The contagion from Greece — how far could it spead?
We have cited with favor the historian Niall Ferguson on many occasions in these pages. Here he discusses the structural problems with the euro:
the worst defect in the design of the EMU…was that it was uniting Europe’s currencies but leaving its fiscal policies completely uncoordinated. There were, to be sure, “convergence criteria,” which specified that a country could join only if its deficit was less than 3 percent of gross domestic product and its public debt was less than 60 percent. But even when these were turned into a permanent set of fiscal rules in the Stability and Growth Pact, there was no obvious way they could be enforced…
Britain decided not to join the single currency. A confidential Bank of England paper circulated in 1998 speculated about what would happen if a country — referred to only as “Country I” — ran much larger deficits than were allowed. The result, the bank warned, would be a colossal mess. Why? Because the new European Central Bank (ECB) was prohibited from bailing out a country with such an excess deficit by lending money directly to the government. Yet, at the same time, there was no mechanism for Country I to exit the monetary union…
For nearly nine years after Greece became the 12th EMU member on Jan. 1, 2001, the Cassandras appeared to have gotten it wrong. The euro was a triumphant success. Long-term interest rates converged. True, the fiscal rules were not tightly enforced — indeed, none of the member states really satisfied the convergence criteria when the euro was launched in 1999 — but the trends were healthy. Deficits shrank. And although there was less convergence of inflation rates and economic performance than had been hoped for, there seemed little cause for concern…
in October 2009, a newly elected Greek government fessed up. Greece’s budget deficit was in fact a whopping 12.7 percent of GDP, as opposed to the 6 percent reported by the old government, and more than three times the 3.7 percent promised to the European Commission at the beginning of 2009. It also turned out that the ECB was indirectly funding more than a third of Greek government borrowing via its emergency lending to Greek banks (giving the lie to the supposed “no bailouts” rule)…
The country went into a fiscal death spiral as rising interest rates made the deficit even larger (it’s now up to 13.6 percent) by increasing the costs of debt service…This Greek tragedy has several more acts to come. The first will be a Greek default…The next act will be even more dramatic. For what makes the crisis in tiny Greece so serious is the contagion effect…Even more alarming is the exposure of other EU banks to Greek debt, which totals $193 billion, according to the Bank for International Settlements. Factor in the risk of copycat crises in Portugal and Spain, and you begin to see the outlines of a disastrous Europewide banking crisis.
We discussed the structural problems of the euro a few years ago when some of the obvious strains were between the economies of Germany and Italy. Now the situation seems much more grave, given the revelations and implications of Greece’s fraudulent accounting. (The USA keeps a lot of its out-of-control entitlements off the books too, by the way.) If the predictions of China’s economic bubble bursting come true as well, the global economic forecast could be grim for an extended period of time.