In an interview that will air Sunday on ABC, Treasury Secretary Tim Geithner says, “”We have much, much lower risk of [a double-dip recession] today than at any time over the last 12 months or so … We are in an economy that was growing at the rate of almost 6 percent of GDP in the fourth quarter of last year. The most rapid rate in six years. So we are beginning the process of healing.”
The timing of this statement is remarkable because, while the US is finally showing some signs of recovery, the global economy is bracing for another major shock – this time coming from the European Union.
The mounting debt and deficit problems in Greece might seem relatively small and faraway to the US Treasury – concerned as it is with China’s exchange rate and the ritual of G7 meetings, and likely distracted by the major snow storm now hitting Washington DC.
But the problems now spreading from Greece to Spain, Portugal, Ireland and even Italy portend serious trouble ahead for the US in the second half of this year – particularly because our banks remain in such weak shape.
Greece is a member of the eurozone, the elite club of European nations that share the euro and are supposed to maintain strong enough economic policies. Greece does not control its own currency – this is in the hands of the European Central Bank in Frankfurt. In good times over the past decade, this helped keep Greek interest rates low and growth relatively strong.
But under the economic pressures of the past year, the Greek government budget has slipped into ever greater deficit and investors have increasingly become uncomfortable about the possibility of future default. This impending doom was postponed for a while by the ability of banks – mostly Greek – to use these bonds as collateral for loans from the European Central Bank (so-called “repos”).
But from the end of this year, the ECB will no longer accept bonds rated below A by major ratings agencies – and Greek government debt no longer falls into this category. The market can do this kind of math in about 20 seconds: If the ECB won’t, indirectly, lend to the Greek government, then interest rates will go up in the future; in anticipation of this, interest rates should go up now.
That is trouble enough for an economy like Greece – or any of the weaker eurozone countries that have been known, for some time and not in an endearing way as the “PIIGS”. But paying higher interest rates on government debt also implies a worsening of the budget; this is exactly the sort of debt dynamics that used to get countries like Brazil into big trouble.
The right approach would be to promise credible budget tightening down the road and to obtain sufficient resources – from within the eurozone (the IMF is irrelevant in the case of such a currency union) – to tide the country over in the interim.
But the Germans have decided to play hardball with their weaker and – it must be said – somewhat annoying neighbors. As we entered the weekend, markets rallied on the expectation that there might be a bailout for Greece (and all the others under pressure). But, honestly, this seems unlikely. The Germans hate bailouts – unless it’s their own banks and auto companies on the line. And the Europeans policy elite loves rules; in this kind of situation, their political process will grind on at a late 20th century pace.
In contrast, markets now move at a 21st century global network pace. This is a full-scale speculative attack on sovereign credits in the eurozone. Brought on by weak fundamentals – it’s the budget deficit, stupid – such attacks take on a life of their own. Remember the spread of pressure from Thailand to Malaysia and Indonesia, and then the big jump to Korea all in the space of two months during fall 1997.
Tim Geithner and the White House may feel they must stand aloof, waiting for the Europeans to get their act together. This is a mistake – the need for US leadership has never been greater, particularly as our banks are really not in good enough shape to withstand a major international adverse event (e.g., Greece defaults, Greece leaves the eurozone, Germany leaves the eurozone, etc).
Yes, we subjected our banks to a stress test in spring 2009 – but the stress scenario was mild and more appropriate as a baseline. Many of our banks – big, medium, and small – simply do not have enough capital to withstand further serious losses (think commercial real estate).
As the international situation deteriorates – or even if it remains at this level of volatility – banks will hunker down and credit conditions will tighten around the US.
And if the European situation spins seriously out of control, as it may well do early next week, the likelihood of a double-dip recession (or significant slowdown in the second half of 2010) increases dramatically.
By Peter Boone and Simon Johnson