In a crisis, worst-case scenarios can be dangerous because they distract the public and policymakers from the mundane task of wrestling with immediate problems. However low the probability, if the European sovereign debt crisis rapidly cascades from bad to worse, the United States could be called upon for help in another massive bailout.
If efforts to stem the current bleeding in Europe fail; if Portugal, then Spain, and perhaps others need outside assistance, existing European bailout funds may be stretched too thin. Europe may be forced to look for more help from the International Monetary Fund (and by extension the U.S. Treasury), the U.S. Federal Reserve and China. How Washington reacts could have grave foreign policy and economic consequences.
In May, the 16 countries that use the euro established the European Financial Stability Facility, which amassed roughly $579 billion in pledges that can be used in conjunction with $79 billion backed by the EU budget and $329 billion from the International Monetary Fund, creating a $1 trillion pot of money available for lending to beleaguered European states.
The question now is whether this financial safety net will be sufficient. Both the Greek rescue package late last year and the recent Irish bailout cost more than first advertised. Some initial estimates put Dublin’s needs at $100 billion. Its final price tag was $112 billion.
And Europe’s costs may continue to grow. The repayment schedule for Greece’s $145 billion loan may be extended, effectively raising the cost to lenders.
Assumptions about future demands could be too optimistic or too pessimistic. But Nomura, the Japanese investment bank, estimates that bailouts of Portugal and Spain could total more than $660 billion, leaving no cushion for other contingencies.
“You can never use your last dollar, or euro … Markets would immediately come to the conclusion that there was no money left,” warned Kenneth Courtis, founding partner of Themes Investment Management. “Markets would then riot.”
“The more countries need access to it, the less capital is available, because every time a country is a recipient of funds, it drops out of the pool that contributes to the loan guarantees.”
The adequacy of the European safety net to deal even with Spain assumes that the European Financial Stability Facility could lend up to or near its limit and still maintain its triple-A bond rating. In reality, it would likely lose that rating and the ability to lend at reasonable rates before it ran out of funds.
Pledges backing Europe’s current pot of bailout money come from some governments, such as Spain and Italy, that could soon become borrowers themselves, effectively depleting available resources. “There is an imbedded contradiction in the way the EFSF has been structured,” said one international financial official.
because every time a country is a recipient of funds, it drops out of the pool
that contributes to the loan guarantees.”
“The more countries need access to it, the less capital is available, because every time a country is a recipient of funds, it drops out of the pool that contributes to the loan guarantees.”
It could get worse. “If Spain and Italy have to be bailed out,” said Courtis, “immediately France and Germany would be on the firing line. They do not have the type of resources required to bail out Spain and Italy without themselves getting into very, very serious financial trouble.” In the face of such demands, Europe’s bailout fund could prove woefully inadequate.
European economists are now speculating about ways to give their financial authorities more ammunition. Klaus Zimmerman, president of the German Institute for Economic Research in Berlin, has suggested doubling available resources to $2 trillion. Axel Weber, the German member of the European Central Bank’s Governing Council, has said that if available funds prove insufficient, “I am convinced euro zone states will do what is necessary to protect the euro.”
Angela Merkel, the German chancellor, disagrees. "I see no need at this time to increase the fund,” she said last week at a news conference in Berlin. The operative words may be “at this time.” European leaders meet in Brussels later this week, and the issue of adding to Europe’s bailout war chest will be high on their agenda.
About a quarter of the Irish bailout came from the IMF. It can be counted on to meet at least that portion of future European borrowing needs. But it may be called on to take on more of the burden if European resources run low. The Fund soon will have about $750 billion for such lending, including funds that member countries are required to make available, commitments to a recently expanded New Arrangements to Borrow (NAB), and commitments from individual cash-rich governments to supply the IMF with money in a pinch.
Still, Edwin M. “Ted” Truman, a senior fellow at the Peterson Institute for International Economics in Washington, has speculated that any demands on the IMF, beyond Spain, “would come close to the capacity of the institution” and “the IMF will need more money sooner rather than later.” (The Peterson Institute is funded by Peter G. Peterson, who also funds The Fiscal Times.)
Will Congress Balk?
Whenever the IMF lends money, as it has to Greece and Ireland, the U.S. bears the risk for about one-sixth of that obligation, reflecting its 16.7 percent share in the institution. Congressional critics, wary of American check-writing for foreigners, could try to limit IMF involvement and thus American taxpayer exposure to future European bailouts. At the time of the Greek crisis late last year, some Republican senators wanted the U.S. to vote against IMF participation in the Greek bailout, which would have stymied IMF involvement. As the largest shareholder in the IMF, Washington holds a veto over the institution’s actions.
Cooler heads prevailed and the Senators backed off. But next year there will be a larger, more conservative GOP voting bloc in the Senate and a Republican majority in the House, with a substantial Tea Party element that is highly skeptical of foreign commitments.
If there is demand for greater IMF participation in a mushrooming European bailout, a new move to block any such commitment may be inevitable. Even if the effort fails, as would be likely, the mere prospect that the IMF might not be available to supplement a Spanish or Italian bailout could cause turmoil in financial markets and substantial economic damage. Such cavalier American behavior would raise profound questions about the ability of the world to depend upon a deeply divided Washington in a time of crisis.
A European cash shortfall might also lead to greater involvement of the U.S. Federal Reserve. In the past, the Fed has provided the European Central Bank and various national central banks with dollars they can then lend to their beleaguered banks in return for collateral. The Fed could expand these efforts or come up with other ways to help Europe shore up its financial system. But recent objections to the Fed’s quantitative easing program, which involves the purchase of Treasury securities, suggests it may be criticized for dangerously expanding its balance sheet.
China Could Be the Big Winner
If Washington isn’t careful, China could end up the big winner from a European financial crisis. Beijing has $2.7 trillion in foreign exchange reserves, by far the largest pool of available resources to throw at this problem. And it has expressed a willingness to use them in Europe.
“China has already bought and is holding Greek bonds and will keep a positive stance in participating and buying bonds that Greece will issue,” promised Chinese Premier Wen Jiabao, when he visited Greece in October. China’s president, Hu Jintao, vowed during a trip to Portugal in November: “We are ready to take concrete measures to help Portugal overcome the global financial crisis.” In addition, the IMF has a bilateral borrowing deal with China that would enable it to turn to Beijing for funds if the IMF runs short.
As any borrower soon learns, however, loans come with strings attached. Beijing is already pulling them. European diplomats say that during recent European Union deliberations over possible anti-dumping and anti-subsidy trade cases against China, some EU members frankly admitted they cannot support such actions because they are looking to Beijing for money.
Postwar Europe has demonstrated that when faced with enormous challenges and disastrous consequences for failing to act, it can do enough to survive. With the fate of the euro and the unity of Europe possibly at stake, history suggests Europe will rise to the occasion.
But it is incumbent on Washington to begin to think about the consequences of Europe’s inability to act, and the challenges ahead if the U.S. needs to get more deeply involved in bailing out its transatlantic partner.
Bruce Stokes is a Senior Fellow at the German Marshall Fund
