May 10, 2010
by Clive Crook
At the end of last week, the US looked hard at Greece and was scared. So tiny an economy should not be bringing all of Europe low and even threatening to explode the euro, but it is. What started as a US financial crisis plunged Europe into recession; was Europe about to return the compliment? What, Americans began to wonder, did Europe’s problems tell them about their own?
The cause of the present turmoil, Greek public debt, has aroused fears of a wider sovereign-debt crisis and heightened concern about US government borrowing. More immediately, investors are asking, what if the European Union keeps making a hash of the problem? Will there be a second European banking crisis, and would it infect the US financial system? Even if the answer is no, the US recovery is still fragile. The economy would not be immune to another slump in EU demand.
These fears can be exaggerated, but none is unfounded. In any event, fears do not have to be well-reasoned to make a bad situation worse and justify themselves.
The least substantial line of alarm is Greece as fiscal harbinger. The US might not be Greece, say pessimists, but California could be. Here is a state so strapped for cash that it recently resorted to paying its workers with IOUs rather than money. (If that is not default, it is the next best thing.) Could California do for the US what Greece is doing for the EU?
Unlikely, is the answer. California is a bigger economy: in that sense its problem is on a larger scale. But its debts and deficits are puny compared with Greece’s. Other defences and safety-valves, notably lacking in Europe, are to hand: an activist federal government, a compliant central bank, a currency that cannot conceivably split apart.
The parallel should not be dismissed altogether. A country whose government borrows beyond its capacity must eventually pay the price. Greece does teach that lesson, in case anybody had forgotten it – and in the US, some have. But the greater worry for the US at the moment is not that Europe shows where it is heading but that secondary effects from Greece and any widening emergency will squash its fledgling recovery.
These influences are pushing in opposite directions. A flight to safety from European markets brings investors back to US bonds and pushes US interest rates lower. On the other hand, it depresses the euro, which makes US exports less competitive in a crucial market. If Europe’s economic recovery – which is both weak and delayed as compared with the US – should fail altogether, the US will not be immune.
Financial contagion is the other big risk. Suppose Greece defaults. That will spread losses across the European banking system. Pressure to default could mount on other European countries, starting with Portugal and Spain but maybe spreading further. Just how badly US banks and non-banks are exposed to to these risks – directly, or through credit default swaps and other derivatives – may be unclear until it happens. Any new financial waves would crash over a US government whose fiscal capacity is all but maxed out and a country whose willingness to rescue banks is exhausted.
Up to now, the US has wanted to think that Greece was a European problem that could be left to the EU to solve. Both parts of that supposition have turned out to be wrong. In recent days, the administration said it pressed for a speedier resolution of the Greek mess, and the involvement of the International Monetary Fund in the deal to supply new lending gave the US formal standing on the issue. Yet the problem is no closer to being solved.
The EU-IMF adjustment programme for Greece improves on the previous EU position that Greece must bear all the costs of its troubles alone – but not by much. European and international taxpayers are now on the hook, too. Greece’s creditors are not, however, which is wrong. Partly for that reason, the new plan is nearly as delusional as the old one. As Arvind Subramanian argued on this page last week, it implies three years of crippling austerity, at the end of which Greece’s flattened economy will have to support a far larger public debt than today’s. (This is assuming things go well.) The plan resolves nothing. It is a delaying action at best, and a pretty desperate one at that.
Default looks ever more likely. This can be planned, with some hope of keeping things orderly – though the best chance of that has now been missed. Or it can be unplanned, after a further period of denial in which the problem worsens. Notice the irony. Conventional wisdom holds that early-resolution mechanisms are needed for failing banks and non-banks: the key thing is to get in front of the problem. But a similar logic applies to distressed governments, especially where sharing pain with creditors is concerned. This lesson, evidently, will have to be learnt all over again.
The harder question is whether even a Greek default will resolve Europe’s difficulties. My bet would be no. Greece has a huge primary budget deficit. At least for a time after a debt restructuring it would struggle to find lenders. So even with its debts written down to nothing, it faces a period of fiscal austerity that will be wrenching at best and politically impossible at worst – with no central bank to support demand, and no currency of its own to devalue.
The EU says that default must be avoided at any cost. I say default will happen. The EU says exit from the euro is not an option. I would not count on that, either. In any event, the US had better brace itself.