February 10, 2010

The New Dominos as the Economic Crisis Enters its Latest Phase

The dislocations from the worldwide, economic meltdown aren’t over by a long shot. Nearly two years after Bear Stearns’ collapse, the crisis continues to generate a stream of nasty twists and turns. Moreover, most of these developments have global dimensions, almost all of them are highly complex and only partly understood, and many require rapid responses that must be carried out under relentless public and partisan scrutiny. This constitutes the largest policymaking challenge since the dawn of the postwar era in foreign policy and international economic arrangements.

The most recent, nasty twist is the specter of a sovereign debt default in Greece. Technically, it means that Greece is running such large deficits, relative to its economy and private savings, that it may find itself unable to finance them while also servicing and refinancing its existing debt. Countries default on their debts regularly — it’s virtually a national habit for places like Argentina — but the crisis makes this situation different. First, the government bonds of Greece and countries like it are held mainly by Western financial institutions such as Citigroup and Deutsche Bank. Another round of big losses for them will mean more delays before normal credit flows to businesses resume, which in turn will mean slower growth, and longer and higher unemployment, for Europe and the United States.

The second ugly twist is that Greece is not alone. For months, international finance experts have worried about the sovereign debt status of not only places such as Portugal, Ukraine and Lithuania, but also Ireland, Spain and Italy. These concerns will heighten if Greece’s debt goes down, which in turn could make additional defaults more likely. And if the debt of a major country fails, we could find ourselves back to the financial conditions of Autumn 2008, but this time with much less fiscal and monetary capacity to address them.

While even President Obama couldn’t explain a U.S. taxpayer bailout for Greece, its implications for the European Union should be enough to spur a European bailout. While Greece represents just 3 percent of the EU’s total GDP, a Greek debt default would trigger a crisis for the Euro — and a Euro crisis in turn would drive up interest rates across Europe and choke off their recovery. An EU bailout of Greece, however, will demonstrate that the EU cannot enforce its own, basic rules on deficits and national debts. That lesson will also weaken the Euro — which means a stronger dollar later this year and weaker U.S. exports to help pull our own economy out of its ditch.

America, of course, has its own serious problems dealing with deficits and national debt. The GOP “party of small government” won’t agree to President Obama’s proposal to create a bipartisan commission to tackle the long-term problem, something Republican presidents and leaders had supported until Obama won the White House. GOP congressional leaders also have said no to pay-as-you-go rules to limit future deficits — rules they also liked in the 1990s — because paying for future tax cuts could mean fewer of them. In the land well beyond Washington, where economic sanity still rules, contemplating tax cuts in the face of trillion dollar deficits makes no sense. And even Ronald Reagan, the fiscal godfather of today’s GOP leaders, agreed to large tax hikes on business (1982), payrolls (1983) and energy (1984) when he faced unmanageable deficits. Yet, even George W. Bush’s catastrophic example of what happens when a serious recessions collides with large underlying deficits hasn’t convinced them to reexamine their talking points on tax cuts.

That’s one reason why the rating service Moody’s acknowledged last week that it might downgrade America’s debtor status from AAA to AA. A downgrade remains pretty remote — unless the economy swoons again, coming this time on top of a $1.4 trillion deficit instead of a $400 billion one. And debt defaults by Greece and another country could certainly trigger such a swoon. As it is, Greece’s problems have produced billions of dollars in speculative bets on Wall Street against the Euro. In fact, these bets follow recent and even more widespread Wall Street speculation against the dollar, winning bets which produced the record profits and large bonuses reported recently by Goldman Sachs and others.

All of this confirms, with disheartening certainty, that the forces which created the global economic crisis are still with us, and most of the policy challenges remain unmet.