So has Europe been saved, or is it a reprieve for a replay in the next couple of years.
The AMP’s chief economist, Dr Shane Oliver takes a look.
Late April to early May saw the Greek debt debacle degenerate into a major crisis, with significant contagion to bond markets in other European peripheral countries and a slump in global share markets on worries about a re-run of the global financial crisis.
Fortunately the European authorities appear to have got the message and have provided a strong package of support involving access to funding for troubled European countries and the European Central Bank (ECB) buying public and private securities in the euro area.
So where does this leave us?
Will the European stabilisation package work or is it just a temporary reprieve on the way to GFC Mark II?
Greece and GFC Mark II
The problems in Greece took a turn for the worst in recent weeks following another upwards revision to Greece’s 2009 budget deficit, a downgrade to its sovereign credit rating and more violent strikes in Greece leading to worries that it will end up defaulting.
This resulted in an accelerating contagion to other perceived high risk countries and a flight to public sector bonds in countries thought to be safer such as Germany.
The end result was sharp falls in share markets, commodity prices and growth oriented currencies on worries that capital flows and lending would freeze up on concerns about counterparty risk and that this, plus increased pressure for austerity measures across Europe, would threaten the global economic recovery.
Many began to fret about a second leg of the global financial crisis (GFC Mark II).
Contagion was arguably starting to become irrational and self feeding, particularly when it came to countries like Spain and Portugal which have lower budget deficits and public debt levels than Greece.
If left to run its course, there was a danger that investor fears about high public debt levels could have spread to France, the UK, the US and Japan, which to date have seen their bond yields remain low.
Why GFC Mark II is unlikely
Although the risk of a broader public debt crisis is high, particularly given the now high levels of public debt in many developed countries, the fallout from the Greek crisis is unlikely to be the trigger for anything as severe as what followed Lehman’s failure back in September 2008:
First, the amount of debt involved in southern European countries is small compared to the trillions involved in the US mortgage market, particularly once leverage had been allowed for in relation to the latter.
The exposures are more transparent this time around and the risks are better understood than was the case for many of the financially engineered investments at the centre of the sub-prime crisis.
Second, global monetary policy is very easy today, compared to when the GFC hit.
Third, the global economy is far stronger today than was the case when Lehman Brothers went bust in 2008.
Back then, the world was already entering recession and leading indicators of economic growth were in free fall.
By contrast, today’s global economic indicators point to the commencement of a significant economic upswing.
In other words, the global economy is far less fragile than it was two years ago.
Finally, policy makers now appear to be acting more decisively than occurred in 2008.
The fact that Europe has not let Greece fail (funds will be disbursed by 19 May to Greece) and the European Commission and the ECB have now adopted a massive policy response indicate they are very keen to get on top of the problem and put an end to irrational contagion.
Uncertainty still remains over parts of the package.
The bilateral loans still require parliamentary approval in individual countries, details are lacking about the ECB’s bond purchasing plans and the package does nothing about the longer term solvency problems of Greece and potentially other countries (and nor could it).
However, the size of the package at 720bn euros or $US915bn indicates the European authorities are serious.
The existing package for Greece means it won’t have to tap bond markets for three years and so will have little reason to default in the short term.
Similarly, the availability of the backstop could remove the need for countries such as Spain and Portugal to have to borrow in the market for the next year or so.
If that isn’t enough, the commitment of the ECB to buy public sector debt will serve to keep a lid on bond yields.
In fact the announcement of ECB buying saw 10 year bond yields fall by 467 basis points in Greece, 163 basis points in Portugal and 51 basis points in Spain.
As such the support packages have helped these and other high debt countries buy time to make some progress in cutting their deficits.
More like the Asian crisis of 1997-98 than the GFC
The outworking of all this is that a re-run of the global financial crisis is unlikely.
The more likely scenario is that it will unfold somewhat like the Asian crisis in 1997-98 which saw sharp economic and share market slumps in key Asian countries but global growth continued.
While the Asian crisis contributed to sharp corrections in global shares in October 1997 and July-August 1998 the global bull market continued.
Moreover, just as the Asian crisis in 1997-98 led to easier than otherwise monetary policy globally and helped fuel the tech
