Greek debt crisis could raise problems for U.S. and other countries

By Neil Irwin

Washington Post Staff Writer

Friday, March 5, 2010; A12



Greece's economy is about the same size as that of Massachusetts. The Mediterranean nation ranks 63rd among buyers of U.S. exports. Athens is 5,139 miles from Washington.



But despite this literal and figurative distance, the Greek debt crisis has created a new set of risks for the U.S. economy -- remote risks, perhaps, but real nonetheless.



Economic policymakers and many private analysts see a danger that the Greek troubles will lead to the next wave of turmoil for the global economy. Investors are pouring money into government debt around the world, viewing it as a safe investment in an uncertain time. That has helped keep interest rates very low in most large countries, fueling the global economic recovery.



But any default or near-default by Greece could lead investors to question those assumptions, raising doubts that the debts of other nations, including Spain and Italy, and even Britain and the United States, are safe.



As investors perceive a greater risk, they would demand higher interest rates on their loans, causing rates to rise and choking economic growth. Mortgage rates would rise, for example, and it would become more expensive for businesses to borrow money to expand.



The fear among some analysts is that just as subprime mortgage loans -- representing a minuscule portion of the global financial landscape -- triggered a massive crisis back in 2007, so could Greece cause problems for much bigger, and apparently more stable, nations around the world.



A taste of Thailand



One of the lessons of the global financial meltdown is that crises tend to evolve in unpredictable ways. That was also the experience in the late 1990s, when market concerns about Thailand's foreign debt led investors to question the finances of several other East Asian nations, resulting in the Asian financial crisis of 1997-98.



"Greece is like Thailand in 1997 and like subprime in the summer of 2007," said Robert H. Dugger, a managing partner at Hanover Investment Group, a financial consulting firm.



Such contagion has not yet spread from Greece, and forecasters generally view this prospect as a "tail risk" -- a danger that's unlikely to arise but that would be nasty if it did. Financial market participants seem confident that Greece's problems will be confined to Greece and perhaps a few other European nations with particularly ugly public finances.



Washington policymakers, their private concern notwithstanding, have said publicly only that they are monitoring the situation and are confident that European authorities will be responsible for any bailout.



So far, the episode has made it cheaper for the U.S. government to borrow, as investors have moved money into dollars -- and Treasury bonds in particular -- to try to reduce exposure to developments in Europe. The federal government could borrow money for 10 years at 3.6 percent on Thursday based on bond yields, very low by any historical standard and down from 3.84 percent at the beginning of the year.



And finally, there was good news Thursday even for Greece, which successfully sold 5 billion euros, about $6.8 billion, of 10-year debt, suggesting that global investors expect Athens to steer its finances into line.



But if a crisis of confidence in government debt were to erupt, it could spread quickly because of the way European economies are linked with one another and with the rest of the world.



Backing the banks



Consider, for example, a foreign bank that loses money on loans it made in Greece or other European nations with fragile finances. That bank's problems in turn can become trouble for its home government, especially now that banks in many large nations are effectively backed by their governments. This support is the result of efforts in many capitals to protect financial firms during the financial crisis by standing behind them.



"The banking system could really act as a shock enhancer in this case," said Elisa Parisi-Capone, a senior research analyst at Roubini Global Economics. "Given that banks in Europe hold large claims on Greece, if Greece gets in trouble and those claims lose value, the governments of the banks that hold Greek paper are on the hook. This is the link through which contagion propagates."



Spreading from one European country to another, these debt troubles could lead to a pullback in bank lending, slowing the continent's economy further. That in turn might have an indirect effect on the recovery in the United States as Europeans reduce their demand for American products.



But fiscal crises in Europe could have a more dramatic impact in the United States if they prompt investors to question the ability of the U.S. government to manage its finances. The United States is running large budget deficits, reflecting a sharp decline in tax revenue because of the recession and increased spending to stimulate the anemic economy.



If bond investors lose faith that the U.S. government will be able to bring the deficits down over time, rates could rise to reflect the risk of default. In turn, that could slow or stop the recovery.



The Federal Reserve controls short-term interest rates but has far less control over longer-term rates, which include those paid on home mortgages and corporate loans.



Moreover, higher Treasury bond rates, by making large budget deficits more expensive to finance, would signal to politicians that they need to trim the deficit more aggressively. This, too, could restrain the recovery by hamstringing efforts to stimulate the economy.