Coming to a city near you?

What has happened in Athens does not have to spread. But the euro zone still faces tough decisions.

IF THERE was ever a week to be depressed about the euro, this was it. After an age of dithering, Europe’s politicians cobble together a colossal rescue package for Greece, worth some €110 billion ($145 billion), nearly three times the level discussed only three weeks ago—and behold the results: carnage on the streets of Athens, where three people lost their lives, and no respite in the markets. Not only have yields on short-term Greek bonds soared once again, but other euro members that the plan was supposed to wall off are under pressure, with Portugal and Ireland hit particularly hard. Stockmarkets around the world have slumped as investors fret about the financial stability of a region that makes up almost a quarter of the world economy.

Many Europeans fear that they have seen a fragment of their future: contagion spreading from one indebted country to the next, the breakdown of social order as public-sector jobs are cut, years of political indecision and the inevitable ousting (or withdrawal) of countries from the euro. And why not? If a bail-out worth nearly half of Greek GDP fails to command support on the streets of Athens or in the markets, it is tempting to say that the game is up.

Tempting but wrong. Europe faces all sorts of social and political problems, which may or may not manifest themselves, but its current dilemma is rooted in basic economics. From this perspective, neither violence nor jitters in financial markets are proof that the Greek rescue and the Europeans’ broader strategy for dealing with their debt crisis have failed. Lamentably, street riots, even violent ones, are an all-too-frequent part of Greek political life. And financial markets do sometimes react too sceptically to rescue strategies. In February 2009 they slumped when Tim Geithner, America’s treasury secretary, announced a plan to stress-test banks, fearing his proposals were inadequate for dealing with the banks’ problems. With hindsight, the decision proved a psychological turning-point.

Three reasons to run for the hills

So nothing is set. But an awful lot depends on what Europe’s leaders do now. The new improved Greek rescue has less in common with the Geithner plan than with the first Greek rescue, whose inadequacy started the spiral downwards. There is the same shortage of political courage, not just in Greece and other weak euro-zone members, but also in Germany. And there is the same attempt to paper over contradictions. These need to be dealt with.

Despite its massive price tag, investors are unconvinced by the bail-out strategy for three separate (and hardly irrational) reasons. First, they fret that the promised €110 billion will not materialise because of continued political opposition in Germany or because the Greeks will not live up to the austerity promises they have made. Second, investors, like German voters, are nervous that, no matter how hard the Greeks try, their country will still be all but bust in three years’ time: the debts are just too big and will have to be rescheduled. Third, and most important, they worry that others, especially Ireland, Portugal and Spain, are in uncomfortably similar boats, facing a future of economic stagnation and spiralling debt.

The first worry is exaggerated—at least in the short term. There seems little doubt that Europe’s governments will cough up. Even in Germany, parliamentary approval of the rescue package now seems likely. Equally, the Greek government has more chance of passing its wage- and pension-cuts than the street protests might suggest (see article). It has a strong parliamentary majority and surprisingly high poll ratings.

But if you look beyond the next few weeks, the fear that something will go wrong later is all too realistic. The list of reforms that the Greeks have signed up to is brutal: the tax cuts and spending measures are worth some 11% of GDP in three years, and structural reforms, such as freeing up a rigid labour market and busting cartels, may prove even less popular. If sceptical Germans want an excuse to pull the plug on Greece’s rescue, they will surely find it. And the numbers for Greece are grim: even if one assumes three years of austerity, the country’s debt burden will have risen to 140% of GDP. Greece will still be perilously close to insolvency. It will surely need more help—either an open-ended rollover of the official loans or some kind of debt rescheduling.

This is the contradiction in the rescue plan. EU governments and the IMF refuse to discuss the possibility of an eventual rescheduling of Greek debt for fear that it would spark uncontrolled contagion. In fact, the logic may increasingly be the opposite. By refusing to admit that Greece faces an obvious solvency problem, whereas Spain, Portugal and Ireland do not, Europe’s policymakers have made it harder to draw a clear distinction between Greece and the rest. As a result contagion has intensified (see article).

Change this—and you change everything

That is the dynamic that must be changed. One priority is more zealous action by Portugal, Spain and others to prove that, although they suffer from some of the same ailments, they are not Greece. Portugal, which has a big deficit and low growth, needs to announce a stronger, bolder fiscal package. Both it and Spain need to speed up competitiveness-enhancing structural reforms, especially freeing up their labour markets. At the same time, the rest of the euro zone must do its part to ensure that this huge internal adjustment succeeds. The ECB must prevent an overall slide into deflation. Germany should cut taxes and do more to boost domestic demand.

Still more urgent, arguably, is a mechanism for supplying the zone’s weaker economies with cash if panic accelerates. One route would be for them to apply for precautionary funds from the IMF. Euro-zone governments could create inter-governmental credit lines. Or the European Central Bank could step in, buying government bonds in the secondary market. None of these solutions is exactly costless. But any is preferable to the implosion of the euro zone. The nightmare vision of Athens being repeated around the continent should not happen; but averting it will require more bravery and honesty than Europe’s leaders have shown so far.