GREECE AND CONTAGION / THE WALL STREET JOURNAL REVIEW & OUTLOOK ( VERY HIGHLY RECOMMENDED READING )

REVIEW & OUTLOOK

MAY 10, 2010.

Greece and Contagion

This shouldn't be a repeat of 2008.

Last week's death-defying plunge (and partial recovery) in stocks was due—pick your favorite—to fear of contagion from Greece, a mistaken sell order from Citigroup, the financial regulation bill in the U.S. Congress, or the rampage of machine trading. The regulators are sure to tell us about any erroneous trades, so our point today is to focus on the risk of contagion.

The Greek economy is indeed a disaster, and the European Union-International Monetary Fund bailout plan will do little to restore growth. But there is no good reason that sovereign debt problems in a country that represents only 2% of the EU economy should send the world into another financial crisis and recession—if our political classes keep their heads.

The world banking system is far stronger than it was two years ago, and U.S. banks in particular have improved their balance sheets. The banks with the most exposure to Greece and the other indebted European nations are German and French. If those banks need to be recapitalized from taking on too much bad sovereign debt, then that will be a task for German and French taxpayers. Far better for taxpayers to put their money into that cause than to guarantee the pensions of Greek civil servants.

The panicky, moonshine cure being offered is to blow up the euro so the debtors can go back to devaluing their currencies. That would lead to more financial chaos, as investors flee the euro for the safety of the dollar, U.S. Treasuries and gold. The pending bailout of Greece has already dented the euro's credibility as a store of value and a system of monetary and fiscal discipline. The world needs more confidence, not more risk aversion from a further run on the euro. Europe's finance ministers were meeting in Brussels Sunday night to come up with a plan to "defend" the euro from what Sweden's Finance Minister, Anders Borg, called the market's "wolfpacks." As we went to press, it wasn't clear what agreement, if any, would be reached. Fingers crossed that the cure doesn't prove worse than the disease.

Investors are also worried about the harm if Europe sinks back into recession, but the world economy is also stronger than it was in 2008. The emerging economies—Brazil, China, India—have led the world out of recession, and the U.S. has had three quarters of recovery. A European double-dip would be a blow, but it shouldn't be a replay of September 2008.

Moreover, the flight to dollar assets has given the Federal Reserve a reprieve on its tightening calendar. As demand for dollars increases, the Fed will have to meet that demand to avoid an even sharper euro plunge and deflationary danger. This could mean higher inflation down the road, a prospect that explains the rising price of gold despite the rising dollar. For now, however, the Fed will see its role as fighting any European-induced deflation.

The Greek debacle should certainly signal the end of the world's neo-Keynesian spending spree. Investors are shorting Europe because they are worried that politicians will keep spending and borrowing without any discipline. Short of tax cuts, the best "stimulus" going forward would be no more stimulus at all.

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