No Lehman on the Aegean

By Desmond Lachman 

Can we be spared a Lehman-style crisis when Greece’s hard default occurs?

After two years of denial about the European periphery’s solvency problem, European policy makers are finally, albeit grudgingly, facing up to reality. Indeed, they are now privately recognizing that Greece is very likely to default by year-end. And they have also come to the conclusion that such an eventuality makes it imperative both that an effective firewall be erected around Spain and Italy and that Europe’s banks need to be recapitalized.


It remains to be seen whether, by the time of the scheduled G-20 Summit on November 3, this recognition will be translated into credible and effective measures that will finally allow European policy makers to get ahead of the markets. If past performance is any guide, one has to wonder whether this will be yet another doleful instance of a “too little, too late” European policy response to an ever-deepening crisis.
Greece’s International Monetary Fund adjustment program is in tatters. The IMF itself is now acknowledging that Greece’s economy, which has already contracted by around 12 percent since 2009, will contract meaningfully further in 2012. And the IMF is also recognizing that Greece will not meet the IMF’s budget targets for 2011 and 2012. As a result, Greece’s public debt-to-GDP level will soon rise to 172 percent, or to more than twice the level that might be considered manageable.

Greece’s public debt-to-GDP level will soon rise to 172 percent, or to more than twice the level that might be considered manageable.

As if to underline how unsustainable the Greek situation is, in the midst of the deepest of domestic recessions, the Greek government is now being required by the IMF to undertake further painful fiscal adjustment measures to meet its ever-elusive budget deficit targets. And to this effect, not only is the IMF insisting that Greece introduce an unpopular property tax, it is also asking a socialist PASOK government whose very existence depends on public sector patronage to cut public wages and to reduce public employment. Little wonder that social and political tensions in Greece are now on the boil.
The IMF is also acknowledging that the Greek government will need more funding to finance its 2012 budget deficit. This is inducing the IMF to seek substantially greater debt reduction from Greece’s bank creditors through the “voluntary” debt exchange that was originally proposed. As might be expected, the banks are resisting the IMF’s proposal, which might complicate the IMF’s efforts to finalize its intended program review by mid-November.
Mindful of the 2008-2009 Lehman experience, European policy makers are fully aware that a Greek default could cause real contagion to the rest of the European periphery. They are particularly fearful that a Greek default could engulf Italy and Spain, Europe’s third and fourth largest economies respectively, which would pose an existential threat to the euro.

If past performance is any guide, one has to wonder whether this will be yet another doleful instance of a ‘too little, too late’ European policy response to an ever-deepening crisis.

Despite these perceived risks and reflecting domestic political constraints from electorates opposed to further bailouts, European policy makers seem to be in no rush to put a credible firewall in place. In particular, they have yet to come up with a plan to leverage up the European Financial Stability Facility from its present size of €440 billion to the €2 trillion range that most market analysts think would be needed to shield Spain and Italy from the fallout of a hard Greek default.
Responding to increased banking sector strains that both the IMF and the European Central Bank fear could tip Europe back into recession, European policy makers are now proposing a coordinated effort to recapitalize the European banking system. However, they have yet to come up with concrete proposals as to how they are to increase the system’s capital by the €200 billion that the IMF estimates would be necessary to put Europe’s banks back on a sound footing. Public differences between the French and German governments on who should pay for the bank recapitalization do not give grounds for encouragement.
The late professor Rudi Dornbusch famously said that in economics things take longer to happen than you think that they will, and then they happen faster than you thought that they could. Hopefully, European policy makers will now recognize that in Greece we are likely in the “faster than you thought they could” phase of the crisis—then we might dare to hope that they will act expeditiously in constructing an effective firewall and in recapitalizing their banks in a manner that will spare us from a Lehman-style crisis when Greece’s hard default occurs.
Desmond Lachman is a resident scholar at the American Enterprise Institute.