JUST AS THE WORLD ECONOMY WAS BEGINNING TO ENJOY A RESPITE from the sub-prime mortgage financial mayhem, the Greek debt crisis detonated. With it come serious risks to the emerging recovery: fears of Greek “contagion” may push up bond prices for other governments and trigger a broader retreat in bank lending; broad efforts at financial regulatory reform may be suspended in deference to dealing with the immediate emergency; initiation of “exit strategies” to unwind crisis-induced fiscal and monetary stimulus may be put even further into the future, leading governing institutions that had been focused on lowering debt levels to go in the opposite direction; the post-World War II welfare state may prove to be unsustainable; so may be the Eurozone; and more broadly, the international financial order as we know it may have to be altered.
Countering these risks is the reality of the recovery and the consequent prospects for declining unemployment and growing government revenues and corporate profits. Therefore, few are predicting such drastic impacts in the near term. Moreover, there is hope that the EU’s May 9 “shock and awe” rescue and prophylactic response will calm the Greek drama and forestall its spread. Yet this outcome is not assured and may only postpone reckoning with overindebtedness until the next downturn. Thus, uncertainty remains endemic. This WIBR will sum up the current situation and look at how Washington and the world are seeking to get a handle on it.
THE CRISIS – The Greek debt crisis and the peril it brings for the euro and the Eurozone is a component of the larger global financial crisis of the past 20 months. It has implications for U.S. policy because: 1) it raises broad issues that this country, too, can’t escape; 2) Washington will be participating directly in the crisis containment effort; 3) U.S. financial institutions hold about $1 trillion in European debt; and 4) because if the rescue fails, the impact will be global, with a spreading crisis potentially threatening the recovery that is now bringing relief to the embattled American economy. And recent news on the recovery front has been good.
Right Now, the Upturn is Real: The economic upturn is taking hold in the U.S., with output, employment, and demand (including in the housing and auto sectors) rising. While the Greek crisis and its surrounding environment have caused market jitters, the recovery does not appear immediately threatened, but any Eurozone slowdown and further euro decline would hurt U.S. exports. In the longer term, however, and especially when the next cyclical downturn begins, both the underlying problems revealed by the Greek crisis and the response to it by governments and financial authorities could make things worse.
But Future Problems Are Just as Real: Basic dilemmas highlighted by the Greek near-default that are on the radar screens of the rest of the developed world center on the ability of governments to begin to rein in debt that has been mounting for decades and picked up pace in response to the global financial crisis. “Exit strategies” from the fiscal and monetary stimulus of the last 20 months are not on anyone’s immediate agenda but are part of everyone’s future plans. These efforts will likely involve higher interest rates and budget austerity measures that will not only face popular resistance but also undercut growth. So the choice will emerge between engaging in actions that renew recessionary pressures or ones that lead to unsustainable government finances and thus also to (recession-inducing) higher interest rates, or even the prospect of default.
On the other side from the immediate targets of austerity are the populations of the economically stronger nations who are being asked to bail out the immediately crisis-prone. The dilemma of pursuing such international rescue efforts in the face of popular resistance is apparent in Germany (witness the ruling party’s May election loss in Germany’s largest state) and in the U.S., where questions are being raised about Washington’s participation in the Greek rescue, through the IMF’s funding offer and the renewal of central bank swap arrangements. Republicans in Congress are already drafting a bill to bar the Treasury from agreeing to IMF loans to any Eurozone nation. They claim such IMF help would put at risk U.S. taxpayer dollars better spent at home while discouraging needed fiscal restraint abroad. Federal Reserve Board Chairman Ben Bernanke met with wary Senators on May 11 to assure them that the Fed’s role in the Eurozone rescue effort would be fully transparent.
In 2009, the debt-to-GDP ratio for Greece was 115%; for the U.S. it was 53%, but it’s expected to reach 90%, the level at which growth is directly impacted, within the decade. It should be noted that Spain and Portugal, thought to be threatened most by “Greek contagion,” have significantly lower debt-to-GDP and deficit-to-GDP ratios than Greece and have just vowed to undertake new austerity steps, while the debt-to-GDP ratio of the UK, another country purported to be at risk, is lower than the Eurozone average. Still, no Eurozone country has kept the pledge to maintain government deficits below 3% of GDP, and there are fears that despite the apparent unity of the response, the current crisis will exacerbate strains within the currency bloc.
Most fundamentally, the Greek crisis has thrown into relief the dilemma of advanced nations whose past spending and indebtedness, public and private, and promises of future spending through entitlement programs is fast catching up with a reality that includes a dwindling ability to raise taxes or print money. The circumstance is exacerbated by the demographics of an aging population -- Japan, for example, has a debt-to-GDP ratio approaching 100% and a population in absolute decline and aging at an accelerating rate.
THE RESPONSE – As the Greek debt crisis unfolded, Europe (after some initial steps viewed as inadequate) was pushed into responses dubbed “shock and awe” and the “nuclear option.” Washington was closely involved, both in the actual measures adopted and in prodding France and, especially, Germany into taking overwhelming steps to reverse the dangerous trajectory of market sentiment. Initial market reaction to the big move was positive, though this quickly tempered to a more cautious attitude as markets awaited further details and questions lingered about the functioning and ultimate impact of the new arrangement. General sentiment remains that Greece’s debt will ultimately have to be restructured. There is also recognition that one lasting impact of all the efforts to counter the global financial crisis is to transfer over-indebtedness from commercial to sovereign debt – a change, but not a solution.
Crafting a New Mechanism: In early May, G7 finance ministers agreed on $145 billion in subsidized loans to prop up Greek finances in exchange for Greek austerity moves. The plan was to be endorsed by EU leaders on May 7 – but by then the effort was recognized as insufficient in amount and scope (directed only at Greece), leading the leaders to tackle the matter themselves on May 9. Encouraged by phone calls from President Barack Obama to his German and French counterparts, they agreed to a rescue package including new lending totaling almost $1 trillion. The largest of all government bailouts to date, it is to remain in effect for three years. Two-thirds of the funding is to come from a new European Financial Stabilization mechanism, to be paid into by the stronger EU economies, and one-third from the International Monetary Fund. This new facility will issue loans and loan guarantees as needed and if needed by any debt-strapped Eurozone country. Further details were not forthcoming.
The hope is that the new mechanism won’t actually be triggered – that the fact of its creation will be enough reassurance for lenders to continue buying bonds of governments with shaky finances because the risk will have been alleviated (in fact, reduced to zero if the commitment to the facility can be trusted, with the risk transferred to European and other taxpayers). It is also hoped that this mechanism will deter speculation against the euro.
Continued market squeamishness comes from the kicking-the-can-down-the-road quality of the arrangement. If the governments it is supposed to help, led by Athens, don’t come through with meaningful and painful belt-tightening – which it is feared they may not, due to the “moral hazard” induced by subsidized and guaranteed borrowing – then the result, whether the facility is triggered or not, will simply be an increase in indebtedness that will be that much more difficult to deal with in the future. For the present, however, the global recovery is expected to bring enough breathing space so that the EU’s “shock and awe” maneuver will be more than enough to contain any immediate risks of a debt or currency blowup.
Renewing an Old Structure: The second component of the European package, one that directly involves the U.S., is revival of a temporary central bank dollar swap program that was in effect from December 2007 to February 2010 and which actually earned interest for the Fed. The program, renewed to next January, will enable the Fed to sell dollars to the central banks of the EU, Canada, the UK, Japan, and Switzerland in exchange for local currency. These central banks, which will later buy back their currencies from the Fed, can in turn lend the U.S. currency to commercial banks which are having trouble acquiring dollars. The dollar problem is due to an incipient liquidity squeeze, spawned by market reaction to the Greek crisis, that has raised fears of a lending paralysis mirroring that which followed the September 2008 collapse of Lehman Brothers. The Fed stated that it took action “in response to the reemergence of strains in U.S. dollar short-term funding markets in Europe,” and to avert the spread of these strains.
Undoing a Commitment: The final element of the response package raised eyebrows. It reversed a previous stance of the European Central Bank, perhaps violating its charter while calling into question its political independence. It is also the element that was put into effect immediately. On May 10 the ECB announced that it would buy government and private bonds - a move of such significance that it is known as the “nuclear option” – when just three days before the ECB had ruled out such action in a statement that helped depress global stock prices. ECB President Jean-Claude Trichet assured the currency markets that the newly authorized purchases would be sterilized (not leading to an increase in euros). He also assured them that the central bank hadn’t buckled to political pressure, though the trigger was pulled on the “nuclear option” in clear coordination with the political leaders’ “shock and awe” blast. (Trichet also admitted that support for the move on the ECB governing council wasn’t unanimous.) The move raises questions about both ECB credibility and euro stability over the longer term.
THE REGULATORY AGENDA – The eruption of the Greece crisis intersected national and international efforts to strengthen banking regulation. Abroad, there hasn’t been much success in new efforts to establish international regulatory mechanisms or even guidelines. But the decades-old Basel Committee on Banking Supervision has won G20 endorsement of an updating of bank rules and capital requirements that currently constitute the main international regulations imposed on financial institutions. Since the Greek crisis emerged, however, the plans to tighten bank accounting of risky assets and impose stiffer “Basel-III” capital requirements over the next couple of years have been called into question. Banks (led by the Europeans) now argue that the crisis shows the global financial system to be too fragile to absorb additional regulations in such a short timeframe. As one private sector analyst put it, politicians must realize they cannot “regulate the banks’ profitability away and expect them to keep buying your debts.”
And on Capitol Hill: The House of Representatives passed a broad banking regulation bill late last year. The Senate is currently debating its version, which most observers expect, given its popular appeal, will pass with bipartisan support and be reconciled with the quite different House legislation. The Senate has already voted for a one-time audit of the Fed’s operations during the financial crisis; the House bill allows continuing audits. The Senate voted down a break-up of large banks and is working on an array of other amendments, including provisions to establish a new consumer protection agency (Republicans wish to restrain its powers) and to regulate (or even ban banks from) derivatives trading. Highly controversial was a Republican amendment to reform mortgage giants Fannie Mae and Freddie Mac, removing government support within two years. That proposal failed, with Democrats vowing to take up the question next year. But with both of these government-sponsored enterprises continually needing new infusions of tax-payer funding (now totaling $145 billion), the issue is likely to be part of the fall political campaigns.
THE CHINA CONNECTION – In further fallout from the Greek/Eurozone crisis, speculation has surfaced that Beijing may not soon resume yuan appreciation that had been expected by summer. It can claim it won’t make a major currency move during global financial turmoil and can argue that the plunge in the euro has in effect caused the yuan to appreciate. However, since the euro fell against the dollar as well, this effective appreciation isn’t reflected in a change in the dollar/yuan rate. Thus, China may once again disappoint U.S. currency expectations, a recipe for a further rise in U.S.-China tensions. Beijing is also now draining some of the liquidity it injected at the onset of the financial crisis. This is an effort at averting inflation and a real estate bubble, but the resulting slowing of the Chinese economy won’t be welcome elsewhere.
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