Reprieve in Greece likely to be temporary

Despite the Greece bailout package approval, fears loom that countries in Europe will find it difficult to turnaround.

Even after European leaders averted a chaotic default by Greece with an eleventh-hour deal for aid, worries persist that a debt disaster on the continent has been delayed, rather than avoided.

The tortured process that culminated in that latest bailout has exposed the severe limitations of Europe’s approach to the crisis. Many fear that policymakers simply don’t have the right tools to deal with other troubled countries like Italy, Spain, Ireland and Portugal, a situation that could weigh on the markets and the broader economy.

“I don’t want to be a Cassandra, but the idea that it’s over is an illusion,” said Kenneth S Rogoff, a professor of economics at Harvard University. “I am amazed by the short-term psychology in the market.”

Throughout the crisis, the European Union’s favoured strategy has been to provide tightly controlled financial support to highly indebted countries, in the hope of buying them enough time to implement policies aimed at cutting budget deficits. While such moves can deepen recessions, the goal is to eventually lower debt levels and win back the confidence of the bond markets.

On the margins, investors have become more optimistic. The continent’s stocks and government bonds have rallied sharply this year on the belief that Greece would avoid a disorderly exit from the euro. Recently stocks rose slightly in US and in Europe.  But Greece’s predicament highlights the weakness in the European response.

The austerity policies imposed by authorities contributed to a sharp contraction of the Greek economy, estimated at 6.8 per cent, last year. In 2010, the International Monetary Fund had forecast that the economy would shrink only 2.6 per cent in 2011.

Greece is also resorting to a move that European officials initially wanted to avoid at all costs. As part of the 130 billion euro aid package, the country is going to reduce its overall debt load by requiring some creditors to take losses on Greek bonds. In total, the restructuring will mean private sector holders of Greek bonds take a hit of more than 70 per cent.

European officials want to avoid similar measures for other countries. To avoid such a situation, European officials have introduced a range of measures over the last year that may buy more time for struggling countries. The EU is setting up large pools of money to make emergency loans. And the region’s leaders have agreed to move toward more coordinated fiscal policies, which may pave the way for richer countries to transfer funds to poorer ones.

In perhaps the boldest move, the European Central Bank lent $620 billion to the region’s banks in December. The cheap money, which the central bank will dole out again later this month, has provided an essential lifeline to the region’s financial firms and prevented a bank run in Europe. The three-year loans have also helped firms continue to finance purchases of sovereign bonds, bolstering the debt markets. Spain’s government has already sold more than 30 percent of the $114 billion worth of bonds it plans to issue this year.

But one of the lessons of the post-crisis period in the United States is that monetary policies may only temporarily lift the markets and can take a long time to seep into the real economy.  For instance, the Fed, in its most forceful stimulus measure, spent hundreds of billions of dollars buying bonds. The purchases supplied banks with immense amounts of cash that they were free to use as they wished. The ECB did something different with its $620 billion of loans in December. Banks had to post collateral against the money they borrowed.

While the banks got cash, they still have to pay back the central bank loans in the future, and they remain exposed to the assets they posted as collateral. As a result, the ECB facility may have less effect than the Fed’s bond-buying, said Guy Mandy, a strategist at Nomura International. Even in the United States, monetary policies did little to repair the balance sheets of the most debt-laden sectors of the economy.

That means European government debt levels may take a lot longer to fall than officials hope. Certain governments may then require even more aid because they will not be able to sell bonds into private markets at affordable interest rates.

As with Greece, aid-disbursing countries like Germany might demand even tougher conditions on loans. For a while, the European Union may decide to keep giving aid to countries that do not meet targets, but this could create wider political conflicts in Europe.

If troubled countries find that they cannot comply with the loan conditions – and their richer neighbors grow increasingly impatient – they may have to follow Greece’s lead.

The idea with Greece was that private investors, not just governments, needed to foot some of the cost of the country’s aid package, so they were pressured to accept losses on Greek government bonds. The big risk is that investors, fearing debt write-downs in many countries, would dump European government bonds, triggering new financial and economic weakness in Europe. “I don’t think we’re anywhere near the endgame,” Rogoff of Harvard said.