Editor’s note: This article was first published in September 2011, at the height of the eurozone debt crisis. Its figures on banks’ exposure to Greek debt and ECB purchases of European government debt, Fitch’s threat to downgrade Spain and the BRICS weighing a capital injection are from then; later events such as the 2012 Greek debt restructuring are not reflected.
Europe’s immediate problem is Greece, although Barack Obama is more worried about the situation in Spain and Italy, because given the size of these countries, any kind of bailout would be unworkable for the global economy. Bank of America and Merrill Lynch warn that if action isn’t taken quickly, the consequences for the world financial system could end in chaos.
With news such as Fitch‘s threat to downgrade Spain’s credit rating, rumors that Italy won’t be able to pay its debts, and the danger that German and French banks will be dragged down by a Greek default, Europe is a continent adrift. Every time someone buys sovereign debt within the European Union, they’ll demand a higher interest rate, and as interest rates rise, public finances will be squeezed more and more.
If Greece defaults, French and German banks will lose money and confidence, considering that their exposure to Greek debt is over €80 billion. The ECB has already bought around €150 billion of European countries’ debt and doesn’t rule out injecting more money to provide liquidity to the banks.
The main problem, which is already plain to see, is that Europe won’t be able to solve its problems on its own, so we need help both from the United States (which already has plenty of problems of its own) and from emerging countries.
Russia, Brazil, South Africa, China and India are considering helping us with a capital injection to avoid what, at this point, may already be inevitable.
The plan being proposed by the United States is to use the same measures that were applied with Lehman Brothers, when its imminent collapse nearly brought down the global financial system. The US Treasury agrees that Europe needs to recapitalize its banks to avoid collapse and, above all, must prevent a Greek default at all costs, since it could spread to the rest of the European Union.
The next problem in this scenario is that it would once again be a temporary patch, and the specter of recession would return within a few months. While the Lehman Brothers rescue is an example of easing a crisis in theory, in practice we can see that we’re even worse off than in 2008, and likely to get worse.
With the risk premium (the spread over German bonds) through the roof and a whole continent paying high interest to place its debt, inflation would soar and people’s purchasing power would fall considerably. That would hold back consumption once again, and we’d be back at the start of the crisis cycle.
In short, things don’t look good, or as they’d say where I’m from, “we’re well and truly screwed.”
Further reading
Featured image: Thijs ter Haar, CC BY 2.0, via Wikimedia Commons.
