Europe

Is this Europe’s Lehman Brothers moment?

Jan. 11, 2015: French President Francois Hollande welcomes German Chancellor Angela Merkel, left, as she arrives at the Elysee Palace, Paris.

Jan. 11, 2015: French President Francois Hollande welcomes German Chancellor Angela Merkel, left, as she arrives at the Elysee Palace, Paris.  (AP Photo/Thibault Camus)

In September 2008, United States policymakers made the costliest of policy miscalculations by allowing the Lehman investment bank to go bankrupt. That mistake triggered the worst global economic recession in the post-war period.

Judging by recent statements by German and French political leaders, it appears that it is now the European policymakers’ turn to make a major economic policy blunder. Since, ahead of the January 25 Greek parliamentary elections, those leaders are clearly signaling that they stand ready to cut Greece loose from the Euro should Greece choose not to comply with its European commitments.

Fast forward to 2015 and it seems that European policymakers have forgotten the Lehman lesson about financial market contagion.

The key lesson from the Lehman crisis was that allowing a major bankruptcy could have unfortunate unintended consequences.  

Fast forward to 2015 and it seems that European policymakers have forgotten the Lehman lesson about financial market contagion.

As U.S. policymakers were to find out almost immediately after the event, the Lehman bankruptcy caused large knock-on effects to the rest of the US and global financial systems, which were highly exposed to Lehman through opaque financial derivative instruments. The global financial turmoil that followed contributed importantly to the onset of the Great Economic Recession of 2008-2009.

Fast forward to 2015 and it seems that European policymakers have forgotten the Lehman lesson about financial market contagion. For those policymakers appear to have convinced themselves that the costs of cutting Greece loose now would be very much more manageable than it would have been three years ago.  

In their conviction of this view, they are clearly signaling to the Greek electorate that Greece should not count on Europe to continue bailing it out should Greece choose not to play by Europe’s rules of the game concerning budget austerity and structural economic reform.

They are also signaling that far from necessarily being a bad thing, a Greek exit might have a salutary effect on the rest of the Eurozone. Indeed, it might send a strong message to countries like Italy, Spain, and Portugal as to the costs of not playing by the European rules of the game when they see the Greek financial system imploding on Greece’s Euro exit.

On the surface, European policymakers have several good reasons for their optimism. Among these is the fact that following its debt restructuring in 2012, Greece no longer has a large amount of privately owned government debt and as such its Euro exit would no longer constitute a direct threat to the European banking system. 

Further, unlike in 2012 an economic recovery, albeit weak, is underway in the rest of the Eurozone’s periphery and Europe now has in place the financial safety net mechanisms to support the rest of the periphery in the event of financial market contagion from a Greek exit.

Sadly, it is all too likely that, as was the case when U.S. policymakers allowed Lehman to go bankrupt, European policymakers are now underestimating the all too real risks of a Greek exit.

Among the most important of these risks is that a Greek exit would send the clearest of messages to the Eurozone public that Euro membership was no longer irrevocable. More importantly, it would  send the message to Eurozone bank depositors that they could no longer count on the European Central Bank (ECB) to always be there to act as a lender of last resort to their banks. That realization could provoke a run on the banks in countries like Italy, Portugal ,and Ireland where public and private debt levels are now at very much higher levels than they were in 2012 and where these countries now find themselves caught in deflationary traps.

Another miscalculation that European policymakers might be making relates to the strength of the financial safety nets that they have put in place. To be sure, the Eurozone now does have a well funded European Stability Mechanism and an ECB that is committed to buying as many bonds as needed to keep member countries’ interest rates at a reasonable level. However, these mechanisms can only be activated should the countries being supported commit themselves to IMF-style economic adjustment programs. Considering the anti-austerity political backlash now characterizing these countries, it is far from clear that they would agree to submit themselves to the tender mercies of the IMF.

In light of the global economy’s unfortunate experience with the Lehman bankruptcy, one has to hope that European policymakers are only posturing with their threats to Greece ahead of its elections. Since, if they are not, both the European and the global economies could be severely tested should Greece indeed be forced out of the Euro following those elections.

Desmond Lachman is a resident fellow at the American Enterprise Institute. He was formerly a Deputy Director in the International Monetary Fund's Policy Development and Review Department and the chief emerging market economic strategist at Salomon Smith Barney.