Lehman Crisis Veterans Say Europe Shouldn’t Push Greece Too Far

Neel Kashkari, who was on the policy frontlines when Lehman Brothers Holdings Inc. crumpled in 2008, warns European governments against pushing Greece too far as they impose conditions for aid.

“It can be very politically satisfying to be tough, but if an uncontrolled default were to lead to contagion around the euro zone, that could be very damaging for all of Europe and for the global economy,” said Kashkari, who four years ago was an aide to then-U.S. Treasury Secretary Henry Paulson and now is head of global equities at Pacific Investment Management Co.

Kashkari is not alone among the Treasury veterans who fought the worst financial turmoil since the Great Depression and now say the euro area should be careful of taking too hard a line with Greece. Their battle-seasoned advice: Avoid encouraging a default unless first acting to ensure foreign economies and banks are protected from the aftershocks.

“This seems like brinkmanship on the part of the European leaders,” said Phillip Swagel, the Treasury’s former chief economist, who now teaches at the University of Maryland in College Park. “The better approach is to prepare for a future failure so they have a more credible threat to allow Greece to default and possibly leave the euro zone.”

First Default

The likelihood of the euro-area’s first default in its 13- year history is growing by the day as Greece faces a March 20 bond redemption totaling 14.5 billion euros ($19 billion). While the nation’s political leaders have signed up for fiscal retrenchment and detailed 325 million euros in new budget cuts for this year, euro-area governments have yet to approve a second bailout of 130 billion euros.

The tactics reflect irritation that Greece backed down on commitments pledged to win a 110 billion euro rescue in 2010, and they suggest greater confidence in Europe’s ability to withstand a default by the Mediterranean nation. German Finance Minister Wolfgang Schaeuble said Feb. 13 that “we’re better prepared than two years ago.”

“The case for going ahead with the second package is that the alternative is worse,” said Nicola Mai, an economist at JPMorgan Chase & Co. in London. “But to the extent that some policy makers think they have ring-fenced the consequences of default and euro exit, then in their minds the case for going ahead is weaker.”

Greek Impact

European governments now have a rescue fund and regional banks have reduced their exposure to Greece to just 1 percent of the euro-area’s gross domestic product, Julian Jessop, chief global economist at Capital Economics Ltd. in London, said in a report yesterday. Greece also accounts for less than 0.5 percent of global GDP and has $455 billion in debt, compared to the $7.5 trillion U.S. mortgage market which was roiled in 2008, he said.

“I haven’t seen arguments that I would consider credible that the Greek government defaulting on its debt obligations would so damage the rest of Europe that the creditors must eliminate the risk of default,” said Keith Hennessey, who directed President George W. Bush’s National Economic Council in 2008 and now teaches at Stanford University in California.

After wrangling over Greece at a Feb. 9 meeting and on a Feb. 15 conference call, euro area finance chiefs reconvene in Brussels in three days to discuss extending more aid and kicking off a bond exchange to stop it from reneging on its debts. If Greece meets the aid conditions, the package will probably be approved, three German officials said yesterday.

Emergency Loans

“Europe is still more likely than not to rescue Greece from disorderly default,” said Christian Schulz, an economist at Berenberg Bank in London.

The drawn-out debate has sparked vitriol from Athens, with Finance Minister Evangelos Venizelos accusing richer European nations of “playing with fire” by toying with the idea of dismissing Greece from the euro. Prime Minister Lucas Papademos nevertheless said Feb. 12 that the economic pain of austerity measures is “contained in comparison to the economic and social catastrophe that will follow if we don’t adopt them.”

The concern among U.S. officials past and present is Europe risks failing to heed lessons from the failure of Lehman Brothers, which triggered chaos in which financial institutions lost or wrote off almost $1 trillion, the Standard & Poor’s 500 Index fell 40 percent in six months and the global economy slumped into the deepest recession since World War II.

‘Messy Way’

“The one thing we should take away from Lehman Brothers is you don’t want a big systemic institution to fail in a messy way, and you clearly don’t want that to happen with a member state,” Paulson told CNBC on Feb. 15. “So when you look at Greece, I think it’s important that if there is a problem that it’s well anticipated and it doesn’t happen in a sloppy sudden way.”

The 2008 crisis-fighters still in office are also pressing European policy makers to bolster their defenses and will likely make their case when finance chiefs from the Group of 20 meet next week in Mexico City.

Federal Reserve Chairman Ben S. Bernanke said Feb. 2 that “there is an awful lot that remains to be done in Europe” given its banking system is under-capitalized. Treasury Secretary Timothy F. Geithner, who in 2008 was president of the Federal Reserve Bank of New York, is urging European governments to build a “stronger firewall” of cash to insulate larger debt-ridden economies such as Spain and Italy.

There remains a “tangled web” in Europe, which means lawmakers and investors shouldn’t be sanguine about a Greek default, said Ethan Harris, co-head of global economic research at Bank of America Merrill Lynch in New York, who previously worked at Lehman Brothers.

French Banks

Bank for International Settlements data from toward the end of last year suggest French banks alone had a $56.7 billion exposure to Greece as a whole and $15 billion to its government, while the U.S. had ties totaling $7.3 billion and $1.5 billion respectively, according to Bank of America Merrill Lynch.

“History shows that when a country defaults it usually causes a default on most foreign claims,” Harris said.

The other concern is that as Greece goes so might others, potentially leading to the breakup of the single currency. In a January analysis of credit default swaps, Danny Gabay, director of London-based Fathom Financial Consulting, found if Greece defaults Portugal faces more than a 60 percent chance of following. If that happens then the odds narrow that Ireland, Spain, Italy and perhaps even France could tumble like dominos.

Systemic Problem

“Letting Greece go or -- worse still -- forcing it out, will not solve anything,” said Gabay. “It is effectively the Lehman strategy. It is a systemic problem and is not confined to just one or even several of the errant countries.”

“The contagion from the collapse of Europe’s banking system to the global financial system would be swift and devastating,” he said.

For Kashkari, a Greek default now remains too big a risk. While the ECB’s issuance of three-year loans has stabilized banks, he says the central bank may need to directly fund some countries, or governments should increase the size of their rescue funds.

Leaders already are scheduled in March to reassess the planned combined aid limit of 500 billion euros which takes effect in July when a permanent rescue fund begins.

“How is the ECB and the EU going to protect Italy and Spain and build a firewall around them? We don’t have clarity on that fact yet” said Kashkari. “If the fears spread to Spain and Italy, those all of a sudden could become Lehman moments.”

To contact the reporters on this story: Sandrine Rastello in Washington at srastello@bloomberg.net Simon Kennedy in London at skennedy4@bloomberg.net

To contact the editor responsible for this story: Christopher Wellisz in Washington at cwellisz@bloomberg.net;

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