Deciphering the Crisis in Greece and Its Significance for America

With the world’s stock and bond markets thoroughly roiled by Greece’s sovereign debt problems, it’s only natural to ask the perennial question, how does it affect us? The outlines of the crisis are certainly familiar. As I have warned for more than a year, governments around the world would inevitably face serious fiscal problems dealing with the daunting debts accumulated from the huge bailouts for the financial meltdown and the large stimulus programs for the subsequent deep recession. In countries that began with large deficits and national debts, such as Greece, Portugal, Spain and Italy, those fiscal stresses have become very serious. Here, in the United States, we’re just beginning to hear calls for deficit reductions. If recent history is any guide, we will ignore the problem for several more years, until voters finally demand that Washington take action.  

Greece has no time to wait, despite the violent protests there against budget austerity. Greece is also burdened with a relatively weak and uncompetitive economy, so it cannot generate strong growth to help ease the budget stresses. Moreover, the organization of the Eurozone has acted like a straight-jacket, denying Greece, along with other member-nations with high and fast-rising public debts, two standard strategies to boost competitiveness and help them grow out of this mess. Greece can’t depreciate its currency to make its exports cheaper in foreign markets, since it shares the Euro with many other countries uninterested in a sharp depreciation that would leave them poorer. Greece also can’t cut its interest rates to spur domestic investment and attract capital from other EU countries, since the European Central Bank (ECB) sets the interest rates for everyone in the Euro area.

That’s why Greece has been headed for a default on its government bonds. The hitch is that a default would shatter the EU’s grand myth, that their (partial) economic confederation enhances the efficiency and competitiveness of its members enough to protect them from such crises. Moreover, if the EU stood by as Greece sank, international investors would dump the public bonds of other debt-burdened EU countries, starting with Portugal, Spain and Ireland. All of this would drive down the value of the Euro, especially relative to the currencies of the EU’s two major trading partners, the United States and China. By the way, that’s both bad and good news for us. A stronger dollar would make our exports more expensive in Europe, undermining the President’s hopes of relying on exports to help drive growth at home.  But a stronger dollar, along with the threat of a sudden crisis for the Euro, also draws more foreign capital to the United States, which helps keep our interest rates low.

So far, the EU and the IMF (prodded by us with promises of a large U.S. financial contribution) have headed off a Greek default by unveiling a $1 trillion bailout plan, consisting mainly of loans and a pledge by the European Central Bank to accept Greek bonds as collateral for loans to the European banks that buy those bonds from the Greek government. The fund is big enough to rescue Portugal and Spain as well, a smart move since serial debt defaults pose the greatest danger of all.  

The announcement of the plan strongly recalls the original TARP bailout. Both plans were pulled together hastily to signal government’s determination to head off a collapse. In both cases, the signal is more important than the actual plan, since neither plan makes much economic sense. The EU plan depends, first, on taxpayers across northern Europe agreeing to shoulder much of the costs to rescue Greece and, second, on Athens following through with deep spending cuts and sharp tax increases that are bitterly opposed by most Greeks. Even if all of that comes to pass, the plan has more fundamental flaws. It purports to respond to Greece’s public debt crisis by expanding the debts of Greek and other European banks, as well as other EU governments – as if international investors will generously overlook Europe piling up debt even faster than today. And if Greece does follow through on the draconian austerity measures contemplated in the plan, its economy will sink further, requiring even more public debt. In short, the EU plan is a fantasy; and Greece and Europe will face another round of this debt crisis not very long from now. 

The improbable shape of the EU bailout does recall our own, original TARP plan. Just as the EU bailout does nothing to address Greece’s lack of competitiveness, the TARP in its various versions never addressed the forces and factors that drove our financial crisis. So, 20 months later, our large banks are still not strong enough to resume normal lending to American businesses. Their continuing vulnerability also makes Europe’s current debt problems even more serious for us.  Greek bonds – along with the bonds of Spain, Portugal, Ireland and Italy – are held mainly by financial institutions. German and French banks are the most exposed, but ours are in the mix as well.  Those bonds have been declining in value for weeks, taking their toll on bank balance sheets. A formal default by Greece would hit all of them; and serial defaults by Greece, Portugal and then Spain – and possibly Italy – would trigger another worldwide financial crisis.

This time, we would have few policy tools left to stop a downward spiral – and Congress almost certainly would fiercely oppose another huge taxpayer bailout, especially Republicans in the midst of a populist purification process that already has purged Bob Bennett in Utah and Charlie Crist in Florida. This is still all speculative – thank goodness – but we could find ourselves with very few options to address a crisis which ultimately could lead to a Second Great Depression. Our best hope for now is that Greece and the Eurozone will somehow muddle through, much as we did in 2009.