A nearly $1 trillion rescue package cobbled together by the European Union (EU) and the International Monetary Fund in early May has so far done little to reassure investors that the Greece debt crisis won't spread – or that the euro currency is secure. Now, European leaders are signaling they may take further regulatory action to ease the pressure.
On Wednesday, the euro dropped to a four-year low against the dollar after German Chancellor Angela Merkel banned naked short-selling in her country and called for much stricter regulation of credit and equity markets across Europe. “The lack of rules and limits... lead to an existential threat to financial stability in Europe and even the world,” Ms. Merkel said at the start of a parliamentary debate on Germany's contribution to the bailout. “The market alone won’t correct these mistakes.”
Merkel is trying to stem public anger over Germany's financing of the rescue fund and a separate $140 billion bailout for heavily indebted Greece. Many Germans are asking why they should be responsible for the debts of other nations and for protecting the large private banks that lent the money in the first place.
Now Merkel and some other European leaders are targeting "speculators" – rather than over-borrowing and spending – as a reason why the region's credit markets remain gummed up.
Naked short selling occurs when an investor promises to deliver an asset at its current market price to another investor, effectively "selling" something he doesn't own in the hope that the price will decline quickly, allowing him to cover his trade and profit. Merkel's government also imposed new rules making it harder for investors to bet against eurozone sovereign debt.
Stocks across Europe fell on Wednesday, over both investor anger at the new German regulation and concern that sovereign defaults may still lie in Europe's future. While politicians and IMF officials had predicted that the promise of money for heavily indebted nations would sufficiently reassure investors, so that the money wouldn't need to be spent at all, that market reassurance has not yet been in evidence.
Many economist are warning that the European Central Bank has merely bought time for heavily indebted eurozone countries like Spain and Portugal to get government debt and spending under control. They fear that weak growth could undermine those efforts and force other countries to take the route of Greece.
What exactly is the package?
The European Stabilization Mechanism consists of commitments from the IMF and EU members to lend up to $1 trillion at low rates to countries that need it. Roughly $560 billion could come from European states, $80 billion from an existing EU fund originally created to deal with natural disasters, and $320 billion from the IMF. The United States has promised to make dollars available in exchange for euros, to help the European Central Bank lend to indebted countries or banks with obligations in dollars.
The eye-catching number aims to reassure investors that no European country or major financial institution will be allowed to default on its debt. IMF Europe director Marek Belka said on May 12 that "as much as Europeans need, we are prepared to provide. We are not worried about lack of resources."
How and when will funds be distributed?
If the confidence-boosting exercise succeeds, little or none of the money may ever be spent, particular if budget cuts recently announced by indebted states like Spain and Ireland reduce their deficits.
But investors remain wary of Europe's debt woes, since the precise circumstances under which the money would be released weren't made clear.
"How these funds will be disbursed, and under what decisionmaking mechanism, is not yet known," wrote Domenico Lombardi, a fellow at the Brookings Institution in Washington and former IMF executive board member in a commentary. "Can they be used to fund precautionary arrangements as a preemptive strike? Or will the requesting countries need to show they have no alternative, as was the case with Greece? ... Markets are eager to know."
What are the politics behind the agreement?
On its face, this amounts to acknowledging that Europeans have a collective responsibility for the spending decisions of individual members like Greece. That has been deeply unpopular in wealthier countries like Germany. On May 9 an election in Germany's most populous state, North-Rhine Westphalia, cost Chancellor Angela Merkel's coalition control of the upper house of parliament. Public outrage at the bailout for Greece contributed.
But leaders like Ms. Merkel concluded that letting any eurozone member default was not an option, given the chance that a default in one nation could touch off a cascade of bank defaults elsewhere. Germany's government and financial institutions, for instance, are owed more than $450 billion by the governments and banks of Greece, Ireland, and Spain. Those last two countries, with Portugal, are seen as Europe's most vulnerable after Greece, and all announced spending cuts and higher taxes in early May.
"I guess what they felt was that letting Greece default would increase the odds that others would default," says Morris Goldstein, a former IMF official and a senior fellow at the Peterson Institute for Economic Research. "If you have a lot of people speculating on a Greek default, then they go on to the next country down the line. Who's holding the Greek bonds? French and German banks."
Mr. Goldstein is more optimistic about Spain and Portugal, which have better control over their debt and are much less likely to default.
Will it work?
For now. But in the longer term, economists have grave doubts that Greece will be able to avoid restructuring its debt, which is default by another name. The reason is that Greece needs to start running large government surpluses within a few years. Some argue that postponing default, even if only for a few years, buys time for Greece and other European governments to get their financial houses in order, possibly leading to less regional fallout if and when debts aren't repaid in full.
While tough spending cuts have been forced on the government by the IMF, the country's powerful unions are promising to fight, and there have already been small riots in the Greek capital. Even if Greece follows through on its belt-tightening, many economists have trouble seeing how it could generate sufficient extra tax revenue to start paying down its debts at a time when almost everyone expects the Greek economy to sputter, if not decline.
"I think most people think that the chances of avoiding an eventual default are slim," says Goldstein. "The numbers for Greece just look awful.... They need lower wages and prices since they can't lower the exchange rate, but if wages and prices are falling," then so does Greek revenue, he says.
Eventually, he expects Greeks will ask: "Why are we going through all this enormous austerity when the debt burden is only going to be even higher in the end? So why not restructure?"