Europe’s Debt Crisis: Back from the Brink?

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Yannis Behrakis / Reuters

So it looks like Greece will dodge a default, at least for now. The Greek parliament passed a new $4.4 billion austerity package on Sunday, which includes a painful 22% cut in the minimum wage and 150,000 public sector job losses. Greece’s euro zone partners were demanding the country approve these painful measures in return for a second, $170 billion bailout. The vote clears the way to finalizing that bailout – first approved way back in July – along with an arrangement between Athens and its private-sector bondholders to restructure some $265 billion of the nation’s sovereign debt.

There was very little chance that the Greek parliament would reject the euro zone’s dictates. The alternative was default and a probable exit from the monetary union, something the Greeks are still not willing to do, as my colleague Joanna Kakissis reported the other day. Caretaker Prime Minister Lucas Papademos said that more austerity was “the only alternative to a catastrophic default … that would force Greece, sooner or later, to leave the euro.”

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Progress on the Greece front isn’t the only bit of good news coming out of Europe these days. Bond yields for giant Italy, the biggest threat to the future of the euro, are down significantly thanks to the aggressive reform program being pushed through by new Prime Minister Mario Monti. The euro zone is in the process of implementing tough new debt and deficit rules for its members, which take a step towards a closer fiscal union to support the monetary union. All of these steps have caused the euro to strengthen. Compared to where we were just a few weeks ago – with Italy sliding towards the abyss, the euro tanking and Greece spiraling towards something ugly – Europe has clearly pulled itself back from the brink.

But for how long?

In the more than two years that Europe’s debt crisis has been raging, we’ve witnessed a couple patches during which sentiment improves, the euro strengthens and investors gain a bit of confidence that the euro zone is actually solving its problems. In each case, the euphoria was short-lived: Investors quickly realized that the Greek debt crisis was far from over, contagion continued to spread, the region’s banking sector was still at risk and Europe’s leaders were still not taking enough action. Call me a skeptic, but there are a bunch of reasons that make me believe we’ll see the debt crisis in Europe roar again soon.

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First of all, does anyone really, honestly believe the Greek debt crisis is over? Yes, this bailout is better than the first one, mainly because it includes some necessary debt reduction. Yet that reduction is not nearly enough to make the country’s sovereign debt sustainable. At best, it is expected to bring Greece’s debt down from 160% of its GDP today to 120% by the end of the decade. (The restructuring, furthermore, is far from a sure thing.)

On top of that, Greece’s politicians have shown little ability to implement the reforms they have promised, and there is every reason to believe they will continue to struggle. Most of all, though, Greece is stuck in a debt trap. The more Greece cuts fiscal spending and hikes taxes, the more growth gets hit, and the harder it becomes to meet deficit and debt targets. Greece’s GDP likely shrunk by some 6% in 2011 – and a recovery is nowhere in sight. That’s why Greece’s debt relative to GDP continues to rise, even after two years of austerity. My guess is that we’ll be revisiting the Greek debt crisis again in a few months, once it becomes apparent that this latest bailout isn’t fixing the country’s problems any better than the first one did.

Investors seem to have also forgotten that Greece isn’t the only member of the euro zone stuck in a debt trap. Concerns continue to boil that Portugal, too, will require a second bailout as its borrowing costs, though down from highs reached in late January, remain astronomical. Most of all, what the continued struggles of Portugal show us is that the bailout programs simply aren’t restoring economies to health or rebuilding investor confidence. Portugal, unlike Greece, has generally received high marks for its reform efforts, and where has that gotten its economy? Not very far. That raises the prospect that Greece and Portugal could end up on near-permanent life support from the rest of the euro zone. The two bailouts for Greece combined are already more than 100% of its GDP. How much higher will the bill go?

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We also seem to be ignoring the fact that growth is tanking not just in Greece and Portugal, but across the euro zone. Europe is expected to suffer a pretty bad recession this year, largely due to the impact of the debt crisis. Unemployment in the euro zone hit 10.4% in December – the highest since the formation of the monetary union. The contracting economies will make it more difficult for countries to reduce deficits and implement reforms. As usual, the euro zone leaders aren’t doing too much about it. Despite endless talk of supporting growth and job creation, no new programs have emerged. Europe’s leaders continue to move in slow motion on other important measures that could help quell the crisis, as well. Most notably, the bank recapitalization plan approved in October has yet to be implemented. The European Central Bank eased the credit crunch threatening the banking sector by flooding it with euros, but the banks’ balance sheets remain vulnerable to the sovereign debt crisis.

I could go on. There’s the political uncertainty on euro zone policy created by upcoming elections in France and Greece, for example, or the fact that the Greek bailout still must be approved by all 17 euro zone countries. The point here is that there are still countless way in which Europe could slip back towards the brink. Let’s not get too excited.

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