What Are They Not Telling Us About the Euro Debt Crisis?

The European Union is scrambling to put together a second bailout for Greece, which would follow the bailout granted last year that everyone now admits isn't enough. See http://www.cnbc.com/id/43219315. The insufficiency of last year's bailout isn't exactly a surprise, since financial markets Cassandras were predicting its failure almost as soon as it was announced. But the celerity of Bailout, Part Deux is notable. Even though objecting conservative political groups in northern Europe have grown more vociferous, there seems little hesitation on the part of Europe's mainstream leaders to gather planes, trains and buses to take more bailout money to Greece. A second, and speedier than the first, bailout only heightens the hazardous morality of the situation. For all practical purposes, every Euro bloc nation is assuming responsibility for all the sovereign and bank debt of all other Euro bloc nations.

What gives? People don't cover the debts of other people they can't control without powerful reasons. Even if Europe's banks have stupidly overextended loans to Greece--and Ireland, Portugal, Spain, Italy and all the other troubled Euro bloc nations--one wonders why they can't take appropriate haircuts on that debt, recapitalize the dumb banks, and move on. The U.S. just largely did that with its banking system to get past the mortgage market morass. While the process was painful and very costly, and left us with high unemployment, the financial system survived. Exactly what is it about Europe's sovereign debt crisis that is so scary?

It may depend on what we don't know. Importantly, the derivatives markets continue to be opaque. Unknown are the size and concentration of credit default swap and currency derivatives exposures that might be affected by a Greek default (which we assume would trigger falling values for Ireland's, Portugal's, Spain's and perhaps Italy's and Belgium's debt). Because derivatives contracts can be traded on a highly leveraged basis, the costs of a Greek default could be multiplied many times over by speculative enthusiasm in the derivatives markets. And because there are no organized exchanges or clearing houses for most derivatives contracts, it's very difficult to find out whether this multiplicity of risk, if it exists, is appropriately dispersed or disastrously concentrated a la AIG, circa 2008.

Even though many European politicians are making noise about soft defaults and other largely symbolic concessions by creditors, the European Central Bank has very firmly stated it will not accept any bailout that involves a restructuring of Greek (or other dodgy) debt. The ECB's resolute refusal to agree to any restructuring whatsoever is another twist in the entrails that indicates something, like a snake pit of derivatives exposures, is mucking up the situation.

We learned from the 2007-08 financial crisis that what we don't know could hurt us. One would hope that financial regulators and other government officials have moved up the learning curve. Perhaps they have. Perhaps they're keeping mum to avoid triggering a run on their banks. It seems that a deep fog has settled over the European financial system, and the costs and ramifications of the Euro sovereign debt crisis might end up gradually emerging, dank and fetid, like a monster from a swamp, except this might be a real swamp and it could be a real monster.