How Greek shock waves could hit U.S.

By Matthew Craft

Associated Press

Published: Friday, June 15 2012 7:00 p.m. MDT

The European Central Bank and European Union would have to persuade investors in government bonds that they will keep Portugal, Spain and Italy from following Greece out the door. Otherwise, borrowing costs for those countries would shoot higher.

The main way European leaders have tried to calm bond markets is by lending to weaker governments from two bailout funds. Experts say these two funds, designed as a financial firewall to stop the crisis from spreading, need more firepower.

Much of the $310 billion left in one of them, the European Financial Stability Facility, was pledged by the same countries that may wind up needing it, Vamvakidis says.

There's also a (euro) 500 billion European Stability Mechanism that's supposed to be up and running next month, but Germany has yet to sign off on it.

"If they fail to reassure bond investors, all of the nightmare scenarios come into play," says Robert Shapiro, a former U.S. undersecretary of commerce in the Clinton administration.

The biggest danger is a fast-spreading crisis known in financial circles as contagion — a term borrowed from medicine and familiar to anyone who has watched a disaster movie about killer viruses on the loose.

"It's like a disease that spreads on contact," says Mark Blythe, professor of international political economy at Brown University.

The bond market, where banks, traders and governments cross paths, provides the setting. If Greece dropped the euro, traders would become more suspicious of Spain, Portugal and Italy and sell those countries' government bonds, pushing their prices down and driving their interest rates up.

Higher borrowing costs squeeze those countries' budgets and push them deeper into debt. Plunging bond prices also would imperil Europe's troubled banks. The banks are big holders of government bonds, which they bought when the bonds were considered safe.

At this point, the risk would be high for a run on banks throughout Europe. People would worry that the banks might fail and would rush to withdraw what they could. Analysts and investors say that's the biggest fear.

People in Spain, for example, have already seen what's happened in Greece and have started pulling euros out of their accounts in fear the country will switch back to cheaper pesetas.

"People see their banks in trouble," Shapiro says.

In less frantic times, the government would come to the rescue with cash or take over the banks. Individual European countries insure bank deposits, so if one bank fails people can still get their money out. But all this is happening in the middle of a government debt crisis, and if the crisis gets worse, the Spanish or Italian government couldn't raise enough money in the bond markets to save the day.

"They can't afford to guarantee deposits or money market balances," Shapiro says. "They don't have the ability to borrow internationally from bond markets. Where are they going to get the funds?"

From here, the crisis could get much worse: Banks could fail, the surviving banks could stop lending to each other, and a credit freeze could shut down commerce in Europe as assuredly as a blizzard did last winter.

One way to stem the contagion would be to create so-called eurobonds — bonds backed by all 17 countries that use the euro. They could be sold to raise money to buy the bonds of troubled European governments. With the backing of 17 countries, including mighty Germany, eurobonds would have a yield far lower than the bonds of countries like Spain and Italy.

Germany, which has the strongest economy of the euro countries, has slowly warmed to the idea but wants weak governments to fix their finances first. "Germany's strength is not infinite," Chancellor Angela Merkel said Thursday.

Cash-strapped European governments should be able to turn to the International Monetary Fund for help, but the IMF's money comes from 188 member countries. Peter Tchir, who runs the TF Market Advisors hedge fund, says the United States and other countries may balk if the IMF asks for help supporting Europe.

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