Pray for Japan, Worry for Europe

Pray for Japan, Worry for Europe

By Robert Samuelson - March 21, 2011

WASHINGTON -- While the world has been transfixed with Japan, Europe has been struggling to avoid another financial crisis. On any Richter scale of economic threats, this may ultimately matter more than Japan's grim tragedy. One reason is size. Europe represents about 20 percent of the world economy; Japan's share is about 6 percent. Another is that Japan may recover faster than is now imagined; that happened after the 1995 Kobe earthquake. It's hard to discuss the "world economic crisis" in the past tense as long as Europe's debt problem festers -- and it does.

Just last week, European leaders were putting the finishing touches on a plan to enlarge a bailout fund from an effective size of roughly 250 billion euros (about $350 billion) to 440 billion euros ($615 billion) and eventually to 500 billion euros ($700 billion). By lending to stricken debtor nations, the fund would aim to prevent them from defaulting on their government bonds, which could have ruinous repercussions. Banks could suffer huge losses in their bond portfolios; investors could panic and dump all European bonds; Europe and the world could relapse into recession.

Unfortunately, the odds of success are no better than 50-50.

Europe must do something. Greece and Ireland are already in receivership. Private investors won't buy their bonds at reasonable rates. There are worries about Portugal and Spain; Moody's recently downgraded both, though Spain's rating is still high. The trouble is that the sponsors of the bailout fund are themselves big debtors. In 2010, Italy's debt burden (the ratio of its government debt to its economy, or gross domestic product) was 131 percent; that exceeded Spain's debt ratio of 72 percent. Debt ratios were high even for France (92 percent) and Germany (80 percent).

As these numbers suggest, there's no automatic threshold beyond which private investors refuse to buy a country's debt. Germany and France are considered sound investments, deserving low interest rates, because their economies are judged to be strong. But investor perceptions and confidence can dissolve in a flash. If private markets lost faith in, say, Italy or Belgium, even the enlarged bailout fund probably wouldn't be big enough to rescue them. The whole scheme is debtors lending to debtors. It could collapse if investors conclude it's unworkable, dump bonds and demand higher interest rates.

What would happen then is anyone's guess. Would defaults occur? Would a banking crisis follow? Would some countries abandon the euro? (This sounds simple; in practice, it would be hugely complex. A country would have to convert all its money into a new national currency. It would be legally impossible to switch some debts from euros. The country would probably have to impose capital controls -- restrictions on money entering or leaving the country.) Would the European Central Bank -- the continent's Fed -- buy vast amounts of government bonds? Would the International Monetary Fund organize a bailout, financed heavily by China, to rescue Europe?

Europe has arrived at this dismal juncture driven by three forces: (a) large welfare states that were too often financed with debt; (b) the financial crisis that led to recession and has pushed some countries (Ireland, Spain) to aid their banks; (c) the perverse side effects of the single currency, the euro.

The euro's role is especially ironic. Adopted in 1999 -- and now used by 17 nations -- the euro was intended to promote prosperity and political unity. Countries could enjoy similarly low interest rates and the convenience of common money. It seemed to work for a while. But low interest rates in Greece, Spain and Ireland encouraged unsustainable booms or housing bubbles that, when burst, aggravated their recessions and budget deficits. Now unity has turned to discord. Countries that back the debt bailout -- particularly Germany -- resent the possible costs; countries being bailed out resent the harsh austerity that's imposed as a condition of aid.

There is a fragile debtor-creditor consensus that could crumble, posing yet another danger to economic recovery. Already, unemployment rates in Greece and Ireland hover around 13 percent. How much budget stringency (spending cuts, tax increases) will countries accept before social unrest or national pride cause politicians to say "enough"? Even European countries not facing an immediate debt problem need to reduce budget deficits to retain market confidence. All confront a common dilemma. Too much austerity too quickly could create a recession, widening deficits. Too little austerity too slowly could unnerve investors, raising interest rates and deficits.

It's understandable that the human suffering, physical destruction and nuclear hazards in Japan compel our attention. But we ought to remember that a greater menace to global stability and prosperity lies halfway around the world.

Copyright 2011, Washington Post Writers Group

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