Walker's World: So much for Davos

What a difference a week makes. Had the latest downgrades by Fitch or the leak of the latest German plan to impose discipline on the Greek economy come as the Davos elite were gathering, the mood in the Alps would have been much colder. The tone for Davos was set by some temporary and probably mistaken signs of good news: The U.S. economy seemed to be recovering and consumer confidence was rising. China seemed to be avoiding a hard landing. The eurozone remained in crisis but the worst fears of a credit crunch had been eased by the extraordinary surge of $500 billion in low-cost lending by the European Central Bank. Even Spain and Italy seemed to be able to sell their latest bonds at less than punitive yields. As a result, the Davos consensus was relatively upbeat, assuming that the world (if not Europe) would avoid a double-dip recession and that even the Germans were coming to realize that the single-minded pursuit of austerity would have to be balanced by some commitment to restoring growth. But had Davos opened this week, the mood would have been different. First, the latest Fitch downgrades make it clear that Greece isn't the only urgent problem. Portugal and Ireland are also in desperate straits. The yield on Portugal's 10-year bonds hit a record 15 percent last week and 3-year bonds hit 21 percent. Fitch also downgraded Spain and Italy, saying that they faced "a marked deterioration in the economic outlook" and that the eurozone countries had yet to build a credible firewall to protect them. Second, the German plan for a takeover the Greek economy by European overlords was only leaked Friday evening. It called for veto rights over the elected Greek government's plans for taxes and budgets along with an insistence that debt repayment become the first charge on all tax revenues. Naturally, the politicians in Athens denounced the plan, although the threat (as Berlin intended) doubtless concentrated their minds. Third, the latest U.S. statistics are seriously worrying. The headline figure of 2.8 percent gross domestic product growth in the fourth quarter of last year looks good on the surface but no less than 1.9 percent was contributed by growth in inventories, which means growth in this quarter is likely to be low. A lot of that inventory went unsold during the unimpressive pre-Christmas retail season. Fourth, that firewall for the eurozone that Fitch said wasn't yet in evidence is now looking to be even bigger than thought, if it can be built at all. At Davos, IMF officials were saying of the record that it would need to be around $2.6 trillion, which is more than the GDP of France. Half of that should come from beefing up the existing eurozone facilities (to which Germany is deeply opposed) with another $660 billion from EU countries and another 500 billion from the International Monetary Fund. "The higher the firewall, the less it would have to be used because of the deterrent effect," French Finance Minister Francois Baroin told the Davos grandees. Unfortunately, the German government thinks there is no point in building a firewall unless and until the eurozone weaklings take their medicine and reform their labor markets and their welfare and pension systems. Indeed, the more there is the promise of a firewall, the less the Greeks and Italians will deliver the structural reforms Germany demands. "No firewall will work unless the real underlying problems are solved," said German Finance Minister Wolfgang Schaeuble. He is, of course, right but there is little point in trying to rebuild a house when it is already on fire. The eurozone crisis is fast running out of time. Even as one problem is tackled, like Greece, other problems (like Portugal) suddenly swell into the danger zone. The German government is turning an immediate crisis into a chicken-and-egg question of which comes first, rescue or reform. This isn't a luxury Europe can afford, with Greece flirting with a move that would trigger "a credit event." This would allow lenders to demand repayment under their credit default swaps, which would throw the European and U.S. financial systems into an immediate liquidity crisis. Even if the Greek drama subsides, we are all about to become very familiar with the problem of Portugal. The highly regarded Kiel Institute for the World Economy announced last week that Portugal had become the new Greece. Its debt had become unsustainable. Even if Portugal could manage and sustain 2 percent real GDP growth, it would have to run annual budget surpluses of 11 percent of GDP to keep its overall debt from exploding. This, as the Kiel report author David Bencek noted, was simply impossible. So Portugal, too, would need the Greek solution of a 50 percent write-down on the debt. This would likely drive Spanish banks into bankruptcy. Moreover, the one man who could claim to be the hero of Davos, the new ECB Gov. Mario Draghi, ended the Davos proceedings on a downbeat note. His provision of $646 billion of cheap loans to banks last month had, as he said, "avoided a major, major credit crunch." But Draghi went on to say that it may have helped the banks but it didn't save the day since in parts of the eurozone "credit is seriously contracting." Would his loans eventually seep through into the wider economy? "We don't have any evidence of that yet. We have to wait," Draghi replied. If he had said that a few days earlier, the message from Davos would have been doom and gloom, as indeed it was from "Dr. Doom" himself, New York University Professor Nouriel Roubini, who warned that the crisis could grind on for the rest of this decade.