Why Greece matters

For months, Greece’s fiscal problems were considered by many to be a local affair. European leaders hoped the small, southern European country’s woes were isolated. The Obama administration and American economic experts generally stressed that Greece was a Europe-only issue that didn’t affect them. Despite the fact that the Greek crisis was causing reverberations across global markets, heads of the Eurozone nations dithered while the US kept its distance. Incredibly, they were repeating an earlier mistake: Western political leaders’ indecisiveness over Greece was strikingly similar to their failure to deal with the emerging financial crisis that resulted in the panic of 2008 (but which was evident in 2006 or, at the latest, 2007).

Finally, Eurozone leaders acted. On 2 May, they produced a €110billion relief package for Greece. In exchange, Greece agreed to severe cuts in government spending. But this package did not stabilise financial markets, especially with bond traders threatening to target other heavily indebted countries in Europe, such as Spain and Portugal.

And so a week later, on 9 May, European leaders tried again. This time, they were more ambitious, coming up with a €750billion bailout plan for the region as a whole. In addition, the European Central Bank announced it would buy government bonds. The rescue plan was a big step, an attempt to ‘shock and awe’ the markets and get ahead of the crisis for once.

With this move, no one could claim that the latest predicament was limited to Greece. But with the focus now on Europe, many missed the bigger picture. The bailout signalled that the crisis that was centred on Greece was truly global in nature, and Western leaders were admitting as much. The European rescue package was not adopted just to stop the debt crisis from spreading to Spain and Portugal; it was primarily aimed at halting a financial panic that was feared would send the world economy back into a deep recession. Indeed, even though this was ostensibly a Eurozone issue, officials from the Obama administration were engaged in discussions with their European counterparts before the package was announced, and Obama himself intervened by telephone to urge European leaders to act.

The initial reaction on 10 May indicated that the bailout had worked. Stock markets around the world rallied, and yields on Greek government bonds improved markedly, moving more in line with German and other bonds. The immediate worry – defaults in Greece, Spain and Portugal – seemed to be addressed. But many commentators soon warned that, by adding more debt on top of the existing high debt levels, the rescue plan only pushed back the day of reckoning, and created its own set of problems.

By the end of the week, global financial markets became volatile again. The Euro tumbled in value, and US share prices fell. Notions that the US had ‘decoupled’ from Europe also collapsed. According to reports, investors were fearful of many things: of low growth due to austerity measures; of civil unrest; of a breakup of the Euro (especially after Paul Volcker, former Federal Reserve chairman and sometime Obama adviser, said that the crisis would lead to the ‘disintegration of the Euro’); of the crisis spreading to the US. Over the past weekend, leaders sought to calm nervous investors ahead of the market opening on Monday. Jean-Claude Trichet, president of the European Central Bank, told Der Spiegel that nothing had changed fundamentally, saying ‘price stability is our primary mandate and compass’. The US treasury secretary, Timothy Geithner, told an interviewer that ‘Europe has the capacity to manage through this. And I think they will.’ These trans-Atlantic efforts at market-management indicated that the problem was not limited to Europe.

Of course, financial markets can be subject to overreactions and panics, but investors today are right to be concerned. The crisis in Greece and across Europe matters because it shows that the rescue attempts in late 2008 and early 2009 in the West have not provided a strong foundation for recovery. The crisis has not been resolved, and is now expressing itself in a new form: a fiscal crisis of the state. The financial crash led to worries that financial institutions might default. The bailouts dealt with that immediate risk, but only at the cost of creating a new concern – that sovereign nations would default.

Prior to the 2008 crisis, European government deficits and debts were not excessive, with the exception of Greece. In 2007, Spain had a two per cent budget surplus, Ireland was in balance and Portugal had a modest 2.6 per cent deficit. These countries went into the red due to the financial crisis, as the recession damaged revenues and government spending on bailouts, stimulus packages and unemployment benefits increased in response. By 2009, accumulated debt levels were high not only among the ‘PIGS’ (Portugal, Ireland, Greece, Spain), but other European countries as well: Italy’s debt was 116 per cent of GDP and Germany’s 73 per cent. The US also joined the club, increasing its government debt to 53 per cent of GDP in 2009; some economists predict US debt will grow to over 100 per cent in the near future. The only recent precedents for such high levels of debt are periods following the world wars of the twentieth century.

An article on MarketWatch last week noted that, for the first time, the cost of insuring against sovereign default in Western Europe exceeded the price of protection against default by North American companies. This shift ‘symbolises how credit risk has been transformed from corporate to sovereign risk, as the solution to the financial and economic crisis was government intervention’, wrote Hans Mikkelsen, a credit strategist at Bank of America Merrill Lynch. Moreover, while there have been sovereign debt crises among emerging countries in recent decades, today’s national debt crises are different in that they involve the biggest developed economies.

At the same time, the fiscal crisis today is different; it is much more bound up with private finance, and much more internationalised, than fiscal crises in the past. Private institutions buy and sell government debt on a daily basis, and credit markets operate in a much more fluid way across borders, making national markets more interconnected. Some American commentators have argued that the US economy will remain immune to the Greek crisis, but that seems overly optimistic.

For instance, a Wall Street Journal editorial contended: ‘The banks with the most exposure to Greece and the other indebted European nations are German and French. If those banks need to be recapitalised from taking on too much bad sovereign debt, then that will be a task for German and French taxpayers.’ However, it’s hardly guaranteed that such a problem would remain isolated. For a start, we really do not know the full extent of US risk-exposure: derivatives (such as the much-discussed ‘credit default swaps’) are not transparent, and US institutions could very well be holding substantial amounts. Furthermore, if a Greek default led to significant losses among German and French banks, it is very likely that would have a domino effect on the entire global financial system, given the extent of interconnectedness.

It’s also worth noting that the financial crises today have a disproportionate impact on the real economy, because of the financial sector’s out-sized influence. The stagnation of productive industry in the US and UK has led to a greater reliance on credit expansion and ‘financialisation’ of the economy generally. Instead of forcing through a restructuring of industry, business and political leaders have exhibited a preference to postpone any reckoning, if at all possible, via the use of credit. Consequently, unlike in the past, crises are less likely to originate within productive industrial sectors, but rather, tend to express themselves by means of financial market collapses.

In turn, measures taken to deal with financial crashes build up problems for the future, and give a slightly different form to the next crisis. Today, the bailouts have meant that the banking crisis has morphed into a state fiscal crisis, but that does not mean that finance has been entirely fixed. Indeed, finance is intimately bound up with the fiscal issues, and is effectively tying the hands of political leaders: for example, government debt in Greece and elsewhere in Europe has not been restructured, because such a relaxation or forgiveness could weaken bank balance sheets, which are still fragile.

As the recession was triggered by a financial crash, it was easy to mistake the problem as being solely a financial one. But while a financial panic was the catalyst, the underlying issue was in fact the stagnation of productive industry. The problems of industry expressed themselves as problems of finance. Similarly today, many think that state fiscal problems revealed in Greece and elsewhere are simply due to over-borrowing or excessive spending. But underneath fiscal issues is, again, the issue of economic growth. A big reason for budgets being in the red is the downturn in economic activity. And a fiscal crisis is not so much a statement on a country’s current status as it is about its future: countries enter a crisis situation when there is a lack of confidence in their ability to grow fast enough to repay debt.

Therefore, the way to address state deficits is to grow faster. Even with existing high debt levels today, greater state spending on pro-growth investments (for example in infrastructure and research) can be justified, because they would pay off in terms of economic output. As long as a strong productive foundation is lacking, economies will be highly vulnerable to the vagaries of the financial markets. This is especially true of the US and UK: neither are members of the Eurozone, yet both are at risk from the fallout from the recent crisis. Frederic Mishkin, Columbia University professor and former Federal Reserve governor, says that the US economy is in a solid recovery, but the ‘European mess’ is a ‘new wild card’: ‘We still don’t know how big of a shock this could end up being.’ But the recovery is far from solid, which is one reason why the US is susceptible to the problems that emanate from Europe.

The bailout measures have encouraged a false sense of security about the economy. These rescue programmes have only patched things back together, on the same un-sound basis that existed before the financial panic hit. If properly understood, the disruptions in Greece and the Eurozone should serve as a wake-up call, reminding us that the global economy is far from healthy or stable.

Sean Collins is a writer based in New York. Visit his blog, The American Situation, here.