A16

F

or the past year, I’ve been warning that the

imbalances underlying the

financial crisis — the explosive growth of credit, the mispricing of risk, the mispricing of real estate and other assets, the overcapacity in the global economy — were so huge that a quick and easy economic recovery was highly unlikely. And for much of that time, it has looked as though I was dead wrong. Stocks rebounded, credit markets revived, corporate profits returned and bank balance sheets have been repaired. But the nagging suspicion is that too much of this rebound is the result of the massive fiscal and monetary stimulus that not only did its job of reversing what was a dangerous downward spiral, but also made it possible for many countries to delay dealing with those fundamental economic imbalances. No better proof exists than the

financial drama now unfolding in Western Europe, where for many years countries from Ireland to

S

KLMNO

Greece used the financial cover offered by a new continental currency to overspend, overborrow and overexpand. In the case of Greece, the

government took on so much debt during the bubble years that there is almost no way out of its predicament. If Athens manages to make good on its promises to cut spending and turn a nation of tax cheats into taxpayers, there’s a good chance it will trigger a vicious deflationary spiral — falling prices, falling employment and falling government revenue — that will make it impossible to repay debts. Or Greece could renege on its promises and find itself shut off from further borrowing. Either path leads to some sort of default. The story is somewhat

Greece and the myth of the easy economic fix

STEVEN PEARLSTEIN

different in other countries, albeit with similar consequences. In Spain and Ireland, the problem is not so much government debt but rather all the private debt used to fuel massive real estate bubbles. Now that those bubbles have burst, the

Vulnerability of Spain, Portugal spreads fear across the eurozone

markets from A1

prove its $40 billion portion of the package for Greece. The deal also requires the approval of the 15 European countries in addition to Greece that use the euro as their common currency. But the austerity measures re- quired by the rescue package — including slashing public pen- sions and raising taxes — sparked protests Tuesday on the streets of Athens. Angry teachers went on strike and Communist Party pro- testers broke through the gates of the Acropolis and hung “Peoples of Europe Rise Up” banners on the ancient monument, according to news media reports. More pro- tests are expected Wednesday. The strikes underscore the hur- dles Greece’s Socialist administra- tion faces as it tries to sell the deal to a public that is used to govern- ment largess. “The Greeks are not exactly em-

bracing the bailout and saying thank you to everyone,” said Ed Yardeni, chief investment strat- egist for Yardeni Research. “It is hard to rescue a country that doesn’t want to be rescued.” Yields on bonds issued by Greece climbed Tuesday, suggest- ing that investors were afraid the rescue package is not big enough and that the country could de- fault on its debt. Win Thin, senior currency

strategist for Brown Brothers Harriman & Co., said that per- haps more important, the market upheaval exposes “the fatal flaws” in the eurozone experiment. The eurozone is a currency union of

Dow Jones industrial average

Intraday trading over five days

10,800 10,900 11,000 11,100 11,200 11,300

April 28 (9:30 a.m.): 11,019.3

DIMITAR DILKOFF/AGENCE FRANCE-PRESSE/GETTY IMAGES

Measures required of Greece by the $145 billion rescue package — including slashing pensions and raising taxes — sparked protests.

28

Tuesday’s close: 10,926.77 29

30

April

Dollar per euro

1.2 1.3 1.4 1.5 $1.6

Daily dollar per euro over past year

Nov. 25, 2009: $1.5134

Tuesday:

$1.2987

3

May

4

April 20, 2009: $1.2921

A M J J A S O N D

2009

SOURCE: Bloomberg News THE WASHINGTON POST

European countries that have a common central bank but inde- pendent budget policies. “Each country is running dif-

ferent fiscal policies, and there’s a lack of overall framework to help a country in trouble,” Thin said. “The Europeans blew this one. It’s become more than a Greece story.” As doubts about the health of

J F M A

2010

Europe spiked, the euro came un- der pressure, falling to its lowest point against the dollar in a year. The drop makes it more difficult for American exports to compete with European products. There is a mounting fear among analysts and investors that if the European Union can- not put together a workable pack- age for a small country like Greece, it would prove even more difficult, should the crisis spill over, to make ambitious changes to government tax and spending policies in nations like Spain with larger economies. Spain’s government debt has al- ready been downgraded, as has Portugal’s. Thin expects many more downgrades for Spain, as do other analysts, adding to growing speculation that Spain may needs its own bailout. The jitters prompted Spanish

Prime Minister José Luis Rodrí- guez Zapatero to speak out at a news conference in Brussels, where he dismissed the rumors as “complete madness.” Yet European stocks were bat-

tered. In Spain, the Ibex 35 Index tumbled 5.4 percent and Euro-

next Lisbon, the stock exchange of Lisbon, Portugal, fell 6 percent. The interest rates that both coun- tries must pay to borrow money rose Tuesday. U.S. stocks also followed. The

Dow, which tracks 30 blue-chip stocks, fell 2 percent, or 225.06 points, to close at 10,926.77. The S&P 500, a broader measure of U.S. stocks, recorded its second- worst sell-off this year, falling 2.4 percent, or 28.66 points, to 1173.60. The tech-heavy Nasdaq composite index took the biggest hit, tumbling 3 percent, or 74.49, to 2424.25. A closely watched measure of stock volatility, the Chicago Board Options Exchange’s volatility in- dex, which measures how much investors expect stocks to swing and is commonly known as the “fear index,” soared more than 18 percent. “This is not an investment landscape without speed bumps,” Greenhaus said. “For the next couple of quarters, I imagine this kind of choppy environment will be the order of the day.”

elboghdadyd@washpost.com merler@washpost.com

banks that lent that money are facing such huge losses that they have had to be bailed out by the government (in the case of Ireland) or may soon have to be (in the case of Spain). And the ensuing recession has now cut so deeply into tax revenue that even the heretofore fiscally responsible governments of these two countries are now finding it difficult and expensive to borrow new money or refinance existing debt when it comes due. Compounding the problem is

that much of this troubled debt, both public and private, is now in the hands of Europe’s biggest banks, many of which were already too thinly capitalized and weakened by losses from soured U.S. investments. For European

leaders, the decision to finally come through with a $145 billion rescue package for Greece represented a calculated decision that it was less painful, financially and politically, to rescue a profligate neighbor than to rescue their own bankers. Indeed, the problem with European leaders’ response to this crisis has been that their exaggerated concerns about appearances have led them to reject useful strategies. It was out of concern for appearances that the European Union initially rejected the idea of allowing the International Monetary Fund to offer an early rescue package for Greece, only to finally relent when the run on Greek bonds turned into a rout. It was out of concern for appearances that the European Central Bank announced sternly several weeks back that it would not allow European banks to borrow by using downgraded Greek bonds as collateral, and that it would never use its balance sheet to monetize Greek debt. This week, however, the ECB began

accepting Greece’s bonds, now junk, as collateral while hinting that it is open to buying even more on the secondary market. It is now with the same misguided determination that some European officials have tried to shut down any discussion of a restructuring of Greece’s debt, or that of any other eurozone country, on the theory that a default for one would be a default for them all. In fact, markets are fully capable of distinguishing between the finances of different countries that may use the same currency, just as they can distinguish the bonds of the state of California from those of Utah. And although any country that defaults will surely face the prospect of being shut out of credit markets for years, that punishment is no different than what wasmeted out in the past to countries such as Greece and Italy,when they were free to escape financial predicaments by repaying their debts in devalued currency.

With the Greek credit crisis

WEDNESDAY, MAY 5, 2010

quickly turning into a eurozone- wide liquidity crisis, European leaders would be well advised to forget about appearances and come up with an acceptable mechanism for the orderly restructuring of sovereign debt. For just as “too big to fail” has proven a lousy strategy for banks, it is just as lousy when applied to countries, in both cases encouraging incaution on the part of lenders and profligacy and risk-taking on the part of borrowers. While a debt restructuring would be painful for Greece and its European bankers, it would surely be less painful than a decade of austerity-induced recession. And while a Greek default would probably lead to higher borrowing costs for some eurozone neighbors, that’s precisely the sort of post-bubble repricing of risk that is necessary to restore confidence in global markets, rebalance the global economy and provide the foundation necessary for sustainable long-term growth.

pearlsteins@washpost.com

Some lawmakers also shorted stocks

Private speculative

investments highlight potential conflicts

by Robert O’Harrow Jr. and Dan Keating

As Congress criticized Wall

Street for the proliferation of risky derivatives investments and short-selling practices in re- cent years, some lawmakers pri- vately made highly speculative investments in derivatives funds that sometimes aimed to profit from a decline in the overall per- formance of the stock market or Treasury bonds, congressional fi- nancial disclosure forms show. The investments underscore the potential conflicts on Capitol Hill between public policy and personal investments that have accompanied a sharp rise in stock market investing by law- makers during the last two dec- ades. The investments also illus- trate the wide latitude lawmak- ers provide themselves under their ethics code to make in- vestments that might be dis- couraged under stricter rules they have mandated for officials in other parts of the federal gov- ernment. The potential conflicts created

by risky congressional investing have become more compelling this spring, as Congress pushes to overhaul financial regulations that would curb the use of de- rivatives and speculation by the nation’s largest investment banks, while creating more transparency of derivatives con- tracts. In 2008, for instance, 17 law-

makers reported investing hun- dreds of thousands of dollars in highly volatile short-selling funds — known as “leveraged shorts” — that are aimed at gen- erating $2 in profit for every $1 in decline of a stock index or Treasury bill. Such funds, which rely on derivatives contracts, came under scrutiny by officials at the Securities and Exchange Commission and other federal regulators, who worry that the funds are being marketed to cas- ual investors when they’re in- tended to be used by profession- als and institutions. Sen. Johnny Isakson (R-Ga.) is among those who have disclosed such investments. He has spoken out against naked short selling. In October 2008, as the financial meltdown was underway, Isak- son had between $30,000 and $100,000 invested in a short- selling fund linked to the decline in Treasury bills, called Pro- Shares UltraShort. The Wall Street Journal re-

ported on those holdings yester- day in a story about 13 law- makers who had short-selling in- vestments. Both the Journal and The Post relied on disclosure documents assembled by the Center for Responsive Politics. Isakson said the investment was made for him by a broker at SmithBarney. He said it was a hedge and part of a larger strat- egy, not a “naked short” sale of the sort he and others have tried to curb. “I have a managed ac- count,” he said.

Earlier in 2008, Sen. Thad

Cochran (R-Miss.) bought up to $180,000 worth of short invest- ments through ProShares funds keyed to the decline of the Dow and S&P 500 indices, documents show. Cochran spokesman Chris Gallegos said the lawmaker also did not control his investments. “All his investments are handled by outside professionals,” he said.

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Rep. Shelley Berkley (D-Nev.) also reported investments in 2008 of several thousand dollars in a variety of leveraged short- selling funds keyed to the decline of the S&P 500-stock index and the prices of oil and gas, among other things. Her spokesman, David Cherry, said the invest- ments were her husband’s and had been managed by a profes- sional adviser. “Neither one of them directs what trades are made by the broker,” Cherry said. “He’s given carte blanche to do whatever he wants.” Cherry took issue with having his boss singled out when many lawmakers invest. He said one of the couple’s accounts that in- cluded those investments had shed a quarter of its value since 2007. “Where is the smoking gun?” he said. “Where is the ‘there’ there?” Tristan Yates, a financial ana- lyst and author of an investment book called “Enhanced Indexing Strategies,” said that bearish in- vestments that profit from the decline of the markets or econo- my have a place, but not in Con- gress, where lawmakers are ex- pected to boost the common- weal. “There’s responsibility that

lawmakers have to prevent prob- lems from occurring,” Yates said. “If you have a lawmaker that’s not only identifying those prob- lems but appearing to trade on them, that’s not right.”

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