Advanced Economies: Minutes to Midnight? Part II

WASHINGTON: The slow-motion European sovereign-debt train wreck is rapidly accelerating. Portugal’s request for a bailout in early April was supposed to build a firewall against financial contagion on the Iberian Peninsula. But Madrid’s cost of money has begun to rise amid growing rumors that Greece’s debt may have to be restructured – a polite word for default – later this year. In an earlier era, the United States might have been expected to ride to Europe’s rescue. But Washington is broke, both financially and politically. It looks increasingly like the rest of the world may have to come to Europe’s aid.

Europe’s troubles began in April 2010, when Greece acknowledged that its government deficit was twice as large as previously thought and asked for a €110 billion bailout from other eurozone countries and the International Monetary Fund. Since then, Ireland, beset by a collapsing housing market, has received €85 billion in help. Now Portugal, facing rising costs of funding its debt, is in the process of getting an €80 billion bailout.

But, a quarter of a trillion euros later, the euro crisis shows no sign of abating.

“The real danger,” said David Gordon, head of research at the Eurasia Group, a global consulting firm, “is that the eurozone countries big enough to matter in global finance, Spain and Italy, will find it increasingly difficult to borrow at rates that are financially sustainable. Should this occur, the chances of a truly systemic crisis will grow dramatically.”

The Europeans have tried to stem the crisis. Last year, they created the European Financial Stability Facility, with €250 billion to lend to countries in distress. And this spring they agree to a permanent European Stabilization Mechanism, to come into being in 2013, with €440 billion available for emergencies.

But countries are judged by achievement, not effort. And at every juncture in the euro crisis, the Europeans have been a day late and a euro short.

They dithered for weeks about who would pay for the Greek bailout, raising the ultimate price tag. The bill for the Irish rescue was underestimated and continues to mount. And the bailout fund the Europeans have created is not sufficient to intimidate financial markets intent on testing Europe’s will.

That bill may come due soon.

New York hedge funds have assembled war chests to attack Spain. And Madrid’s cost of borrowing money is rising rapidly. Despite the bursting of Spain’s housing bubble, housing prices have fallen far less than those in Ireland, suggesting prices still have a long way to go before hitting bottom. This could pose real problems for Spain’s savings banks. If the value of the homes on their books shrinks and home foreclosures rise, it would severely undermine their creditworthiness and their ability to lend. Estimates of the eventual cost of restructuring these banks range as high as €100 billion.

European hopes of muddling through the crisis are also premised on unrealistic expectations about economic growth. European growth is doing slightly better than anticipated, but that’s not likely to last. The European Central Bank recently raised its main interest rate, albeit to only 1.25 percent – and, fearful of rising inflation, is expected to do so again soon. This could choke off Europe’s recovery.

And Europe’s economic fortunes remain tied to volatile oil prices. If the price of oil goes above $150 a barrel and stays there through 2012, thanks to continued unrest in the Middle East, then growth in the euro area could slip to 1.5 percent in 2011 and fall into recession in 2012, according to estimates by AXA, one of France’s largest insurance companies.

The main side effect of any new recession would be a full-blown euro debt crisis, triggering a liquidity squeeze for weaker economies such as Spain and possibly Italy. And Europe’s banks, especially those in Germany, are not prepared for a new shortage of capital. German and French banks hold $383 billion in Greek, Irish and Portuguese debt. If these debts must be written down, and their market value may be half what their book value is, German and French banks will be hard pressed. They’ll need to cut their local lending, further impairing European growth prospects.

Europe is now conducting a stress test of its banks to assess their ability to withstand a deepening of the euro crisis. A similar test was conducted in 2010 and found the Irish banks to be safe just weeks before they went belly up. So the tests have little credibility.

If the deepening euro crisis gets out of hand, financial markets once would have expected the United States to take the lead in helping rescue Europe and the world economy.

But the US Treasury has a limited war chest to draw on in the event of trouble in Europe. And even that money is unavailable thanks to congressional restrictions. The US Federal Reserve could offer liquidity to the European Central Bank and European financial institutions. But Fed critics in Congress are likely to make the institution pay a stiff price for such efforts. The White House can jawbone Wall Street to remain calm. But the success of such efforts is likely to be limited.

In the end, all Washington may be able to offer is free advice. And that may be greeted with skepticism. In November 2010, when Ireland’s economy hit the wall, many Europeans suspected that US Secretary of Treasury Timothy Geithner advised Dublin to bail out the Irish banks to avoid another Lehman Brothers debacle – many analysts now credit Washington’s September 2008 decision to allow Lehman Brothers to fail for triggering the global financial meltdown. In retrospect, the bailout saddled the Irish government with massive, unsustainable debts. More advice like that the Europeans don’t want.

If the euro crisis worsens, the rest of the world will have to step up to help. If the euro would begin to plummet, the G20 group of major economies could jointly intervene in currency markets to stem its fall, much as these nations worked together in March 2011 to curb the destabilizing rise of the Japanese yen after the tsunami and nuclear disaster.

Non-European G20 nations could also buy European debt. Before its recent devastating earthquake, the Japanese government offered to buy up to 20 percent of any bonds issued by the European bailout facility. Other G20 members, such as China, India and Brazil, could make a similar commitment, possibly based on some fraction of their foreign-exchange reserves. Such an effort would lower Europe’s borrowing costs and help calm financial markets. If Washington, Tokyo and others choose to do nothing, Brussels will have little choice but to turn to the only lender with deep pockets: Beijing.

It’s not in anyone’s interest that Beijing write this check itself. The leverage such a bailout of Europe would give the Chinese would haunt Washington, Delhi, Tokyo and others for years to come.

So the storm clouds are gathering over Europe again. And this time, governments may not muddle through. If the financial crisis spreads to Spain, Europeans may no longer be able to handle the crisis themselves. With Washington hamstrung, it will be time for the G20 to step up and save the world economy by bailing out Europe.