Greece fails, Europe follows?

Europe’s politicians gather together for a colossal rescue package for Greece. The package is worth €110 billion ($145 billion), this is nearly three times the amount which was discussed only three weeks ago. The results so far: riots in the streets of the capital, where three people lost their lives and no clear response of the markets. Not only have yields on short-term Greek bonds soared once again, but other euro members that the plan was supposed to protect are under pressure, with Portugal and Ireland hit particularly hard. Stock markets around the world have slumped as investors fret about the financial stability of a region that makes up almost a quarter of the world economy.

The fear in Europe for now is the contagion spreading from one indebted country to the next, Europeans also fear the breakdown of social order as public-sector jobs are cut and last but not least they fear the ousting of countries from the euro. Are the legitimate fears? If a bail-out which is worth nearly half of Greek GDP fails to command support on the streets of Athens or in the markets, one will agree it is very normal for Europeans to fear the near future.

Although this all points to a failure of the plan, it is incorrect to say so. Europe faces all sorts of social and political problems and violence and riots in Greece do not suffice to conclude that the Greek rescue and the European’s broader strategy for dealing with their debt crisis have failed. It has to be stated that street riots, even violent ones, are a very frequent part of Greek political life. And financial markets do sometimes react too skeptically to rescue strategies.

As the situation evolves, nothing has thus far been set. But an awful lot depends on what Europe’s leaders do now. The new improved Greek rescue plan has less in common with the Geithner plan than with the first Greek rescue, whose inadequacy started the spiral downwards. There is the same shortage of political courage, not just in Greece and other weak euro-zone members, but also in Germany. These need to be dealt with.

Although this large sum has been gathered, investors are unconvinced by the bail-out strategy for three separate main reasons:

· First, they worry that the promised €110 billion will not materialize because of continued political opposition in Germany or because the Greeks will not live up to the austerity promises they have made.

· Second, investors, like German voters, are nervous that, no matter how hard the Greeks try, their country will still be all but bust in three years’ time: the debts are just too big and will have to be rescheduled.

· Third, and most important, they worry that others, especially Ireland, Portugal and Spain, are in uncomfortably similar boats, facing a future of economic stagnation and spiraling debt.

The main priority today is, I believe, for countries like Portugal, Spain or Ireland to prove that although they suffer from some of the same problems, they are not Greece! Portugal, which has a big deficit and low growth, needs to announce a stronger, bolder fiscal package. Both it and Spain need to speed up competitiveness-enhancing structural reforms, especially freeing up their labour markets. At the same time, the rest of the euro zone must do its part to ensure that this huge internal adjustment succeeds. The ECB must prevent an overall slide into deflation. Germany should cut taxes and do more to boost domestic demand.

Furthermore, it is urgent to put a mechanism in place which could supply the euro-zone’s weaker economies with cash if this panic is accelerated. One way would be for them to apply for precautionary funds from the IMF. Euro-zone governments could create inter-governmental credit lines or the European Central Bank could step in, buying government bonds in the secondary market. None of these solutions are costless but any is preferable to the implosion of the euro zone.