Can the Crisis in Greece Be Contained?

The words scrawled in green and black spray paint on the sidewalk outside Greece’s parliament summed up the mood: “George get out. Out IMF and U.S. and E.U.” A few days earlier, Prime Minister George Papandreou — the George in question — had the unhappy duty of telling Greeks that the bill for past excesses had come due. On May 2, he and other Greek ministers had filed into an extraordinary Cabinet meeting where the terms of a bailout deal hammered out with the International Monetary Fund (IMF) and European states was confirmed. After months of tense negotiations, and failed attempts to convince markets that European pledges to help Greece were more than talk, Papandreou handed over Greece’s sovereignty in exchange for a rescue. Now he’s not only fending off bankruptcy, but rebellion on the streets too.

Violent protest is as Greek as feta, but it’s usually calculated, part of the country’s intricate political theater. On May 5, however, anger at Papandreou’s government for agreeing to slash $38 billion from the state budget over the next three years boiled over with deadly consequences. Three bank workers died in a blaze set by rioting protesters at Marfin Egnatia Bank, as fierce battles between police and angry citizens raged on the streets of Athens. The government had hoped that Greeks would accept the austerity program with stoicism, but those hopes are now in tatters. With Greece teetering on the edge of bankruptcy, Papandreou’s government agreed to harsh measures — which include deep cuts to civil-service pay, higher taxes and sweeping reforms to pensions and labor laws — as a condition of $146 billion in loans from other euro-zone countries and the IMF. It will be the largest such bailout ever, and questions remain about whether it will even work. During talks over the terms of the bailout, the Greek government had warned that there was only so far the Greek people could be pushed. “We will be in the streets for as long as it takes,” says Christos Sarris, 40, a professor at a private university. “It’s our only chance, otherwise we will be full of unemployment and poverty. It’s our responsibility to ourselves and our children.”

(See pictures of the violent protests in Greece.)

Many Greeks, even those who joined the protests, disapprove of the violence. But few believe the bailout will bring better times soon. According to a new poll for the Greek newspaper To Vima, only 14.8% percent of Greeks were relieved at the bailout, compared to 31% who were angry and nearly 23% who felt ashamed. For Greeks, who are proud of their contribution to Western culture but have felt squeezed by foreign powers for much of their modern history, it’s humiliating to have to beg from Germany and play by the IMF’s tough rules on conditionality. Out on the streets in a May Day march in Athens, computer engineer Dimitris Mitrovgenis said many young Greeks like himself are thinking about leaving Greece for places where the economy is better and merit, rather than connections, is rewarded. Even before the crisis, Greece suffered from a brain drain of its young talent and now there are rising fears that the crisis will spark a wave of mass emigration.

Ripple Effects
The question bothering world leaders now is whether Greece’s problems will be exported, just like its talented young people. Just about everywhere you look these days, the green shoots that began to sprout in the global economy late last year are blossoming and bearing fruit. The IMF in April upgraded its 2010 forecast for global economic growth once again to 4.2%. Hopes were buoyed that the all-important American consumer has started spending again after the U.S. economy expanded at an annual rate of 3.2% in the first quarter of 2010. In emerging markets, the recovery is zooming ahead. Singapore’s gross domestic product grew an annualized 32% in the first quarter, while China posted 11.9% GDP growth, compared to the first quarter of 2009.

(See how political delays drove up the cost of Greece’s bailout.)

But we haven’t shaken the gloom from the Great Recession just yet. “Even if the recovery is stronger and faster than expected, it is fragile,” IMF Managing Director Dominique Strauss-Kahn said in late April. “The world is still a dangerous place and I would not like that too many people have in mind that the crisis is over and that we can go back to business as usual.” Private demand and investment is still weak, especially in the advanced economies, financial sectors are not fully repaired and unemployment is still extremely high.

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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.

(See whether the Greek bailout will be a savior for the euro.)

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.

(See pictures of the global financial crisis.)

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.

(See a Q&A with Greek Prime Minister George Papandreou.)

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.”

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Both Portugal and Spain also suffer from anemic growth — in Portugal’s case, lagging behind the E.U. average since 2002. For Spain, which thanks to its ill-founded housing boom was not long ago experiencing growth rates that neared 4%, the drop has been dramatic: its economy continues to contract, making its recession the most enduring among euro zone states. But even as projections suggest its numbers will finally — if barely — move into the black in 2011, there is hardly enough consensus to make them reassuring. “Whether we see a slight contraction or a slight rise, the problem is that the Spanish economy is in for a prolonged stall,” says Ballabriga. “And that’s what is so worrying. When you put all the pieces together, you have a highly indebted country whose possibilities for generating revenue are fairly deteriorated. So it’s going to have problems servicing its debt.”

Spain’s crippling unemployment rate — the highest in the euro zone — is only making things worse. When Spain’s housing bubble burst, it took millions of jobs with it, and they have yet to be replaced. As long as unemployment remains high, it’s going to be hard, if not impossible, to reduce public debt both because of the high cost of unemployment benefits, and because the more than 4.6 million who are out of work aren’t generating the income in the form of taxes the government so desperately needs.

(See pictures of immigration in Europe.)

Add to that the nervousness of the markets, and the chance of dominoes falling just increases. “By itself, Spain isn’t at risk of defaulting on its sovereign debt,” says Alfredo Pastor, an economist at the University of Navarra’s IESE business school and former deputy Finance Minister. “But the market isn’t always rational. If Portugal should fall, the market would say that the problem is southern Europe, and then both Spain and Italy would be at risk.” As if to prove his point, on May 4, both the Spanish and Portuguese stock markets fell around 3% amid unfounded rumors — “complete craziness” as Prime Minister José Luis Rodríguez Zapatero put it — that Spain was about to request a bailout.

Which is why MIT professor Simon Johnson, former IMF chief economist, says no one should wait. “Portugal is the firebreak,” he says. “If I were Spain I’d be working really hard to get a preventative package in place for them.” It’s not hard to see why; Portugal, like Greece, is a small economy. But Spain, the world’s eighth-largest economy and the contributor of 12% of the E.U.’s GDP, would require a bailout the like of which has never been seen before. As Pastor says, “They would have to come up with a new kind of measure. And I have no idea what that would be.”

(Read: “What wil it Take to Save Greece?”)

No Quick Fix
Every crisis is an opportunity, of course, and there are plenty of observers in Spain who see a chance to engage in the thoroughgoing reform that has been lacking hitherto. The solution to its level of debt, they argue, is not simply fiscal austerity — though more of that, which Spain has thus far been lax in enforcing, is surely warranted: the government is also going to have to reform its financial sector, loosen the rigid labor market that impedes economic growth and encourage new investment from foreign sources. “If they can improve things within all these areas, they can save themselves,” says economist Ballabriga. “But it has to be all of them, and it has to be now. In a few months, it will be too late.”

In Greece, similarly, there are those who think the bailout may turn out to be a blessing, one day. In agreeing to the euro-zone and IMF terms, the government has pledged to trim its tangled bureaucracy, tackle tax evasion and reduce waste — all measures aimed at helping to stimulate the economy and offset the impact of the austerity measures. “The important thing now is strict implementation, capacity-building in the state sector and tax administration, and trying also to make a clear impact on tax evasion,” says Jens Bastian, a German political economist at the Hellenic Foundation for European and Foreign Policy. “This is something that goes beyond financial assistance. This is about a mentality change in Greek society, a cultural revolution in the relationship between citizen and state.”

(See 25 people to blame for the financial crisis.)

Is Greece ready for that? If so, the curious case of the Greek debt will turn out to be no more than a footnote to the history of the Great Recession. If not, and bailout follows bailout until there are defaults on sovereign debt galore, that word recession may yet have to be replaced with one that sounds similar — but begins not with an R, but a D.

Read “Euro Nations Hope to Finalize Greek Bailout”.

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