European Bailout Plan Follows Violence in Greece and Malfunctioning U.S. Stock Market

This past weekend, while most of us were off celebrating Mother's Day, European ministers and economic policymakers were laboring in Brussels to cobble together a scheme to alleviate the current euro financial crisis. As the declines in stock markets elsewhere attested Thursday and Friday, the government debt debacle in Greece was on its way to inflicting harm quite far away from the Mediterranean Sea. The policymakers met late Sunday night and on into Monday morning in an effort to get an agreement before markets opened in Asia. The announcements came around 9:00PM Sunday night Eastern time, which was 3:00AM Monday in Brussels and 11:00AM in Tokyo. World stock markets indeed surged on the news, with Tokyo up 1.6%, Germany up 5.3% and London up 5.2%; markets in France, Italy and Belgium were even stronger. In the late New York morning as we write, the Dow Jones has gained just over 4%.

Violence in the Streets of Athens . . .
This drama came about in the wake of several disturbing events. The rioting in Greece we talked about here last week continued and on Wednesday a bank was firebombed and three people killed. We've heard about people committing suicide over financial reverses and turmoil, and that's sad enough. But we have to say, in a decades-long career, we've never heard of such mass violence directed at government financial policies. Yes, the people are angry that their wages and pensions will be cut. But government isn't seizing their property and kidnapping their families or constraining their civil rights, or even censoring the press. At the same time, German voters yesterday showed their displeasure at having to help the Greeks by voting out some members of parliament from the majority party and eliminating that majority in the upper house of parliament. Tough stuff.

. . . Prompts Formation of Huge Bailout Program
The plan calls for almost $1 trillion in potential bailout funds to be contributed by all the members of the European Union. To distinguish, the Euro Zone (sometimes called the Euro Area) is the group of 16 countries that use the euro as their currency. Additionally, 11 other countries are banded together with them in a customs union, or free trade zone; the broader group of 27 then is called the European Union, or EU. The rescue money is meant to be available for any member country running into debt financing strains or other major financial tangles.

Greece Is Just Part of the Problem
Finances indeed got tangled on several fronts at the end of last week. Stock markets everywhere had reacted to the Greek budget deficit problem and the expectation that other governments, especially Spain and Portugal, might face the same situation. The trading glitch that caused U.S. stocks to plummet Thursday afternoon upset everyone (more on this below). The oil spill in the Gulf of Mexico is making people tense about risks, as are repeated interruptions in air travel in Europe due to volcanic ash in the atmosphere. Also, last week, less visible but more fundamental, liquidity showed further strains in European bond markets. In their nervousness, investors who had U.S. dollars didn't want to lend them to others, so interest rates on short-term dollar loans headed markedly higher. This is problematic because such short-term transactions may be needed to pay for imports, to cover some payrolls, to complete some other financial interchanges in the highly interconnected global financial network. It was getting perilously close to the market freeze conditions of autumn 2008.

Thus, besides the large weekend EU bailout arrangement, the U.S. Federal Reserve arranged a dollar-lending facility with its counterpart central banks in Europe, the U.K., Canada, Switzerland and Japan. It announced this renewed program at 9:15 Sunday night, about the same time the main EU bailout facility was being announced. The Fed will lend dollars to these official banks, who can, in turn, lend them on to banks in their countries. This is meant to increase the supply of dollars in world markets and help pull related interest rates back down. This same "swap facility" was used from December 2007 through this past January; at its peak in December 2008, it provided $580 billion to foreign banks.

Budgets Still Have To Be Cut
Clearly, these two huge programs of the EU and the Fed only address symptoms. They are meant to "buy time" for fundamental issues to be dealt with. The Greek Parliament actually did at least some of what it is supposed to do last Thursday in enacting legislation that will cut government spending and raise taxes. But the Greek people need time to calm down. And other Parliaments need to take similar kinds of budgetary actions. The U.K., with its own government presently in a blur after last Thursday's inconclusive election results, will also need to buckle down when the new leaders get into place and get its own budget situation rationalized. Nobody gets a free ride.

U.S. Stock Market Goes Bungee Jumping
Then, there's that awful U.S. stock market trading glitch. On Thursday, the Dow Jones Average was already down about 500 points at mid-afternoon, when a sudden downdraft pushed it off another 500. The charts of that look like a bungee jump. Fortunately, the bounce of the bungee did take place, and almost as fast as the downward plunge. What is this? There is extensive electronic trading and in some transactions no human input is involved. Surely no human intervention caused Accenture's shares, as one example, to fall from $40 to 18 cents in minutes. One electronic trading company did announce that they had stopped trading on the downside since they felt their "algorithm" would exacerbate the drop, but others argue that the removal of that automated response system may have made it worse by removing liquidity – there's that word again – from the whole system, causing it all to fall even more.

These mathematical trading routines, or algorithms, activate when prices cross thresholds determined by analytical formulas. Not all trading is conducted this way, indeed, perhaps only a fraction. Generally, it is very efficient, helping to smooth the timing of trades, particularly when investors are shifting a large holding. But as we saw the other day, things can go wrong and they can get very wrong in a hurry. There can be two types of problems. The formulas might be based in statistical probabilities, and it's possible that prices and trading volumes can move outside the usual probability range. We can measure the margin for error, but when a result comes there, sometimes the best we can do is say, "Oh, that's an outlier." We may not be able to react to the outlier before the trading formula pushes prices on a trajectory outside the carefully demarcated region. Secondly, these algorithms work as long as the players are "us" versus "the rest of the market". Then our action can be counterbalanced with a re-action. But when "the rest of the market" is using a similar tool, then we're all on taking the same kinds of action at the same time and it all goes one way – as it did Thursday.

Stock exchange officials were to meet this morning at the Securities and Exchange Commission in Washington to assess more carefully what might have happened. We hope they have better answers than we do. Automatic trading stoppages, called circuit breakers, have been used in the past to interrupt undesirable patterns, and perhaps strengthening those for today's bigger, faster market systems can help.

Better News, Though, on the Jobs Front
Fortunately, in the middle of all this turmoil, there was good news on U.S. economic fundamentals with the April jobs report showing sizable and widespread employment growth. Banks and other financial institutions are also in much better shape than they were in the 2008 crisis period. So perhaps we won't have a major setback to recovery. But these recent events serve as serious warnings that all of us need to stay cautious in buying, selling, investing and especially borrowing.