On Greece and Contagion

It’s Not About Greece Anymore

The Greek “rescue” package announced last weekend is dramatic, unprecedented and far from enough to stabilize the euro zone.

The Greek government and the European Union leadership...have abandoned previous rounds of optimistic forecasts and have now admitted to a profoundly worse situation.

This new program calls for “fiscal adjustments” — cuts to the fiscal deficit, mostly through spending cuts...

This new program is honest enough to show why it is unlikely to succeed.

Daniel Gros, an eminent economist on euro zone issues who is based in Brussels, has argued that for each 1 percent of G.D.P. decline in Greek government spending, total demand in the country falls by 2.5 percent of G.D.P. 

If the government reduces spending by 15 percent of G.D.P. — the initial shock to demand could be well over 30 percent of G.D.P.

...Greece is likely to experience a very sharp recession — and there is substantial uncertainty around how bad the economy will get. 

...Since most Greek debt is held abroad, roughly 80 percent of the budget savings the Greek government makes go straight to Germans, the French and other foreign debt holders...

If growth turns out poorly, will the Greeks be prepared for ever-tougher austerity to pay the Germans?

...If the euro zone proves unwilling to protect a member like Greece from default, then bond investors will run from Portugal and Spain also...  Higher yields on government debt would have caused concerns about potential bank runs in these nations, and then spread to more nations in Europe.

When there is such a “run,” it is not clear where it stops.  In the hazy distance, Belgium, France, Austria and many others were potentially at risk. Even the Germans cannot afford to bail out those nations.

...The program as announced has only a small chance of preventing eventual Greek bankruptcy, but it may still slow or avert a dangerous spiral downward — and enormous collateral damage — in the rest of Europe.

...Someone has to decide who should be defended and at what cost, and the European structures are completely unsuited to this kind of tough decision-making under pressure.

In the extreme downside scenario, Germany is the only obvious safe haven within the euro zone, so its government bond yields would collapse while other governments face sharply rising yields.

The euro zone would likely not hold together.

PETER BOONE AND SIMON JOHNSON
New York Times, May 6, 2010