Why Greece’s debt crisis matters (again)

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If you’re watching recent developments in Europe with an uneasy feeling of déjà vu, you have good reason. It was almost exactly a year ago that the European Union stepped in with a 110 billion euro ($158 billion) bailout for debt-plagued Greece. Yet here we are, a year later, and Greece’s debt is again the primary focus of Europe’s policymakers. A meeting of euro zone officials conceded last week that the current bailout was insufficient. Now there’s talk that Greece might get a whole new rescue deal, possibly including eased lending terms and reform commitments, which would increase the program’s chances of success, as well as fresh bailout funds. The Wall Street Journal is reporting that Greece may require an additional 60 billion euros ($86 billion) to cover its financing needs in coming years.

Nothing is final yet, but a do-over on the Greek bailout appears inevitable. European leaders are finally conceding what everyone else on the planet already knew – that last year’s Greek bailout was little more than a delaying tactic on the route towards a real reckoning. The momentum towards effectively trashing the old arrangement is also symbolic of the growing realization in European capitals that the initial steps taken to resolve the euro zone’s debt crisis fell far short of what was necessary.

That’s positive of course, but at the same time, an overhaul of Greece’s bailout could cause potential ugliness for not just Europe, but the entire global economy as well. The fact is that Greece’s debt problem is still very much a problem for all of us.

Why didn’t the original Greek bailout work? (1) The bailout just offered more loans to give the Greeks time to fix their national finances; it did nothing to reduce the debt itself, and little to make it more likely Greece could pay that debt off. In fact, Greek government debt, as a percentage of GDP, keeps growing, and is now around 140%. (2) The austerity and reform program imposed on Athens was probably impossible to sustain, at least not without unbearable pain on the Greek people. Greece is missing its budget deficit targets, and hasn’t made the progress expected on raising revenues through taxes or privatization. The adjustment necessary to get Greece back on a more stable financial path is so difficult that investors haven’t had much faith that Athens could hold up its end of the bailout bargain. (3) Therefore, investors remained unconvinced that Greece would be able pay back its debt. Yields on Greek bonds have continued to rise – those on five-year bonds are well above 20% — while agencies continue to punish its credit rating. Standard & Poor’s downgraded Greece yet again this week. In other words, the bailout did nothing to change the basics of Greece’s debt crisis.

So the current situation can’t continue. Greece is just falling deeper into a hole. So some sort of new bailout arrangement is unavoidable. Offering the Greeks a better bailout could alleviate at least some of the pressure on Athens, by giving the government more time to implement reforms and easier terms on bailout loans.

But will that be enough to rebuild investor confidence? In my opinion, no. Simply re-writing or extending the bailout will likely prove to be just another euro zone band aid, like so many others used in the past year to muddle through the debt crisis. The government in Athens has to run large primary surpluses over a significant number of years to stabilize and then bring down the level of debt, and that looks nearly impossible. Meanwhile, the prospects for economic growth are dire, making it more difficult for Greece to increase tax revenues and improve its financial position. (The IMF predicts Greece’s GDP will contract in 2011 for the third consecutive year.) Yes, the EU can give Greece a better rescue plan. But unless private investors become more confident about Greece’s creditworthiness, the country could remain dependent on the EU for financing. Simply, Greece might become a perpetual burden on the wealthier euro zone governments.

That’s not good for anyone. Politically, it would be extremely difficult for elected leaders in Berlin and elsewhere to continue to justify shoveling more and more money to save Greece. And with Greece’s fate continually uncertain, investors would remain nervous about other weak euro zone nations as well, keeping debt crises alive across the periphery.

So what’s the solution? In more than a year of covering the euro debt crisis, I don’t recall speaking to anyone involved in European finance or economics who believed Greece could avoid a debt restructuring. On the positive side, a debt restructuring would alter Greece’s burden in a way that was more sustainable and more likely to allow the economy to return to healthy growth. On the other hand, a restructuring would impose losses on bondholders, which is probably only fair, but nonetheless would make it riskier for investors to hold the sovereign bonds of other suspect euro zone economies. That’s why Spain’s bonds have been weakening once again in recent weeks. Pressure would likely mount on those countries already in rescue programs – Ireland and Portugal – and then maybe they, too, would require new bailout agreements. And losses for bondholders mean losses at the banks of Europe that hold Greek debt, an outcome Europe’s policymakers have been trying to avoid.

Basically, a debt restructuring in Greece could reopen the debt crisis in the entire euro zone. And an inflamed debt crisis in Europe would be yet another reason to fear for the health of the global economy, on top of high oil prices, inflation and persistent unemployment.

That’s why Europe’s leaders usually avoid any talk about restructuring debt in the euro zone. Publicly, the option has been ruled out. But not talking about it doesn’t mean the problem isn’t there. The recent moves towards softer bailout terms for Greece is a good step, but right now, Europe’s leaders seem to be in something of a no-win situation with Greece. Keep matters how they are or tweak the existing agreement, and either keep Greece on a politically sensitive EU lifeline or just delay the inevitable pain. Or head for a restructuring that could possibly worsen the debt crises elsewhere in the zone, at least in the short term.

I’ll write again what I’ve been writing all along: Band-aids and prayer won’t solve Europe’s debt crisis. Only a comprehensive package of reform across the euro zone to foster greater integration and growth will achieve that. And increasingly, I’m thinking debt restructuring has to be added to the mix as well. But that won’t happen, not in the current political climate in Europe. My guess is that Europe’s leaders will continue to push the Greek debt problem into the future and hope some miracle occurs that makes it go away. That means this time next year, we’re likely to experience that sickening sense of déjà vu all over again.

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