The European Union’s decision to rescue Greece and to create a massive financial safety net for its other vulnerable debtors is a momentous event — though success is hardly guaranteed. Contrary to popular belief, the main purpose was not to save Greece but to prevent another financial panic that might plunge the world economy back into recession.
How could tiny Greece trigger such a dreadful chain reaction? Simple.
Suppose Greece had defaulted on its government bonds. That might have caused a flight from the bonds of Spain, Portugal and other European countries with high budget deficits or debt. European bank cross-border holdings of Greek, Portuguese, Irish and Spanish bonds total about $250 billion, estimates the Institute of International Finance. With mounting losses, banks would have trouble raising funds. Their stocks would drop.
Panics thrive on fear and ignorance. After Lehman Brothers failure, investors rushed to safety. Markets plunged; lending fell; optimism collapsed and the economy sank.
America’s interest lies in preventing a repetition. We ought to support Europe’s rescue package. Europe’s problems aren’t its alone; markets are global. In 2009, U.S. bank lending to Europe was $1.5 trillion. This larger lesson seems lost on the U.S. Senate. Just the other day, it voted 94-0, in a largely symbolic gesture, to limit American participation, through the International Monetary Fund, in the European rescue. That may be good politics, pandering to populist hostility to “bailouts.” But the overt nationalism could shake confidence and backfire on everyone.
The European rescue plan has three parts.
First, it provides a 110 billion euro loan to Greece — 80 billion euros from other European countries and 30 billion from the IMF. In dollars, that’s about $135 billion at present exchange rates. With these funds, Greece could repay maturing bonds and temporarily wouldn’t have to borrow from private markets.
Second, European governments and the IMF have created a 750 billion euro safety net for other vulnerable debtors. (The dollar amount: about $925 billion.) These loans would provide a backstop for Portugal, Spain and Ireland.
Third, the European Central Bank — Europe’s equivalent of the Federal Reserve — has pledged to buy unspecified amounts of the bonds of weaker debtors. Reversing a previous policy, the ECB would create a further financial safety net and aim to keep interest rates low.
All this amounts to a “grand bargain,” says economist Jacob Kirkegaard of the Peterson Institute. Debtor countries get temporary loans and ECB support. In return, they cut budget deficits enough to restore the confidence of private lenders. To qualify for loans, Greece committed to spending cuts and tax increases. Spain has announced cuts in government salaries, suspension of an increase in old- age benefits and the scrapping of a proposed subsidy for new parents. Portugal has also announced deficit cuts.
Plenty could go wrong. Kirkegaard and many budget experts believe that Greece will ultimately default. Its debts are too large in relation to its economy; they will need to be written down. At best, the rescues buy time. They allow for a larger crisis to be defused. But even this requires Spain, Portugal, Ireland and others to act decisively.
The euro’s steady decline on foreign exchange markets in recent weeks suggests much skepticism that Europe can win its gamble. Even if it does, the spending cuts and tax increases will dampen already-low economic growth. Europe’s contribution to the global recovery will be meager.
But if the gamble fails, much worse may lie ahead. Europe is trying to muddle through. We should not make the job any harder.
