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Greece Bailout May Fan the Flames of Contagion

Brussels has applied a $228 billion prophylactic to Greece in hopes of stopping the sovereign-debt virus from infecting the region's other economies. Now will it work?

At least global investors are cheered. European stock markets rose. Bond yields sank from their panicky levels earlier this week. New IMF managing director Christine Lagarde did a jig for joy. Some of that joy is warranted, since European leaders appear to have at least established a basic framework for containing the epidemic by, among other things:

  • Establishing a $628 billion fund to buy debt from ailing euronzone countries
  • Providing for banks holding Greek debt to be recapitalized
  • Vowing in principle to pump enough money into Portugal, Ireland, Italy and other indebted countries to keep their economies stable
Crossing the Rubicon
In short, we've stepped off the ledge. Said one economist with a large Italian bank whose stock was pounded this week amid growing fears that Europe's third-largest economy was wobbling:
"These measures are welcome because they create the best possible conditions for Greece and other peripheral countries to put their houses in order and hence limit the risk of contagion," said Marco Valli, chief euro-area economist at UniCredit SpA in Milan.
That may be true, but the key question is for how long? After all, the "best possible conditions" for avoiding fiscal calamity may not be the same as sovereign debtors require to repair their economies. It's hard to see how these nations can grow while the whole of Europe is slashing deficits, as required under the deal. If they can't, then Armageddon has merely been postponed.

And while French President Nicolas Sarkozy chose to dress up the arrangement as a "European Monetary Fund," Felix Salmon notes that the Rubicon of default has been crossed. Whatever the Eurocrats may say about barring other countries from defaulting, the door has been thrown wide open. He writes:

The nature of massive precedent-setting international financing deals is that they never happen only once. There's lots of talk today that this deal is for Greece and for Greece only, but some of the more explicit language to that effect was excised from the final statement. On thing is for sure: these tools will be used again, in future. They will be used again in Greece, since this deal is not enough on its own to bring Greece into solvency; and they will be used in other countries on Europe's periphery too, with Portugal and/or Ireland probably coming next.
That, in turn, raises questions about whether the bailout fund for debtor countries, the so-called European Financial Stability Facility, is sizable enough to withstand future defaults, especially if Italy and Spain continue to deteriorate. Said one London-based economist:
We doubt that this package alone will bring an end to recent contagion effects and prevent the broader debt crisis from continuing to deepen over the coming months.
Sticking it to Germany
If the financial terms of the bailout remain in question, the politics of the deal are even dicier. While European banks will have to accept some losses on their holdings of Greek bonds, German taxpayers are being asked to bear the brunt of the pain. Why? Because they, along with people in Europe's other economically healthier "core" countries, will have to kick in to fund the EFSF, which needs more money to backstop the weaker "peripheral" economies. That's a huge risk now that the default demon is out of the box. As Credit Writedown asks:
[W]hat happens tomorrow when every German (in a population of 82 very efficient million) wakes up to newspaper headlines screaming that their country is now on the hook to 32 percent of its GDP in order to keep insolvent Greece, with its 50-some-year-old retirement age, not to mention Ireland, Portugal, and soon Italy and Spain, as part of the Eurozone?
The Greece bailout has the whiff of TARP, the U.S. government's bank bailout program -- it buys time by postponing calamity, but fails to address the underlying factors that created the crisis in the first place. The disease festers.


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