A Two-Speed Reaction To the Euro Crisis

Among the clearest of patterns that has characterized the Eurozone debt crisis has been the very different pace at which markets and the European official sector have reacted to the unfolding drama. Whereas markets have reacted more at the speed of light, the official reaction has been more at the speed of molasses. The all too likely persistence of the official sector's institutional inability to get ahead of the markets could very well prove to be the Euro's undoing.

Markets were slow to recognize Greece's solvency problems prior to Prime Minister Papandreou's admission in October 2009 that Greece had been egregiously understating the real size of its budget deficit. Once markets internalized that Greece's budget deficit was more of the order of 15 percent of GDP rather than the earlier reported 6 percent, they sent Greek sovereign interest rates on a sharply upward trajectory. The Greek government and its official creditors soon recognized that the maintenance of such high interest rates would place Greece's public debt on a clearly unsustainable path. However, they were painfully slow in reacting.

While market pressure on Greece started to manifest itself in January 2010, it took Greece's Euro partner countries till as long as May10, 2010 to mount a credible defense of the Greek economy. By that time, however, market fears of contagion had spread to Ireland and Portugal, which shared at least in part some of Greece's domestic and external vulnerabilities. And by that time, the cost of the Greek support package, which had initially been estimated at around U.S.$40 billion, had skyrocketed to $150 billion.

An important reason for the tardy official response was the difficulty of getting 17 European governments to agree on the nature and size of a rescue package. The internal governing rules of the European Monetary Union require that a decision of this sort must be adopted by unanimous consent. Such agreement proved very difficult to get in short order particularly when a large part of the electorate in Germany, Finland, the Netherlands, and Austria was vehemently opposed to the notion of bailing out the wayward European periphery. Fearing an electoral backlash, Mrs. Merkel had hoped to postpone the May 2010 Greek bailout until after the all important state election in Westphalia that month.

An equally egregious case of tardiness in the official response to the intensifying Eurozone debt crisis was the slow and inadequate official reaction to the spreading of the crisis to Spain and Italy in early July 2011. Sensing that a hard Greek default was not far off, and that Spain and Italy had considerable external financing needs even in a benign global environment, markets pushed Spanish and Italian sovereign interest rates to close to 7 percent.

While there could be no doubt that the spread of the crisis to Spain and Italy put the entire Euro project at grave risk, the official policy response on July 21, 2011 was disproportionately muted. All that the 17 European governments could muster was a proposed increase in the flexibility and in the effective size of the European Financial Stability Facility to EUR440 billion, or to a far cry from the EUR2 trillion that market analysts generally estimated was necessary to ring fence a hard Greek default spreading to Spain and Italy. And even now, it will only be in the middle of October 2011 that all seventeen EMU parliaments will have ratified the relatively modest EFSF changes.

The stage now seems to be set for perhaps the final act in the Euro-zone debt crisis. With its economy literally imploding, social tensions close to the boiling point, and its IMF program woefully off track, there is every prospect that Greece will experience a hard default by year end. Yet, there seems to be little likelihood that Greece's European partners will succeed in mounting in a timely fashion a firewall of the size needed to effectively ring fence such a default.

If one had any doubt on that score, all one need do is to reflect upon the assurances that Mrs. Merkel had to give members of her own ruling coalition that the EFSF would not be further enlarged in order to secure approval of the modest July 21 changes to the EFSF. Or one might consider the recent warnings by the head of the German constitutional court to the German government that it must refrain from trying to pull the wool over the German electorates' eyes by using the EFSF as a backdoor way towards a fiscal transfer union.

It stretches credulity to think that the German government, let alone the remaining sixteen European governments, will be able to secure approval for any proposal to meaningfully leverage up the EFSF anytime soon. With Greece now heading inexorably for a hard default over the next few months and with agreement yet to be reached on an upsizing of the EFSF, U.S. policymakers should be bracing for a meaningful economic shock emanating from a European banking crisis.