The Euro Crisis: Lessons From Bear Stearns
Europe can’t afford to bail out Italy, so it might as well send the right message now by forcing Greece to restructure its debt.
By DAVID SKEEL
Ask a European official to sum up the euro-zone crisis, and you are almost certain to hear the “L” word. German Chancellor Angela Merkel recently warned that a Greek default could be Europe’s Lehman, triggering a world-wide market crisis.
A Google search of Greece and Lehman Brothers now yields over five million hits. There are indeed frightening similarities between the euro-zone crisis and the 2008 market meltdown in the U.S., but Ms. Merkel and the conventional wisdom have pinned their tail on the wrong donkey.
Start with the analogy between Europe and Lehman. According to the conventional wisdom, failing to bail out Lehman in September 2008 was the U.S. government’s biggest mistake in the crisis. Having watched the damage unleashed by Lehman, the reasoning goes, we now know that regulators must stand ready to step in with rescue funding. This conventional wisdom completely misinterprets the significance of Lehman.
The real misstep came six months earlier, when the U.S. government was faced with the decision to bail out Bear Stearns or let it file for bankruptcy. By opting for a bailout, the government signaled that it would bail out any of the largest financial institutions if they threatened to fail. Heeding this message, Lehman failed to take the tough measures it needed or to make any serious plans for its eventual bankruptcy.
Like everyone else, Lehman’s managers assumed that the government would come to the rescue. If Bear Stearns hadn’t been bailed out, everything would have been different.
Greece is Europe’s Bear Stearns. If the European Union continues to treat rescue as the principal option for Greece, and to treat “default” like a dirty word, it is headed down the same path the U.S. took in 2008. As bad as that sounds, the consequences of going the bailout route will be far worse than they were in the U.S. It is no secret that the next crisis on the European horizon will involve Italy. Even if the EU wanted to bail out Italy, it almost certainly couldn’t. With €1.9 trillion of debt, Italy is too big to save, even if the euro zone’s rescue fund, the European Financial Stability Facility, is significantly expanded.
Bear Stearns isn’t the only place to look for these lessons. Europeans can find the same message even closer to home, in the divergent fortunes of Ireland and Iceland. As scholars like Karl Whelan of University College Dublin and Ásgeir Jónsson and Fridrik Baldursson of the University of Iceland have pointed out, Ireland stepped in with a blanket guarantee of its six main banks when Anglo Irish Bank threatened to collapse in September 2008. Iceland, facing an equally dire crisis, split its banks into good banks and bad ones, and permitted bank bondholders to take serious losses. Although Iceland’s medicine was harsh, the costs of the crisis have been and will be far lower in Iceland than in Ireland. The moral is clear: Taking the pain now is far superior to postponing the needed adjustments and stringing out the crisis.
What would a Greek default and restructuring entail? It would mean a vastly greater restructuring of Greek bond debt than the “voluntary” plan that was proposed earlier this year, which asks bondholders to accept new bonds with a longer term and slightly different payout. Under the most generous projections, this plan would only reduce Greek bonds by 21%; under more realistic calculations, the reduction is 4%-5%. To make any real difference, the bonds would need to be written down far more, by as much as 70% or even 80%.
Europe also needs to take seriously the possibility that Greece will need to leave the euro for a time. Although this sounds catastrophic, a restructuring of Greek debt and a return to the devalued drachma could set the stage for the economy to finally start growing again.
There is another dimension to the crisis that pushes toward the same conclusion. One reason that European decision makers have been so reluctant to allow a serious restructuring in Greece is because major French (and to a lesser extent German) banks have large holdings of Greek bonds, and those banks stand to suffer if the bonds are written down.
In effect, Europe is protecting the shareholders of French banks at the expense of a generation of Greek youth who will have little hope of finding meaningful jobs until Greece undergoes a serious restructuring and the economy begins to grow again. By any ordinary standard of fairness, protecting bank investors at the expense of Greek workers is deeply unfair.
The U.S. isn’t setting the best of examples in this regard, of course. By continuing to inject the government into the economy and failing to allow the markets—especially the housing markets—to return to normal, we almost certainly have prolonged our own period of low growth.
The key moment in 2008 was the decision to rescue Bear Stearns. This is the lesson that Germany’s Ms. Merkel and French President Nicolas Sarkozy should bear in mind as they negotiate over the future of Europe in the coming weeks.
Mr. Skeel, a law professor at the University of Pennsylvania, is author of “The New Financial Deal: Understanding Dodd-Frank and its (Unintended) Consequences” (Wiley, 2011).