The Next Financial Crisis: the European Chapter?

European leaders have had it relatively easy in the recent crisis. The events that sparked the crisis occurred in America, and many of the effects of the crisis have been more severe there (big exceptions in smaller countries like Ireland, Latvia, and Greece, but also Spain). That the housing bubble triggered the crisis has made it easy to blame the entire crisis on America. Increasingly, though, Europe is beginning to look very weak. These problems, though, are homegrown.

Everyone is aware of Greece's current liquidity issues. It now appears that European leaders will head off a crisis in Greece by bailing the country out. Although many political and legal problems remain unresolved in doing this, it does look like it will be done. As The Economist argues, Greece will then have about three years to resolve its budget issues.

It also points out, however, that even with help from the EU and severe budget tightening (of which the actual application is questionable), Greece's debt will stabilize at around 150% of GDP, a huge amount by any standards (except Japan's, which is a different case, however, with lots of domestic savings, domestic financial repression, and assets abroad). Even assuming Greece manages to cut its deficit from something around 12% of GDP to under 3% in the next three years (a highly questionable assumption given the country's economic and political prospects), there is still every possibility the country could decide not paying back its debts was a better option. Indeed, that might even be true for Greece. Such a massive debt burden would hinder growth and spread economic and social malaise for years to come. In a country where social unrest bubbles beneath the surface, such austerity measures might simply be too unpalatable.

So why not let Greece default now and save ourselves the trouble (and extra money) of bailing it out? EU law stipulates that bailouts are illegal, and Germany has been opposed to them until recently. Why the change of heart? Cold calculation. Germany's Chancellor, Angela Merkel, has realized that a Greek default could sweep other countries with it, most notably Portugal, but possibly Ireland, Spain, or even Italy. Assuming that did not happen, though, the damages would be bad enough. European banks hold a lot of Greek bonds, and German banks are among the largest holders. If Greece goes down, bank bailouts may be necessary instead of a country bailout.

So a homegrown banking crisis could hit Europe. Apparently, Europe's banks are even more leveraged than American ones and even more thinly capitalized. Several banks would be unlikely to withstand a large-scale Greek default, never mind one involving several Euro-area countries. It seems the Europeans are not invulnerable to bad investment decisions, either.

Of course, this is no time for schadenfreude; such a disaster would ripple throughout the globe, nailing already weak economies and overly stretched government budgets. It was a couple of years after the 1929 crash before the Great Depression hit its deepest point. Let us hope that we are not about to repeat the false optimism that prevailed into 1930 again...