The Trillion-Dollar Treatment

European leaders still don't understand what caused the Aegean Contagion that swept through the eurozone in late April and early May. Swedish Finance Minister Anders Borg blamed "wolf-pack behavior" by speculators. Others have railed against clueless rating agencies, feckless debtors, and unreasonable creditors. Then there are those who ask if there's an inherent flaw in the bond markets that made them cascade, turning vague worries into scary, self-fulfilling prophecies.

You can't defeat an enemy you don't understand, and unless Europe gets a better grasp on what went wrong, it will be vulnerable to more turmoil, even with the nearly $1 trillion backstop lending authority that calmed markets. "I still think it's a very fragile situation," says Gary Gorton, a Yale University economist.

The reality isn't all that complicated. Europe was vulnerable to contagion, and remains so, because its governance and its financial system are weak. It was lax fiscal oversight that allowed nations such as Greece to violate European Union rules on the size of their budget deficits in the first place. Overleveraged investors made matters worse: When the value of their Greek debt fell, they were forced to reduce the size and risk of their portfolio by selling other assets—the debt of Portugal and Spain, for example.

In retrospect, Europe's crisis was a done deal last November, when a new Greek government announced that its deficit-to-gross domestic product ratio for 2009 would be 12.7 percent, more than double what the previous government had projected and four times what the European Union allows. Interest rates on Greek debt, which had been nearly as low as rates on German bonds, inched upward. In a vicious circle, the higher rates themselves increased Greece's debt burden. That made default more likely and pushed rates even higher. On Apr. 27, Standard & Poor's lowered Greece's credit rating to junk. By May 7, the yield on two-year Greek government bonds hit 18 percent. Yields on Portuguese bonds reached 6 percent that day, double their level of three weeks earlier. Spanish and Italian credit was beginning to be affected as well.

Eventually the Europeans had no choice but to agree to a backstop lending arrangement for seriously threatened governments. That brought two-year Greek bond yields back down to a bit below 7 percent by May 12—about what an American might pay for a car loan but far higher than any other eurozone nation pays to service its debt.

Now that it has some breathing room, Europe needs to think hard about what just happened. The best place to start is with another contagion, the 2007-09 financial crisis that began with shoddy subprime mortgage lending in the U.S. In his new book, Slapped by the Invisible Hand, Yale's Gorton describes the dangerous tipping point that comes when investors lose faith in complicated financial instruments they once took for granted. Mortgage-backed securities had been treated like Treasuries—investors looked at the yield and the credit rating and didn't bother asking what was inside. When subprime mortgages started going into default, investors suddenly wanted to know if the securities in their portfolio contained any of those bad loans—and discovered they couldn't disentangle the assets. They got scared and bailed out. In Gorton's terminology, the securities went from being "information-insensitive" (a good thing for market liquidity) to "information-sensitive" (bad). Gorton says the same fate befell Greek bonds when players in the credit default swap market began digging up information pointing to a risk of default that bond investors hadn't bothered to ferret out in advance.

As with a physical disease, financial contagion spreads faster in a weakened population. Europe's problem is that many of Greece's creditors are themselves debtors on a massive scale. If the value of their assets declines, the only way they can stay solvent is by reducing their debt, and the only way they can pay down the debt is by selling assets, which pushes their price down even further, exacerbating the problem and spreading it to other securities. It's revealing that the ultimate beneficiaries of Europe's rescue are the big banks, not the Greeks, who will barely touch any rescue money before it goes out the window to their lenders.

To prevent a spreading financial contagion, then, it's not just the debtors that need to develop a stronger immune system. It's the creditors, too. As Princeton University economist Markus Brunnermeier pointed out in a 2010 paper, "Deciphering the Liquidity and Credit Crunch, 2007-2008," the big global investment banks became heavily dependent in 2007-08 on so-called repo financing. They borrowed money using bonds, asset-backed securities, and the like for collateral. Repo lenders give the best terms on overnight loans because there's less risk the collateral will lose value. But if borrowers can't roll over their debt, they must sell assets at fire-sale prices—and, in turn, stop extending loans to their clients. In 2007, according to Brunnermeier, repo lending that has to be rolled over daily amounted to some 25 percent of the assets of the 19 big U.S., European, Japanese, and Canadian primary dealers in U.S. Treasury securities. (The calculation is based on gross repo borrowing. They also make repo loans.)

One might suppose that these large investment banks learned their lesson in the crisis and weaned themselves off overnight repo loans—which, after all, force them to scrounge up fresh loans every single day or go bust. Not quite. Bloomberg Businessweek updated Brunnermeier's calculation using publicly available data from the Federal Reserve Board and the Federal Reserve Bank of New York. As of the end of 2009, overnight and continuing repo loans were down more than 40 percent from their peak, but still funded 15 percent of the big banks' assets. Even after the pullback, overnight repo grew 155 percent from the beginning of 2000 through the end of April 2010. That compares to growth of just 82 percent in a broad measure of the money supply known as M2. Bottom line: A big chunk of their financing remains precarious.

Many Europeans would prefer to blame the crisis on outsiders, the favorite scapegoats being speculators and ratings agencies. On Apr. 30, German Foreign Minister Guido Westerwelle called for the creation of a European credit rating agency. Complaining about the U.S. rating agencies, Pierre Lellouche, the French minister for European affairs, told The New York Times: "I'd be interested to know what these 30-year-old boys know about the disaster they are causing to people in Spain or Portugal or anywhere else." In reality, the rating agencies were no more than the bearers of bad tidings. Greeks are tired of having ancient ancestors quoted at them, but it's hard to resist citing Sophocles: "No one loves the messenger who brings bad news."

For countries with the highest deficits, the challenge now is to cut government spending and increase revenue in a time of slow growth or outright recession. It's not clear whether Greece in particular will be able to muster the social solidarity necessary to do so. It's equally difficult to see how Germany will go ahead with backstop loans to Greece if the country doesn't meet its commitments. "This deal is necessary. I don't know if it's sufficient," says Sandra Valentina Lizarazo, an economist at the Mexico Autonomous Institute of Technology who has studied emerging-market debt crises.

The EU's problems resemble those of the young and weak United States of America from 1781 until 1788, before the Constitution was ratified. Under the Articles of Confederation, the federal government had no power to tax. It relied on contributions from the states. Alexander Hamilton, who later became the nation's first Treasury secretary, warned in 1780 that "without revenues, a government can have no power. That power which holds the purse-strings absolutely, must rule." So Europe is discovering nearly 230 years later. For Europe, the strongest defense against another bout of Aegean Contagion would be a unified Continental government with authority over taxation and spending—a United States of Europe. A unified Europe would have the power to prohibit, not just remonstrate against, the fiscal frivolity that brought on this virus. Since such a political solution does not seem remotely possible, more bouts of fiscal sickness are all but certain.

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