Can the Crisis in Greece Be Contained?

ARIS MESSINIS / AFP / GETTY
Anger Three died when protesters laid siege to this Athens bank on May 5

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It's against this uncertain backdrop that the euro-zone debt crisis takes on special significance. Though unlikely to completely derail the global recovery, the crisis will very likely make it even more anemic and tentative. "The bottom line is that [Europe's debt crisis] will almost certainly have ripple effects around the world," says Eswar Prasad, an economist at Cornell University. "This is going to act as a drag on global output and employment growth." The impact is amplified, he says, due to the weak nature of the recovery. Though the debt crisis may be a "small minus" for the global economy, "even a minor blow will set   back the recovery. It will drag things out a little more."

That's because Europe's debt crisis could have a dampening effect on the region's economic growth, which, in turn, could slow up the entire global recovery. The euro zone was already slated for an especially meager rebound. The IMF in April forecast only 1% economic growth for the euro zone in 2010 (compared to 3.1% in the U.S.). Now there are fears growth could be even worse. The Greek crisis will likely force other weak economies in the euro zone to get their deficits under control, with a corresponding reduction in demand. Will the private sector step into the breach? Maybe not. Consumers in these countries could delay spending in the face of continued high unemployment and expected tax hikes. And banks throughout the euro zone could well become more cautious and keep credit tight. Barry Eichengreen, an economist at the University of California, Berkeley, argues that Europe could experience a "double-dip" recession, possibly again slipping into a contraction in 2010.

That's bad news for everyone, since Europe is a key source of global demand. Many nations, from Brazil to South Korea, and even the U.S., are hoping that increased exports will help sustain the recovery and create jobs. But with a weakened Europe, that becomes more difficult. China, for example, ships about a fifth of its exports to the European Union, and if those falter, the resulting pain would move along tightly knit supply chains and manufacturing networks to the rest of Asia. "The direct effects [on Asia] are going to be limited," says Cornell's Prasad, "but Europe is a major consumer of exports from Asia." Adds Eichengreen: "There is cause to be very worried. [The Europeans] are important to the rest of us."

Nor is the effect on trade the whole story. The euro-zone crisis could make investors generally more risk-averse, leading to a flight to safety, especially dollar-denominated assets. That could help the U.S. finance its own deficits, but also make American goods less competitive on world markets, dampening hopes for an export-led recovery. In Asia, the stronger dollar could reverse inward flows of capital. BNP Paribas forecast in an April 30 report that Asian stocks could potentially tumble by 17% in the short term as a result.

The Next to Fall?

Perhaps the biggest worry of all is the chance that the Greek crisis is a window into the future of the entire Western world. Stephen King, chief economist for HSBC, notes that heavily indebted governments with large fiscal deficits can be found not just through the weak points of the euro zone, but in much of the developed world the U.K. and the U.S. included. These countries, says King, have "no credible plans to reduce their deficits." Eventually, they'll all have to implement austerity programs like Greece is doing now, which would suppress growth, not just through the pain of spending cuts, but by depressing business and consumer sentiment as well. King worries that such a mix "doesn't create a double dip, but a stagnation scenario," much like the one Japan has experienced for the past 20 years.

Such fears are particularly acute in Spain if only because the past 20 years have not been stagnant but golden. To move in Spain's financial circles these days is to know what England must have felt as it awaited the invasion of the Spanish Armada. Dread tempered with the occasional flicker of patriotic hope, knowledge that other nations have fallen victim to the same threat, an uncomfortable awareness that the rest of the known world expects your most imminent demise. The arrival of King Philip's conquering navy, or Greek contagion: turns out they feel like much the same thing.

As Greece swallowed its medicine, one rating agency lowered its grade on Spain, another warned it may downgrade Portugal's debt, and the Spanish unemployment rate officially passed the 20% mark. Both countries have emphasized the ways in which they are not like Greece. They have comparatively low levels of public debt (85% of GDP for Portugal and 67% for Spain vs. Greece's 124%) and, in Portugal's case, a recent history of making tough fiscal reforms. "All serious analysts have made it perfectly clear that Spain's situation is very different from Greece's," says Finance Minister Elena Salgado. "Spain does not have, nor is it going to have, a solvency problem, so there is no need for outside aid." But if Spain has its sovereign debt under relative control, it has other problems almost as troubling. For one thing, its levels of private debt are extremely elevated. Taken together, private and public debt reach 170% of the country's GDP an amount actually higher than Greece's total debt. And the problem with that, economists point out, is that it reduces the flexibility with which the government can respond to its own citizens' needs. "What happens if the private sector needs a bailout?" asks Fernando Ballabriga, economist at Barcelona's ESADE business school. "The rise in public debt even if it's still below Greek levels means that the public sector won't be able to rescue the private sector."