Greek default on its sovereign debt obligations will happen — as it did in 1826, 1843, 1860, 1894 and 1932. Germans won’t continue to bail out their fragile neighbors unless there is some consequence for irresponsibility. And irresponsibility is now Greece’s main economic product. So the short-term goal is to manage a Greek default while creating a firewall round the rest of the European Union.
The problem is that such firewalls are easily leapt during a financial panic. “Greece is about 2 percent of European GDP,” World Bank President Bob Zoellick told me, “but if not handled with care, it could have an effect like Lehman.”
Greece is a genuine basket case — not only unable to pay its debts but unable to maintain its current standard of living unless it becomes more competitive in global markets. Portugal may be in the same category. Right now, Spain and Italy are not. They lack the cash to pay their debts but not the long-term capacity to meet their obligations, at least at reasonable interest rates. But a financial panic would change this overnight. Investors would flee to investments safer than Spanish and Italian bonds. Increased interest rates would turn the Spanish and Italian cash-flow challenge into a solvency crisis. The dominoes would begin to fall.
Who will save Europe? Some have mentioned China as a possibility — a nation with sufficient cash on hand. But Zoellick counters, “The role of China as the euro zone’s savior is overstated. China is reluctant to spend money to bail out uncertain credits when its own per capita income is just above $4,000 and Europe’s is more than $38,000.”
The U.S. Federal Reserve has helped to prop up European financial institutions. But only Europe can address the underlying problems. Its response, so far, has been incremental rather than decisive. The bailout fund it created was too small. Now it is attempting to increase the fund’s size and flexibility, with the goal of assuring investors that Spain and Italy won’t go under. All along, the goal has been to relieve pressure, not resolve fundamental issues.
“They are taking a ‘buy time’ approach,” says Zoellick. “But buying time to do what? They need a solution that interconnects sovereign debt, banks and, for some, competitiveness. Europe needs to decide what type of fiscal union would complement monetary union — or how to manage the consequences of the alternative.”
The European Union’s long-term problem is a structural flaw. It shares a common currency but not a system to ensure that its individual members are fiscally responsible. The United States faced a similar challenge in 1790, when Treasury Secretary Alexander Hamilton engineered the federal assumption of state debts incurred during the Revolution — a remarkable success, which caused the price of American bonds to soar. “He touched the dead corpse of public credit,” said Daniel Webster of Hamilton, “and it sprung upon its feet.”
Only Germany has the strength and standing to play a similar role in Europe. But Germans are reluctant Hamiltonians. They naturally resist paying the bills for their profligate European cousins. And other nations have plenty of historical reasons to fear German dominance in Europe. Still, Germany is being led, step by shuffling step, into this role — as its recent approval of an expanded bailout fund indicates. It has made some progress imposing fiscal discipline on the weaker parts of Europe as a condition for bailout money.
But a “buy time” approach may not be enough. If the bailout fund — and Germany’s hesitant leadership — proves insufficient to stop a European panic, the U.S. economy would be further unnerved. The value of U.S.-owned European assets would tumble. U.S. businesses, currently sitting on significant amounts of cash, would be tempted, once again, to postpone investment decisions. Consumers, once again, would feel hesitant about making major expenditures. Slow growth would further undermine America’s fiscal position.
“The U.S. problem could be as serious as Europe’s,” says Zoellick, “but it is not as imminent.” The difficulty is that Europe’s problem could make ours more complex.