George Papandreou, Greece's prime minister, listens during a news… (Jock Fistick, Bloomberg )
Europe's new bailout plan for its weakest economies finally recognizes the brutal reality of the developed world's financial woes: Many governments simply can't pay what they owe — or will reach that point soon.
The rescue plan announced Thursday by the European Union extends another $157 billion in loans to Greece to help it cover its debts, but also asks private Greek bondholders to take a haircut on their securities.
Imagine if you owned a U.S. Treasury note maturing in five years and the government asked you to turn it in for a lower-yielding security that would mature in 30 years.
That's the gist of what European leaders want Greek bondholders to do, to help the country dig out from nearly $500 billion in debt.
Ever since the extent of Greece's financial mess became evident in late 2009, many analysts have warned that the only sure way out was some level of debt forgiveness. In one of the formulas the EU has proposed for Greece's creditors, the equivalent of a $1,000 bond would become a new bond worth $800.
Debt forgiveness is default by any other name, of course. The bailout plan for Greece ought to at least remind small investors who continue to pour money into bonds that the idea of "safety" in debt securities is a relative term.
Meanwhile, the millions of U.S. homeowners who are underwater on their mortgages may look wistfully at debt forgiveness for Greece and wonder why it can't happen for them.
But America just isn't in the mood for more bailouts. By contrast, Europe collectively decided it couldn't afford not to try another rescue plan, given that its government debt crisis was spreading from Greece, Ireland and Portugal to the far larger and more important economies of Spain and Italy.
By pushing market yields on the countries' bonds sharply higher in recent months, investors were making it difficult if not impossible for governments to roll over outstanding debt in the private market. That threatened to cause a financial crisis so virulent it could torch the European economy.
So the EU's richer states, led by Germany and France, have decided to foot the bill for what they hope will be the last backstop needed to calm markets and restore investor confidence in holding debt of the weaker states.
You might well ask, though, how Greece's default on its bonds will make investors more confident about buying Irish, Portuguese, Spanish or Italian bonds if there's a chance that those countries ultimately will need debt forgiveness too.
Carl Lantz, head of interest rate strategy at Credit Suisse Securities in New York, doubts that Europe's debt crisis has been permanently doused by the EU's new plan.
"We see it as a 'Bear Stearns' moment for them, but not their 'Lehman' moment," he said, referring to the collapse of U.S. brokerage Bear Stearns in March 2008, which foreshadowed Lehman Bros.' demise — and the global financial crisis — six months later.
One critical issue, Lantz said, is how the latest bailout will play with the citizenry of the richer states, especially Germany.
"For this to work Germany is going to have to absorb a lot of the burden," Lantz said. "This will raise the cost of borrowing for Germany and lower it for everyone else."
A key element of the bailout program is a deep cut in interest rates on outstanding EU long-term loans to Ireland and Portugal, to about 3.5%.
And by throwing more money at Greece, Ireland and Portugal, Europe faces the risk that it will come up short if Spain and Italy need significant help with their own debt burdens.
"One euro spent on Greece is one less to go to Spain or Italy," Lantz said.
European financial markets ended mixed Friday as investors reacted to the bailout plan. In an encouraging sign, bond yields tumbled in Greece, Ireland and Portugal.
The annualized market yield on two-year Greek bonds plunged to 27.6%, down from 33.8% on Thursday and its lowest level since July 5. Two-year Irish bond yields slid to 15.1% from 19.1% on Thursday.
Still, those interest rates would be prohibitively expensive for the countries to pay if they sought to borrow in the market.
Investors were warier of pushing bond yields lower in Spain and Italy, the countries with the most to lose if the debt crisis were to worsen again. Two-year Spanish bond yields rose to 3.87% from 3.77% on Thursday, though they have fallen from 4.56% on Monday.
If Europe has stabilized for the moment, the next major obstacle for global markets is the showdown in Washington over the federal debt ceiling and a deficit-cutting plan.
President Obama and House Speaker John A. Boehner (R-Ohio) announced Friday that they "couldn't connect," in Boehner's words, on a grand plan to slash trillions of dollars in spending over the next decade.