EUROPE´S BEAR STERNS / THE WALL STREET JOURNAL REVIEW & OUTLOOK ( VERY HIGHLY RECOMMENDED READING )

REVIEW & OUTLOOK

APRIL 24, 2010.

Europe's Bear Stearns

The real systemic risk for the euro-zone is a Greek bailout.

In formally requesting €45 billion ($60 billion) from the International Monetary Fund and European Union Friday, Greek Prime Minister George Papandreou sought to end the drama over whether Greece can pay its bills. Such a bailout would, of course, end nothing. What it would do instead is open a wide new world of moral hazard—for Greece, for the countries providing aid, and for the future of the entire euro-zone.

The Greek government has played the victim for all it's worth over the past several months, insisting that the same credit markets that finance its extravagant spending were charging too much in interest. But on Thursday, following another upward revision to its budget deficit, bond yields soared and forced Mr. Papandreou's capitulation.

Thursday's market turmoil left Greek bonds in emerging markets territory at 8.7% on 10-year debt—5.7 percentage points above the German benchmark. This came after the EU's statistical agency, Eurostat, said it still lacked confidence in Greek figures and raised its 2009 deficit estimate to 13.6% of GDP from 12.7%. Moody's promptly downgraded the country's sovereign debt. Meanwhile, tens of thousands of Greek public workers took to the streets to protest the government's austerity measures, such as they are. Could there be a greater disconnect?

Some €8.5 billion in Greek debt is set to mature May 19, and IMF money may come in time to finance that. But over the next five and a half years, Greece will face some €240 billion in debt-service and refinancing costs—roughly equal to Greece's gross domestic product. Even if Athens did raise that on the open market, it would be left with a crippling debt ratio close to 150% of GDP. Interest payments alone could reach 10% of GDP a year. Loans might delay, but cannot prevent, a radical restructuring of Greek debt.

At the same time, a bailout comes with baleful consequences for the entire euro-zone. Further austerity demanded as a quid pro quo might take some domestic political heat off Mr. Papandreou, but the IMF's policy history does not bode well for future economic growth. The EU countries expected to shell out €30 billion for Greece have their own debt challenges. If Greece is bailed out, the markets will rightly conclude that a line has been crossed, and that Portugal and even Spain will be rescued too. Even the Germans don't have that much money.

This debate is now roiling in Germany, which would have to approve any aid package. Chancellor Angela Merkel agreed to the EU's bailout pledge two weeks ago only after considerable pressure from France, Italy and her own finance minister, Wolfgang Schäuble. Mr. Schäuble is so worried about Berlin's finances that he opposes tax cuts for Germans, but he nonetheless wants to bail out a spendthrift Greece. In an interview Monday in Der Spiegel, he warned that "We cannot allow the bankruptcy of a euro member state like Greece to turn into a second Lehman Brothers," adding that "Greece is just as systemically important as a major bank."

But Greece isn't Lehman, though it could become so if the EU keeps trying to solve Greece's real debt problems by press release and bailout. Greece represents only 2% of euro-zone GDP. While European banks would take losses on any Greek debt restructuring, those losses would not by themselves be catastrophic. But that wouldn't be true if the sovereign debt panic spreads to Portugal and Spain. Far better for the EU to draw the line now, force Greece and its creditors to take their pain, and demonstrate to markets that there won't be a rolling series of bailouts. To adapt Mr. Schäuble's Lehman analogy, better to stop the moral hazard at Bear Stearns, lest Spain become Lehman Brothers.

As a sovereign debtor, Greece can declare an interest standstill while it restructures via a maturity extension, a haircut to bondholders, or both. Countries that spend beyond their means have often had to restructure, some more chaotically than others, but there is no obvious reason a Greek restructuring should prove contagious.

Greece's problems are familiar across Europe: a welfare-entitlement state that is unaffordable given the country's anemic economic growth. This is what has to change, but it won't as long as the Greeks marching in the street believe their standard of living will be salvaged by German or French taxpayers. The real systemic risk is letting Greece believe it can continue its spendthrift ways, and letting creditors believe they can lend Greece money without fear of losses. This is a far greater threat to the euro-zone and European prosperity than a Greek debt restructuring or default.

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