Europe's debt still a risk to U.S.; question is how much?

McClatchy NewspapersJuly 21, 2011 

WASHINGTON — The Dow Jones industrial average enjoyed triple-digit gains in two of the last three days thanks to investor optimism that Europe is getting its debt crisis under control. However, experts warn that this may prove overly optimistic and problems abroad still could spread to our shores.

The Dow gained 152.50 points Thursday, a strong showing after Tuesday's 202-point gain, the largest one-day gain this year. A draft document from a European summit on Greece's debt woes prompted Thursday's rally.

Investors cheered the defeat of a French plan to tax healthy banks to pay for Greek bailout loans, and the empowerment of a bailout commission to do more. European Union leaders also offered more flexible lending terms to sick economies.

However, the deal also made it a near-certainty that a first-ever default by a euro-zone country since its common currency was introduced in 1999 soon will follow. Credit rating agencies are poised to declare a buyback plan for Greek bonds a technical default, the first by a developed nation in at least 60 years.

Events in faraway places may yet threaten the fragile U.S. economic recovery. Here are answers to questions about how.

Q: Greece is a fairly small country on the periphery of Europe. Why do its debt problems matter?

A: Greece alone isn't so much of a threat. What's making markets nervous is that several other European countries — Italy, Ireland, Spain and Portugal, to name a few — have similar problems, and much larger ones. How the Greek debt crisis is resolved will have bearing on how these other nations' debt problems are resolved.

"Markets and people are going to realize that in Europe, they're going to change the rules of the game," Peter Boone, a senior fellow at the Peterson Institute for International Economics, said at a forum Thursday on the European debt crisis.

European leaders already have said that they'd require private-sector losses instead of government bailouts in the future, and they've signed off on some losses to Greek bondholders, i.e. a debt default.

European banks borrowed heavily to invest in government bonds from all these troubled EU nations, a process called leverage. Those banks now have insufficient capital on hand to cover potential losses. This is what happened with U.S. banks in the near-collapse of the U.S. financial system in 2008.

"This is an over-leveraged, undercapitalized system," Simon Johnson, a former director of research at the International Monetary Fund, warned at the same forum.

Q: What's the source of problems in these other countries?

A: Greece, Ireland, Portugal, Spain and Italy all have tremendous short-term debt that's due to be paid off soon. Investors fear that these governments may not be able to pay up. That's a default. Many European banks own these government-issued bonds. Investors are fleeing banks in Spain and Italy in particular and shifting deposits to Germany, out of concern that the troubled nations' banks may need government intervention to keep afloat.

Q: How does this threaten the U.S. economy?

A: The most immediate way is that the euro zone is barely growing, so U.S. exports — one of our few economic bright spots — are likely to suffer. There's also fear that banking system problems there could spread here.

"I think if any of the bigger European countries got in serious financial difficulty, there would be spillover to the United States. U.S. banks do have a fair amount of loans to Italy, not to mention Spain or France, so if there were wide contagion in Europe, it would spill over here," said Fred Bergsten, the director of the Peterson institute. "I think that explains why the U.S. government has been very aggressive in urging Europeans to get their act together."

Q: There's growing concern about Italy?

A: "Italy is the big worry because of its magnitude. Italy has the third-largest bond market in the world, so there is a lot of Italian debt out there," Bergsten said. "If it ever became seriously at risk, or certainly if it were impaired, there would be spillover in lots of markets with lots of impact."

Q: What exactly got worked out for Greece?

A: European leaders said Thursday that they'd give Greece a lower interest rate on emergency loans — 3.5 percent, instead of the earlier 5.5 percent — and they more than doubled the period in which prior emergency loans must be repaid, from the original seven years to 15 years.

The troubling part was word that Greek bondholders would lose money when either the Greek government or a European institution buys back bonds under the new program. This is being referred to as a structured default, and though European leaders say that this default is only for Greece, a precedent appears to have been set.

Q: Isn't Thursday's euro deal just kicking the can down the road? Why are investors happy?

A: Investors seem happy that the precedent has been set to do it again should other euro economies need rescuing. The move would lower the cost of borrowing, thus easing the burden that new borrowing places on a struggling economy.

In some ways, this is similar to what was done during the U.S. financial crisis, when an accounting rule was loosened so that banks didn't have to count toxic loans on their balance sheets in present-day values. The problem didn't go away, but an immediate solution wasn't needed and the hope was that the banks would grow out of their difficulties. The same goes for European bond issuers.

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