Even after European leaders appeared to have averted a chaotic default by Greece with an eleventh-hour deal for aid, worries persist that a debt disaster on the continent has merely been delayed.
The tortured process that culminated in that latest bailout has exposed the severe limitations of Europe?s approach to the crisis. Many fear that policy makers simply don?t have the right tools to deal with other troubled countries like Italy, Spain, Ireland and Portugal, a situation that could weigh on the markets and the broader economy.
?I don?t want to be a Cassandra, but the idea that it?s over is an illusion,? said Kenneth S Rogoff, a professor of economics at Harvard and co-author of ?This Time Is Different: Eight Centuries of Financial Folly.? ?I am amazed by the short-term psychology in the market.?
Throughout the crisis, the European Union?s favoured strategy has been to provide tightly controlled financial support to highly indebted countries, in the hope of buying them enough time to put in place policies aimed at cutting budget deficits. While such moves can deepen recessions, the goal is to eventually lower debt levels and win back the confidence of the bond markets.
On the margins, investors have become more optimistic. European stocks and government bonds have rallied sharply this year on the belief that Greece would avoid a disorderly exit from the euro. On Tuesday, United States equities rose slightly after the Greek deal, while European stocks fell modestly, giving up some of their gains from the previous day.
But Greece?s predicament highlights the weakness in the European response. Austerity policies imposed by the authorities contributed to a sharp contraction of the Greek economy last year. In 2010, the International Monetary Fund had forecast that the economy would shrink only 2.6% in 2011, but current estimates suggest a contraction of 6.8%.
Greece is also resorting to a move that European officials initially wanted to avoid at all costs. As part of the 130 billion euro aid package, the country is going to reduce its overall debt load by requiring some creditors to take losses on Greek bonds. In total, the restructuring will mean private sector holders of Greek bonds take a hit of more than 70%.
European officials want to avoid similar measures for other countries. Last year, after European officials suggested debt restructurings might be employed beyond Greece, the region?s government bonds plunged in price. The market reaction prompted officials to remove debt haircuts from the crisis management toolbox ? at least for now.
Instead, European officials have introduced a range of measures over the last year that may buy more time for struggling countries. The EU is setting up large pools of money to make emergency loans. And the region?s leaders have agreed to move towards more coordinated fiscal policies, which may pave the way for richer countries to transfer funds to poorer ones. In perhaps the boldest move, the European Central Bank lent $620 billion to the region?s banks in December. The cheap money, which the central bank will dole out again later this month, has provided an essential lifeline to the region?s financial firms and prevented a bank run in Europe.
The three-year loans have also helped firms continue to finance purchases of sovereign bonds, bolstering the debt markets. Spain?s government has already sold more than 30 percent of the $114 billion worth of bonds it plans to issue this year.
But one of the lessons of the postcrisis period in the United States is that monetary policies may only temporarily lift the markets and can take a long time to seep into the real economy. Some economists believe that although the European Central Bank has stepped up its response to the crisis, its efforts are not yet as stimulative as those of the US Federal Reserve.
For instance, the Fed, in its most forceful stimulus measure, spent hundreds of billions of dollars buying bonds. The purchases supplied banks with immense amounts of cash that they were free to use as they wished.
The European Central Bank did something different with its $620 billion of loans in December. Banks had to post collateral against the money they borrowed. While the banks got cash, they still have to pay back the central bank loans in the future, and they still own the assets they posted as collateral. As a result, the central bank loans may have less effect than the Fed?s bond-buying, said Guy Mandy, a strategist at Nomura International.
Even in the US, monetary policies did little to repair the balance sheets of the most debt-laden sectors of the economy. That means European government debt levels may take a lot longer to fall than officials hope. Certain governments may then require even more aid because they will not be able to sell bonds into private markets at affordable interest rates.
As with Greece, aid-disbursing countries like Germany might demand even tougher conditions on loans. But doing this can set up potential flashpoints that threaten to destabilise domestic politics and markets. ?This creates a rolling crisis,? said Silvio Peruzzo, an economist at the Royal Bank of Scotland.
Raoul Ruparel, head of economic research at Open Europe, a policy group that is sometimes sceptical of the need for closer European integration, said, ?The approach failed monumentally in Greece.?
For a while, the EU may decide to keep giving aid to countries that do not meet goals, but this could create wider political conflicts in Europe. ?It could drive a wedge between north and south in political terms in Europe,? Ruparel said.
If troubled countries
find they cannot comply with the loan conditions ? and the richer ones grow increasingly impatient ? they may have to follow Greece?s lead.
