Europe's Perfect Financial Storm

The heads of the European Union are meeting in an emergency summit to try to resolve the Greek debt situation. But the best they are likely to manage is a temporary fix. A tentative plan agreed to yesterday by French President Nicolas Sarkozy and German Chancellor Angela Merkel is to be presented to the summit this afternoon. But it is unlikely to resolve the long-term structural problems.

Greece's inability to roll over its public debt is rapidly turning into a crisis for the EU as a whole, because speculators in money markets anticipate "contagion" to other nations' debts, and thus make bets against other euro-using countries with relatively weak economies such as Portugal, Spain, Ireland, and most recently Italy. In this manner, the prediction of defaults becomes a self-fulfilling prophecy. It's the equivalent of a run on the bank.

There are two basic views of what caused this crisis and what to do about it. In the prevailing view, these nations largely brought the debt calamity upon themselves by borrowing too much. Many conservative critics also argue that the euro was a mistake to begin with, because it imagined an economic convergence where none existed. The Eurozone, in effect, permitted countries with weaker economies to borrow at low interest rates. Investors treated Greece as if it were Germany, and Greece took full advantage. This invited an orgy of irresponsible debt.

The euro, in this view, was a risky proposition in two other respects. It denied countries with lagging economies the ability to devalue their currencies, the usual remedy. Devaluation increases the cost of imports, while making exports cheaper in world markets. But Italy, which repeatedly devalued the lira in years past, cannot devalue its way out of the present crisis. Same story for Greece. Both are stuck with the euro.

A second oft-heard criticism is that the euro system created a European Central Bank (ECB), but not a European fiscal authority. Taxing and spending are mostly the province of member governments, while financial regulation is divided between the EU and its member states. This could work tolerably well in normal times, but not in a severe crisis, say the critics.

In fact, the ECB performed very well in the 2007-2008 phase of the crisis, when commercial banks were stuck with often worthless securities spawned by the subprime mess. The ECB just kept advancing banks' money. But when the crisis mutated into one of money markets betting against sovereign debt, the ECB lacked sufficient unilateral power to devise a solution, while the EU's member states each looked to their own interests.

In this conservative view, it is up to the suffering countries that money markets are betting against -- Greece, Portugal, Spain, Ireland -- to tighten their belts even further, to reassure private speculators and save the euro. The ECB can do its part by advancing these governments just enough money to pay back banks as debts come due. Some leaders, like France's Sarkozy, want the banks to agree to some voluntary debt reduction. If leaders fail to broker some kind of a deal along these lines, the entire EU could blow up, with catastrophic spillover effects on the rest of the world economy, because there are so many linkages among the world's financial systems.

This conservative view of the crisis is mostly self-serving fiction. The piece of it that is partly true is the fact that the institutions of the European Union are so fragmented that they do not perform well in a severe crisis. When the United States experienced a rolling financial collapse in September 2008, Fed Chair Ben Bernanke, then-Treasury Secretary Hank Paulson, and the then-president of the New York Fed, Tim Geithner, could huddle with major bankers and come up with a plan. It was a lousy plan, whose inadequacies are still reverberating -- basically, the government threw money at the banks -- but it did prevent a full-blown depression.

But there is no such small committee in Europe that controls both the power to print money with the power to appropriate public funds and regulate banks. In Europe, that power is fragmented.

It's also a fair criticism that Greece, and maybe Italy, borrowed too much, though that's not true of Ireland, Spain, and Portugal, countries that were mainly victims of the mistakes of others in the private sector. However, Europe finds itself in such dire straits mainly because of the behavior of private banks, the risks that they took and the exotic securities that bankers invented, not because of inadequacies of European institutions.

Consider Greece, a fairly small country within the larger EU. Greece owes about $350 billion, about 70 percent to foreign borrowers. It can afford to pay back maybe half of that. Normally, a $175 billion foreign debt crisis is well within the capacity of a major government such as the U.S. or EU. The Latin America debt crisis of the 1980s was much larger.

But in that era, there were no credit-default swaps magnifying the size of the financial system's exposure. Under the Brady plan, debts were restructured, banks suffered losses averaging around 30 cents on the dollar, Latin American growth resumed, and that was that. However, since that era, the wise guys in the money markets invented swaps, which they are using to bet on a Greek default. That means more money is at risk than the value of the Greek bonds -- nobody knows exactly how much.

The European authorities have been dithering and delaying a day of reckoning because a sensible restructuring of Greek debt would be considered a default event, which would trigger payments under swaps contracts, most of which are backed by nothing. In other words, the banking authorities have learned nothing since the AIG collapse -- pure gambling with swaps still is rampant.

As a consequence, Europe's governments have been imploring banks to agree to a "voluntary," partial restructuring that would not be considered a default. That way, swaps payments would not be triggered. But the banks are no dummies; they have the governments over a barrel, and they know it.

The longer Europe's leaders wait, the more the speculators bet against the bonds of other counties. It would be far better policy for the Europeans to proceed with a Brady style-plan that restructures Greece's debts, and let speculators take a big hit. They can contain the spillover damage and get on with the business of reforming the system.

Those reforms should include massive tax reform within Greece, maybe even an EU takeover of Greece's revenue-collection system, in exchange for real debt relief so that Greece can begin growing again. Another reform should ban "naked" credit-default swaps, which are pure gambling and not insurance contracts backed by reserves.

A longer-term reform would create a European fiscal authority. It would sell Euro bonds backed by the full faith and credit of Europe's strongest governments. Countries could utilize those bonds, within fiscal limits. If they wanted to sell their own bonds beyond those limits, they would very likely have to pay higher rates. But there would be no use of credit-default swaps to bet on their default.

Because of Europe's fragmented political system, getting real reforms is institutionally very challenging. By contrast, solving the U.S. debt crisis -- an entirely artificial one created by Republican demagoguery -- is relatively easy. Global money markets, even now, still have confidence in the dollar and in U.S. Treasury bonds.

If Europe lets Greece default, it will be the result of complex institutional blockages compounded by reckless private money-market behavior. If the U.S. defaults, it will be the result of partisan stupidity. And if there are near simultaneous defaults on both sides of the Atlantic, God help us all.

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