Europe Risks Another Global Depression

The entirely pointless G7 meeting this weekend only served to underline the fact that Europe is again entering a serious economic crisis.
At the end of the meeting yesterday, Treasury Secretary Tim Geithner told reporters, “I just want to underscore they made it clear to us, they the European authorities, that they will manage this [the Greek debt crisis] with great care.”
But the Europeans are not being careful – and it’s not just about Greece any more.  Worries about government debt and associated public sector liabilities (e.g., because banking systems are in deep trouble) have spread through the eurozone to Spain and Portugal.  Ireland and Italy are next up for hostile reconsideration by the markets, and the UK may not be far behind. 
What are the stronger European countries, specifically Germany and France, doing to contain the self-fulfilling fear that weaker eurozone countries may not be able to pay their debt – this panic that pushes up interest rates and makes it harder for beleaguered governments to actually pay?
The Europeans with deep-pockets are doing nothing – except insist that all countries under pressure cut their budgets quickly and in ways that are probably politically infeasible.  This kind of precipitate fiscal austerity contributed directly to the onset of the Great Depression in the 1930s.
The International Monetary Fund was created after World War II specifically to prevent such a situation from recurring.  The Fund is supposed to lend to countries in trouble, to cushion the blow of crisis.  The idea is not to prevent necessary adjustments – for example, in the form of budget deficit reduction – but to spread those out over time, to restore confidence, and to serve as an external seal of approval on a government’s credibility.
Dominique Strauss-Khan, the Managing Director of the IMF, said Thursday on French radio that the Fund stands ready to help Greece.  But he knows this is wishful thinking.

• “Going to the IMF” brings with it a great deal of stigma.  European governments are unwilling to take such a step as it could well be their last.
• The IMF is supposed to provide only “balance of payments” lending.  That doesn’t fit well when a country is in a currency union such as the euro, which floats freely and does not have a current account issue, and the main problem is just the budget.
• Greece and the other weak eurozone countries need euro loans, not any other currency.  If the IMF lent euros, that would be distinctly awkward – as this is what the European Central Bank (ECB) is supposed to control. 
• Sending Greece to the IMF would result in some international “burden sharing,” as it would be IMF resources – from all its member countries around the world – on the line, rather than just European Union funds.  But is the US really willing to burden share through the IMF?  After all, Europe has long refused to confront the trouble in its weaker countries, now known as PIIGS (Portugal, Ireland, Italy, Greece, and Spain)?  How would the Chinese react if such a proposition came to the IMF? 
• Would the Europeans really want the IMF and its somewhat cumbersome rules to get involved – this would be a huge loss of prestige.  It could also lead to some perverse outcomes – you never know what the IMF and the US Treasury (and Larry Summers) will come up with in terms of needed policies (ask Korea about 1997-98; not a good experience).  The European Union (EU) has handled IMF recent engagement well in eastern Europe (from the EU perspective), but that was seen as the EU’s backyard.  If the eurozone is in trouble, everyone will be paying much more attention – no more sweetheart deals.
• The IMF gave eastern Europe amazingly good deals over the past 2 years (by IMF standards).  Would this fly with financial markets in the sense of restoring confidence in the PIIGS and their medium-term fiscal futures? 
• Does the IMF really have enough resources to backstop all the PIIGS?  The IMF’s notional capital was increased substantially last year, but just based on what we see now, the Fund would need even more ready money to tackle the eurozone – all the weaker countries would need at least preventive lending programs and these would need to be large.  If that is where this goes, the EU looks simply awful and has failed at a deep level.
• The IMF could play a constructive “technical assistance role” alongside the European Commission, but everyone would want to keep this pretty low profile.  Anything that goes to the IMF executive board would result in a lot of cheering and jeering from emerging markets.  This would break the power of Europe on the international stage – perhaps a good thing, but not at all what the European policy elite is looking for.

The IMF cannot help in any meaningful way.  And the stronger EU countries are not willing to help – in part because they want to be tough, but also because they do not have effective mechanisms for providing assistance-with-strings.  Unconditional bailouts are simple – just send a check.  Structuring a rescue package that will garner support among the German electorate – whose current and future taxes will be on the line – is considerably more complicated.
The financial markets know all this and last week sharpened their swords.  As we move into this week, expect more selling pressure across a wide range of European assets. 
As this pressure mounts, we’ll see cracks appear also in the private sector.  Significant banks and large hedge funds have been selling insurance against default by European sovereigns.  As countries lose creditworthiness – and, under sufficient pressure, very few government credit ratings will hold up – these financial institutions will need to come up with cash to post increasing amounts of collateral against their derivative obligations (yes, the same credit default swaps that triggered the collapse last time).
Remember that none of the opaqueness of the credit default swap market has been addressed since the crisis of September 2008.  And generalized counter-party risk – the fear that your insurer will fail and this will bring down all connected banks – raises its ugly head again. 
In such a situation, investors scramble for the safest assets available – “cash”, which actually (and ironically, given our budget woes) means short-term US government securities.  It’s not that the US is in good shape or even has anything approaching a credible medium-term fiscal framework, it’s just that everyone else is in much worse shape.
Another Lehman/AIG-type situation lurks somewhere on the European continent, and again our purported G7 (or even G20) leaders are slow to see the risk.  And this time, given that they already used almost all their fiscal bullets, it will be considerably more difficult for governments to respond effectively when they do wake up.
By Simon Johnson