Shortly after Greece won its latest reprieve from financial collapse in a European deal that will slash its crippling public debt, a plainly relieved Greek Prime Minister George Papandreou said: "Let us hope a new and better day dawns, both for Greece and for Europe."
Hope is at the heart of the new bailout package designed to derail a full-blown regional financial crisis. Hope that it will be enough to stop the contagion of fear, calm jittery markets and keep credit flowing, while buying Greece and Europe enough time to tackle massive debt problems, repair broken financial systems and fix widening imbalances.
But the euphoria that erupted upon news of the deal to boost the firepower of a euro zone rescue fund, recapitalize European banks and reduce Greece's mountain of debt can't be sustained on optimism alone.
The market-calming exercise flunked its first real test on Friday when the Italian government issued new debt. The new bailout package was aimed at providing greater confidence among market participants and bringing bond yields down, thereby reducing financing costs for debt-heavy governments. Instead, Italian 10-year bond yields rose significantly Friday, topping 6 per cent for the first time since the euro's launch. Yields on 10-year Spanish bonds also jumped north of 5.5 per cent after falling to 5.33 per cent a day earlier.
And then debt-rating agency Fitch Ratings threw a wrench into the plan for institutional investors to accept a 50 per cent haircut on their Greek bond holdings. Fitch warned that if investors accept the reduction, it will amount to a clear-cut default, an assessment that adds more uncertainty to the success of the debt restructuring process.
Even if Europe's rescue plan reduces the risk of a near-term financial crisis, experts warn that countries have yet to address their core debt and structural problems that threaten to tear the euro zone apart. They may stanch the bleeding for now, but the causes remain untreated. And the risk grows that Europe's sovereign debt and banking woes will spread through the financial system to other advanced and emerging economies.
"If there is a financial meltdown in Europe, there is an impact on the global financial system," said Nicolas Véron, a senior fellow at Bruegel, a think tank in Brussels. "Which is why the rest of the world is so concerned about the decisions that the Europeans are making or not making."
A study by a trio of economists at the Bank for International Settlements concluded that combined public, non-financial corporate and household debt becomes a permanent drag on economic growth when it exceeds 250 per cent of GDP. Most European countries are in the 300 per cent range. "Debt problems facing advanced economies are even worse than we thought," the economists said.
Public debt alone begins to exact a toll on economies and markets when it goes much beyond 80 to 100 per cent. So the European goal of getting Greek public debt down to 120 per cent of GDP by 2020 from an estimated 162 per cent this year is not a recipe for an economic turnaround.
"Even if everything goes swimmingly, the Greek economy is going to be crippled for the next decade and a half to two decades," said Constantin Gurdgiev, a lecturer in finance at Trinity College in Dublin.
"It is an absolute disaster across the board," he said of the broader European rescue plan. "The worst possible scenario is the one they came up with, where you damage the patient and you don't do anything to the disease."
Already there is disagreement over the terms of the Greek bond haircut.
Because European officials have deemed the plan to be voluntary on the part of bondholders, they argued that it should not trigger a default. The International Swaps and Derivatives Association, which oversees the credit default swaps market, including $3.7-billion (U.S.) worth of insurance on Greek bonds, agrees. So for now, the declaration of a default by the rating agencies will not have any serious financial repercussions. Indeed, the yield on Greece's 10-year bonds narrowed slightly Friday to 23.25 per cent.
But Fitch's view that the move amounts to a default is likely to be followed by other credit raters. That could entice bondholders with credit insurance to balk at the voluntary plan and seek payment on their insurance.
Fitch, meanwhile, said the broad rescue plan addresses the key causes of Europe's financial crisis, but problems remain that are likely to cause countries' creditworthiness to deteriorate further. "Further bouts of financial market volatility appear likely and downward pressure on sovereign ratings will persist," the agency said.
European leaders aren't saying much about the future of the single monetary system. Some observers say the crisis has put them on the right path, albeit at a slow pace, toward the tighter integration and centralized fiscal control needed to ensure the euro's survival. But others have a more jaundiced view of the eventual outcome. "I'm pretty skeptical that the euro zone will keep all of its members," said Kenneth Rogoff, a Harvard economics professor and former chief IMF economist. For any long-term plan to work, he argues that troubled members like Greece and Portugal have to be cast away.
Those that remain must form "a much tighter confederation of states," Mr. Rogoff said. Within this more integrated union, he advocates two major reforms: a tax policy that sends revenues to a central body that is given the power to assist troubled countries and a common regulator that assesses the entire region's problems and keeps watch over national fiscal disparities.
"I think that's the only end game here."
Tim Kiladze