The global stock markets yo-yoed in early May, first plunging on the news that Greece, the European Union's perennial spendthrift, might default on its debt and trigger a tsunami of other national bankruptcies that could include Portugal, Ireland, Italy and Spain, only to quickly rebound after fast action by the European Union and the International Monetary Fund in the form of a nearly trillion-dollar bailout that reminded many of the Troubled Asset Relief Program that saved U.S. banks.
But even as stock markets enjoyed a comeback and interest rates on Greek bonds staged a rally, some experts, including Jeff Rosensweig, an associate professor of International business and finance at Emory University's Goizueta Business School, sounded a note of caution. In the short term, the EU-IMF coordination probably saved global markets from toppling into an economic abyss, according to Rosensweig, a former senior international economist at the Federal Reserve Bank of Atlanta. But in a Q&A with Knowledge@Emory, he cautioned that the long term will likely present some significant challenges.
Knowledge@Emory: Let's recap recent events. In early May, markets shriveled as Greece appeared to be headed towards default on its massive international debt, even though the Greek government committed itself to an austerity program. The next thing we know, the global economy is teetering. What's happening?
Rosensweig: Unfortunately, the Greek government's reasonable approach to cutting spending was met by massive rioting, which threatened to undermine the ability of the government to effectively respond to the economic crisis. Greece has long spent far beyond its capabilities, but now that everything's interconnected, both within Europe and globally, Greece's problems could spread far beyond its borders. The creation of the European Union and Greece's admittance into the EU was designed in part to get countries like the PIIGS-Portugal, Ireland, Italy, Greece and Spain-to rein in their runaway spending, but unfortunately it didn't work out that way, especially in Greece.
Knowledge@Emory: So why should other countries care what happens to Greece?
Rosensweig: Again, it goes back to the global economy. Part of it is the fact that the finances of so many nations are directly linked by debt, and part of it's that Greece's integration into the EU meant that a default by Greece could threaten the integrity of the euro itself, the common currency of the EU nations.
Knowledge@Emory: So Greece was the catalyst, but the other PIIGS are also worrying the markets?
Rosensweig: That's right. You've effectively got five nations that use the euro that have way too much government debt and are suffering huge deficits. To compensate for the perceived risks, the market has been saddling their debt with high interest rates. But the response of the EU and the IMF, opening the floodgates of monetary policy, appears to be calming the markets by acting as a kind of reserve, or piggy bank for the PIIGS. The hope is that they'll get their acts together and the nearly $1 trillion of aid won't actually have to be disbursed. We've already seen the stock markets jump and interest rates back off in the wake of the bailout.
Knowledge@Emory: But didn't the financial markets give back at least some of their gains by the end of the day?
Rosensweig: That's right, and I think it indicates that the euphoria we've seen will be short lived. Ultimately the markets want to see some positive steps being taken by the free-spending countries in question.
Knowledge@Emory: Do you think the fact that the EU and IMF were able to work together so quickly had a positive effect on the market?
Rosensweig: There's no doubt it did. The EU had previously come under some criticism for its rather tepid response to the bubble of debt surrounding the PIIGS, but when everything threatened to break, the EU and the IMF, or really the world's central banks, responded quickly, which I'm sure gave a boost to investor confidence. That's important, because otherwise everyone would start dumping their securities and that can lead to a severe economic downturn that begins to feed on itself.
Knowledge@Emory: The U.S. stock market also seemed to benefit. What do you think is behind that?
Rosensweig: Remember that the U.S. is a big contributor to the IMF, so the U.S. effectively took a big, though indirect, part in the bailout. When the market responded positively to the moves, some of it was bound to reflect back to the U.S. Of course that means we've got more exposure if things don't work out so well in the longer term.
Knowledge@Emory: What about the inflationary effects of the central banks' response? Doesn't it basically amount to printing up money, which will lead to more inflation over the long run?
Rosensweig: The potential is there, but inflation is preferable to an economic sinkhole. It's similar to what the U.S. is doing domestically, expanding the money supply and increasing government spending. As I noted before, the other option is falling into an economic abyss that could be very difficult to climb out of.
Knowledge@Emory: What could derail the recovery?
Rosensweig: The big worry is self control, especially in Greece. The rioters there just don't seem to get the idea that they'll have to make some sacrifices for long term gains. While they're out overspending, evading taxes and demonstrating, the Germans are saving their money. So this bailout, like TARP, raises the question of moral hazard. If Greece and the other PIIGS think they'll always be rescued at the last minute, it could act as a disincentive to adopt sound monetary and fiscal policies. But sooner or later the Germans and other countries may get tired of sacrificing to bail out these spendthrifts.
Knowledge@Emory: Does that mean that the concepts behind the EU and the euro were mistakes?
Rosensweig: Not exactly, but it does make one wonder if perhaps the EU threw too wide a net when it was established. When you place high-saving, low inflation countries under the same economic umbrella as high-spending, high-inflation nations, there's bound to be some conflicts. It may have been unrealistic to think they could all prosper under a single currency unless there were solid mechanisms to ensure that deficit spending also would be reined in. But again, I believe that the central bankers' reactions were good, and may strengthen the euro and keep its economy growing. It could even auger well for the PIIGS, except possibly for Greece, which has to get its act together.