Hesitation by leaders drove cost of Europe’s crisis higher

The U.S. government and the International Monetary Fund warned European officials as early as February that escalating financial problems on their continent had to be addressed quickly to forestall a larger threat to the world economy, but those urgings were discounted, according to participants in the private discussions.

By the time European officials acted several months later — prompted by a near-meltdown in Greece and gathering chaos in other countries — the price tag for stemming the financial contagion had soared.

After the meltdown of the U.S. housing market showed how one country’s financial problems can spill across borders, the IMF and leaders of the world’s top economies have spoken of a heightened sensitivity to “systemic risk” and a greater focus on preventing it.

But the upheaval in Europe, sparked by the threat of a Greek default, underscored a paradox in how economic powers confront evolving crises. Political systems and their leaders often prove hesitant to take dramatic action on the sort of partial evidence available when a threat is emerging, avoiding decisions on controversial and expensive measures until there is no choice. But once the markets have delivered a full verdict, the crisis is in full swing and stopping it becomes harder and more expensive.

Despite mounting market evidence, warnings from the IMF and what U.S. officials described as “alarm bells” being sounded by the U.S. Treasury, European leaders this winter continued to take a minimalist approach and conclude that Greece could solve its own problems. It was only after world bond markets had all but abandoned the country, interest rates had begun rising in other European nations, and banks had become hesitant to lend each other money — a phenomenon reminiscent of the 2008 global credit meltdown — that European officials acted in earnest.

Over the intervening months, the cost of helping Greece avoid default increased about fourfold, to $140 billion from roughly $35 billion at the start of the year. Confidence in the European economy was so badly battered that European leaders together with the IMF had to pledge another nearly $1 trillion to reassure investors. The world’s nascent economic recovery was put into jeopardy.

“If we had been able to address it right from the start, say in February, I think we would have been able to prevent it from snowballing the way that it did,” French Finance Minister Christine Lagarde said in an interview.

Her conclusion was shared in hindsight by many of the key figures involved in the Greek crisis, according to interviews with more than a dozen direct participants in the discussions.

Some senior European economic officials acknowledged that the Americans had pushed for an aggressive response but said they weren’t the only ones. Other European officials said no one, including the United States and the IMF, fully understood the gravity of the situation until late April nor pushed intensely to address it.

Although the measures finally taken by European leaders in May helped stabilize markets, the experience raises questions about one of the basic principles now shaping debate over the world economy in the wake of the global finance crisis that spiked in 2008 — namely that with the right information and tools, political and financial leaders can minimize systemwide risks and forestall problems before they become too serious.

Much as Federal Reserve Chairman Ben S. Bernanke insisted for months in 2007 that U.S. financial problems would remain mainly limited to the subprime mortgage market, key Greek and European financial leaders maintained that Greece would be able to borrow the money it needed on the open market, restructure its economy and not pose any larger threat.

And just as Congress initially balked at a proposed bailout for U.S. banks, Europe’s political leadership assumed it could tame markets with mere statements of support for Greece, and would not commit public money until the need was certain — a delay that allowed the financial decay to reach crisis levels.

In the U.S. and European cases, evidence about the scope and potential spread of the problem were on the table, but the leaders involved were reluctant to act.

“What the IMF said from the beginning is that you need a much more comprehensive program,” said a top IMF official familiar with the discussions. “The economics of it got worse and worse because market sentiment was essentially in a free fall. What could be seen as a small, manageable problem six months ago transformed into a huge, oversized problem.”

He said leaders were initially daunted by the cost of shoring up the European financial system, though the sum was a great bargain compared with the ultimate price.

From the trading floors of London investment houses to the halls of the U.S. Treasury and the executive suites of the IMF, observers outside Europe began looking for — and in some cases urging — a decisive step as early as November.

That’s when Greek-born interest rate strategist Ioannis Sokos noted on his flat-screen displays at BNP Paribas how Greek banks had begun vacuuming up low-interest loans from the European Central Bank and suspected the firms were trying to stockpile funds before investors cut them off. He interpreted this as a sign of desperation.

“There was too much borrowing going on,” he said, “and it was then — in November — that we had the first real indication of the depth of the problem.”

The markets rendered a more public judgment in December. The new Greek prime minister, George Papandreou, laid out plans to cut the country’s budget deficit and reinvigorate its economy, but international bond-rating agencies were unimpressed. They downgraded the country’s credit standing, the start of a rout that pushed Greece’s borrowing costs to levels more familiar to credit card customers than sovereign nations.

Papandreou’s proposals were “unlikely, on their own, to lead to a sustainable reduction” in Greece’s debt, Standard and Poor’s wrote.

At that point, top officials in the White House and at the IMF were still in accord with Europe that Greece had a chance to fix its own problems. If the country needed help, the cost was considered large but manageable — $30 billion to $35 billion.

The level of concern began to surge in January, as the first evidence of financial contagion surfaced outside Greece in Spain and Portugal, reflected in the higher borrowing costs they were facing.

IMF officials foresaw the need for a larger and more sustained effort to help Greece than envisioned at the time by many Europeans.

By early February, U.S. officials were growing deeply worried, according to a senior administration official, and Treasury Secretary Timothy F. Geithner and others began “engaging and engaging frequently” with European leaders for a broader and faster response.

He was in close contact with his German and French counterparts. Treasury officials were particularly exasperated with the apparent inability of the 16 eurozone countries, which share a common currency, to muster an emergency rescue for one of their own.

At a gathering of top world finance ministers in Iqaluit, Northwest Territories, in early February, Geithner pressed the issue with an increasing sense of urgency, even as his European counterparts insisted they were in control.

European leaders “will make sure it is managed,” Lagarde said as she left the meeting. Asked how he felt about Greece’s situation, European Central Bank President Jean-Claude Trichet, summed up the feeling on the European side: “confident.”