NEW YORK – After 14 summit meetings, stock market turmoil and even a fistfight between Italian lawmakers, European leaders have finally agreed on a rescue package that will stop the debt crisis there from dragging the world into recession.
That’s the hope, at least.
A bailout fund for the continent will be beefed up, and banks will take a 50 percent loss on their holdings of Greek government bonds. The banks will also put more money aside to cushion the blow from future losses.
Investors are cheering. The Dow Jones industrial average surged almost 340 points Thursday, the euro rose, and even the stocks of battered European banks gained ground.
But dangers lurk. The bank losses and the new cushion might not prove enough. The plan could exact big pain in the short term, hobbling a weak European economy. The region could still fall into recession, and drag the U.S. economy down with it.
Here are some questions and answers about what happened and what it means.
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Q: What was the original problem?
A: The Greek government spent too much, didn’t collect enough in taxes and had to sell bonds to make up the difference. It ran up budget deficits well beyond limits set by the European Union, a group of 27 nations that allow goods and workers to cross their borders freely.
When Greece fell into recession two years ago, bondholders worried they wouldn’t get their money back. To make sure they did, the EU started lending money to Greece, essentially allowing it to use new debt to pay off old debt.
Greece shares a currency, the euro, with 16 countries, so its problems are Italy’s problems, and Spain’s, and Germany’s, too. And many other European countries have debt problems of their own.
The challenge was to figure out a way to fix the problem so Greece didn’t have to come back for bailout after bailout.
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Q: Is the risk from Europe gone?
A: No. Even if the rescue package keeps Greece and the European banks afloat, the crisis has already damaged the European economy. Some manufacturers have slashed production and hoarded cash. Banks are demanding higher rates for loans, if they’re lending at all.
On Monday, an important economic indicator suggested business activity in the zone of nations that use the euro currency shrank in October for the first time in three years.
The European Union accounts for 20 percent of world’s economic output. It is a big trading partner for many countries. A recession there could push other economies into recession.
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Q: How vulnerable is the U.S.?
Some good news out Thursday suggests the U.S. is in better shape to weather any blow. The economy grew almost twice as fast over the summer as it did in the spring. But it’s still dangerously weak.
Federal Reserve Chairman Ben Bernanke told Congress earlier this month that the economic recovery was “close to faltering.” And the co-founder of the Economic Cycle Research Institute, a forecasting firm that predicted the last three downturns, said a recession was all but inevitable. Consumer confidence is the lowest in two and a half years.
“It almost looks like the world is worrying itself into another recession,” Klaus Kleinfeld, the CEO of Alcoa, said Oct. 11.
One danger from Europe is that it could buy fewer U.S. goods. Europe buys 20 percent of U.S. exports.
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Q: Will the bailout plan be enough to keep the debt crisis from spreading?
A: Maybe. There are a lot of unknowns.
Because the banks are accepting losses on Greek bonds, Greece won’t owe as much as it did before. That helps. But it still has too much debt and needs its economy to grow if it hopes to pay it back.
The new plan sees Greek debt falling to 120 percent of the country’s economic output by 2020 — a level believed to be sufficient to ease investors’ fears. Its debt had been expected to grow to 180 percent. But it’s uncertain whether Greece can dig itself out of recession amid riots, strikes and despair.
Problems lurk at the European banks, too. The plan calls for banks to raise 106 billion euros, or about $150 billion, as a cushion against future losses. But that might not be enough to protect against losses on holdings of Greek, Italian and other countries’ bonds. Before the summit meeting, the International Monetary Fund estimated banks needed 200 billion euros more to protect themselves.
What’s more, even that lower cushion might do a lot of harm. It could force banks to cut back on lending even more, hurting companies and slowing economic growth.
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Q: What about U.S. banks?
Unlike their European counterparts, U.S. banks do not hold a lot of European government bonds. But they may be exposed in other ways.
U.S. banks and other financial institutions have sold investors a type of insurance policy known as credit default swaps. They require the banks to pay billions of dollars if Greece and other indebted European countries default, or stop paying back their debt.
Even though Greece won’t have to pay the face value on its bonds, European leaders structured the deal so that the banks wouldn’t have to pay the credit default swaps. Because Greek bonds holders agreed to the plan, Greece isn’t technically in default.
Good news, right? Sebastian Mallaby, a director at the Council on Foreign Relations, fears that some European banks taking losses on Greek bonds were also investors in credit default swaps — meaning they lose both ways.
The upshot: In a complex and interconnected financial system, it’s difficult to know whether savings for one financial institution will actually trigger deep losses elsewhere. That uncertainty tends to spread fear and freeze lending.
“The chances of contagion are not awful,” Mallaby says. “It’s the unknown dangers. And fear itself can spook markets.”
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Q: If there are so many questions, why did U.S. stocks jump?
Actually, they’ve been moving up for a while. Stocks have risen in five of the last six trading days through Thursday, and are up 14 percent this month.
Credit a bit of good timing. Anxiety over this latest summit was rising just as U.S. companies were reporting surprisingly good third quarter profits. They are expected to be up 14 percent for companies in the Standard & Poor’s 500, the eighth quarter in a row of at least 10 percent gains. Record profits are expected for the full year.
Despite the rising prices, many financial analysts note that stocks have been trading as if Europe were about to explode or the U.S. about to slip into recession — or both. On Thursday, stocks were trading at 12 times the annual per-share profits. They typically trade at 15, meaning prices should be higher.
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Q: Will fear continue to recede from the stock market?
It depends partly on the U.S. economy. Many analysts and economists think the recovery will eventually pick up speed. But if Europe does push the U.S. into recession, you can forget about those impressive corporate profits, and surging stock prices.
Before the last recession, companies in the S&P 500 stock index were reporting record profits, too. Within a year, those profits turned into losses. Stocks eventually lost half their value.
