If Only Greece Were AIG

Here comes Financial Crisis 2.0. Like its predecessor, it was caused by the banks.

The first crisis was the result of banks inventing toxic financial products and then promoting bets on different kinds of securities with borrowed money. When the speculative bubble popped, tens of trillions of dollars in financial and housing assets vanished. At that point, governments and central banks stepped in and rescued the banks. The only thing that suffered was the rest of the economy.

On all policy fronts, banks called the shots. The supposed cure for the large public deficits caused by the financial crisis and resulting recession was belt tightening--for everyone but the banks. Yet voters were oddly passive because the issues seemed technical, elected leaders sided with bankers, and citizens were not quite sure whom to blame.

Now, the worm is turning. Austerity itself is creating a second crisis, and this time it has some political bite.

The epicenter of the new crisis is Greece, which epitomizes the folly of banker rule.

Greece has large public deficits, partly caused by bad accounting and tax evasion, but mostly by the recession itself. It's obvious that Greece cannot afford to pay its current debts, so money markets expect a default. As speculative global markets decide Greece's fate, the cost of Greek government borrowing has been pushed up to nearly 30 percent.

The world's finance ministries and central banks, which sprang into action when AIG or Citibank needed help, are not rescuing Greece. After all, Greece is only a country with suffering citizens. AIG is a corporation! Citi is a bank!

Instead, the European authorities and the International Monetary Fund have pressed the Greeks to pursue more and more painful austerity policies as a condition for any relief. But austerity doesn't work: As belt tightening pushes Greece deeper and deeper into depression, markets lose even more confidence in its capacity to pay its debts.

There is an easy solution, one similar to the restructuring of Latin American and other third world debts nearly two decades ago: Trade Greek short-term debt for longer-term debt. In addition, give Greece some debt relief at the expense of its bondholders, who are mainly the European Central Bank (ECB) and various commercial banks. When Latin American debt was restructured, bondholders lost about 30 cents on the dollar, but Latin countries were freed to resume growth.

This solution has been off the table because of the political power of creditors. The European Central Bank in particular has acted as the agent of Greece's creditors, and without ECB support, no restructuring of Greek debt is possible. Even the German finance ministry--not exactly a hotbed of profligacy--has been pressing for bondholders to share in the losses so that restructuring can go forward. But their effort has been stymied by the bankers.

This impasse is made worse by the prevalence of one of the toxic products that caused Crisis 1.0, credit default swaps (CDS), which are thinly capitalized insurance policies against a default. There is huge resistance from financiers to a Greek restructuring, not just because bondholders would lose money, but because it would also trigger payments required by CDS contracts, causing other speculators to take a bath.

Now, however, citizens are finally waking up and pushing back. The Greek government, led by a very talented and competent Socialist, George Papandreou, has been unable to get his own caucus to approve the latest austerity budget. Financial markets are beginning to grasp that either a default or a restructuring is inevitable, which means that bankers will have to take some losses.

And though Greece is the epicenter, popular backlash against banker rule and austerity policies is growing across Europe. Reporting for The New York Times from Athens, correspondent Rachel Donadio writes: "Across Europe, people are complaining that they are unfairly paying the price for the mistakes of their governments while they are growing increasingly resentful of the international banks and the preferential treatment they seem to receive. And they are getting louder."

There is still time to for the world's leaders to reverse course before the latest fruit of banker rule turns into another full-fledged financial panic. When the casualties were banks, the Fed and the European Central Banks didn't dither; they raced to help them, partly because banks had so much political clout, partly for fear of broader spillovers.

Now it is dawning on officials at these institutions that letting a small country collapse can have a similar effect--imagine that.

The world's central banks and governments need to fashion a restructuring plan for Greece--and fast. They need to create some backup support for the financial system to stem any panic. More broadly, the world's policy makers need to reverse their embrace of the austerity cure for the fallout from the last financial collapse.

As always, such reversals only come via a rekindling of popular politics. It took three agonizing years, but popular consciousness about who caused the crisis and who is needlessly prolonging it is finally coming back to life.