioned on its creditors taking a 50 percent “haircut”; that hit to banks, insurance companies and the like, plus structural reforms and austerity measures, was supposed to help Greece cut the ratio between its debt and its gross domestic product to a sustainable 120 percent by 2020.

Without a deal, Greece’s backers in Europe and the International Monetary Fund might refuse to supply the cash Greece needs to pay off $18.5 billion worth of bonds maturing in March. If that happens, the long-anticipated and much-feared messy default would be at hand.

The sticking point in the talks is how much interest Greece would pay on new bonds creditors would receive in exchange for their old ones. According to news reports, Athens is offering something in the neighborhood of 3.5 percent; bondholders want 4 percent. Either way, it should be noted, creditors would be taking much more than a 50 percent hit, in present-value terms. Still, banks are probably willing to cut a deal. Hedge funds, by contrast, are holding out, because they bought their bonds at deep discounts and therefore have relatively little to lose.

The hedgies’ supposed greed infuriates many in Europe but is an issue that Europe’s leaders, especially Germany’s Angela Merkel, created by insisting that the private sector take losses in the first place. That gave bondholders an incentive to dump their paper, and bottom-feeding hedge funds an incentive to gamble on it.

The likeliest outcome is a last-minute deal, with all but a relative handful of creditors taking part. But even then, Greece could well need tens of billions of dollars in additional funds to meet its debt-reduction targets, because its fiscal situation deteriorated so substantially during the protracted haggling with the banks. In fact, the reluctance of the IMF or Germany to make up that shortfall explains the current impasse. They won’t let Greece sign a deal that leaves them excessively on the hook.

What everyone needs to see, of course, is clear evidence that Greece’s government is on an irreversible path to reform and growth. And despite the best intentions of the technocratic government under Prime Minister Lucas Papademos, there is no such evidence. There probably won’t be before national elections in April.

If the crunch comes before then, “notions of European solidarity will truly be tested,” as Jacob Kirkegaard of the Peterson institute for International Economics puts it. Translation: Germany may have to decide once and for all whether the benefits of keeping Greece afloat as a member of the euro outweigh the costs. It’s discomfiting to reflect on how much the United States depends on the outcome — and how little influence Washington has.

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