The Greek debt crisis is coming to a head at an awkward moment for the global financial system, coinciding, as it does, with the imminent end of the US Federal Reserve Board’s QE2 program of quantitative easing.

The problem with that coincidence is that it creates two sets of “known unknowns” that generate the kind of uncertainty that breeds investor nervousness and risk-aversion, either of which could trigger something unpleasant.

The QE2 program, which ends this month, was designed to provide support for riskier asset classes and, while there is some dispute about the extent to which it has impacted various markets, the “coincidence” of soaring commodity markets, surprisingly strong equity markets, a spike in oil prices and a rush to investment in emerging market debt suggests that it was successful.

Indeed, as it has become clear that, while not ruling out an extension of the program, the Fed is disinclined to do so, there has been a sell-off and considerable volatile in those markets, presumably because some of the big carry trades that involved borrowing at zero interest rates and shorting the US dollar in order to invest in those riskier assets were being unwound.

What we don’t know, of course, is what is still out there and whether there is potential for a last-minute rush for the exit from what appear to have been quite crowded carry trades (where investors are, whether they realise it or not, effectively pursuing similar strategies).

By itself, apart from a significant increase in volatility and some retreat of those commodity prices most affected by speculative activity — and there has already been significant deflation of what looked like speculative bubbles — an unwinding of the carry trades could probably be managed without creating a new crisis.

That is similar to the predicament the Europeans are having dealing with Greece’s impossible indebtedness. It’s not news that the Greeks have an unsustainable fiscal position and are either going to have to be bailed out again or will be forced to default, although the European authorities are making hard work of coming up with a new rescue package and the Greek government is confronting a revolt from its own people at the prospect of even more severe austerity measures.

Even the prospect of a default ought to have been factored into the market some time ago and, in more normal times, the prospect of its default — while catastrophic for Greece itself in the near term — wouldn’t have been regarded as a threat to global stability.

The worst-case scenario, however, is one of a ripple effect that would be triggered by a default that would see massive sell-offs in the holdings of bonds in other debt-laden economies — initially the obvious, such as Portugal, Ireland, Spain and Italy, but with the potential to develop into the kind of global panic that would spread to the UK, US and Japan.

There has been a lot of discussion that depicts Greece as the new Lehman Brothers, where the collapse of an apparently peripheral player in the global system ignites a general flight to safety and liquidity that spawns, not just a sell-off of risky assets, but anything that has sufficient liquidity to be converted into cash.

That contagion scenario is unlikely but, after the experience of the financial crisis and the extent to which it has left even the major economies and financial systems vulnerable, means it is at least conceivable.

More likely, as they have since the crisis emerged, the Europeans will continue to muddle through, buying time in the hope that time itself will help diminish the severity of the problem and/or enable them to build the capacity to better respond to the problems posed by their weakest member states.

If the ending of QE2 were to increase the tensions and volatility in global financial markets, or pose any discernible threat to the US economy or global markets, one would expect the Fed to (as it did after the ending of QE1 sparked some convulsions) restart the program and again flood the market with free money.

The Americans and the Europeans know, having peered into the abyss during the crisis, how scary the financial crisis was and how close the global financial system came to melting down.

They also know that the major developed economies are carrying the legacies of their responses to that crisis and are in no shape to cope any kind of repeat of 2008. They can’t afford to take the risk of allowing/forcing Greece to default, and will inevitably be closely monitoring global markets for signs of any unintended consequences that might emerge as the QE2 program ends.

*This first appeared at Business Spectator.

Peter Fray

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