Last week's EU agreement to refinance Greece's debt seems to have calmed markets concerned with the possible default of Greece and subsequent contagion in the eurozone. But EU refinancing was not the only solution on offer: in June, an entirely different solution was hinted at from an unlikely source.

When Chinese Premier Wen Jiabao was on a tour of European capitals last month, he stressed two things at each stop: that a stable eurozone is vital to China and that China is Europe's friend. Indeed, from Beijing's perspective, when it comes to Europe, self-interest and altruism neatly coincide. If China were to buy only half of all outstanding Greek sovereign debt (a bargain at around $220 billion, a fraction of China's dollar assets), it would not only resolve the eurozone crisis and add to Chinese prestige but it would help give Beijing the sort of reserve asset that it needs to diversify its holdings out of dollars. Currently, 70 percent of China's reserves are in dollars, and China does not even make the list of the top 40 holders of Greek debt. But why would China not take such an opportunity?

For one, China probably has as little faith in the EU's ability to solve its debt crisis over the long run as do the rest of the world's financial markets, more bailouts notwithstanding. But another answer is possible -- one that links the 2008 financial crisis and the 2011 European bond market crisis to a possible Chinese end run around the 2007 Foreign Investment and National Security Act. This U.S. law makes it hard for China to diversify out of its $3 trillion-plus holdings of U.S. dollars and buy sensitive U.S. assets such as aerospace, technology, and defense-related companies.

As a result of the unintended consequences of U.S. and European actions in financial markets, there is now the possibility that, even with this latest bailout, China could buy such sensitive assets from Europe, at fire-sale prices.

To see how this could happen, it is necessary to go back to 2008, when a set of globally connected and highly leveraged financial institutions hemorrhaged money on U.S. mortgage-backed securities and uncollateralized insurance policies known as credit default swaps. Fearing the collapse of the global payments system, the large economies in the West bailed out their banks. When the bailouts landed on the public balance sheet, private debt became public debt; across the member states of the Organization for Economic Cooperation and Development, debt-to-GDP ratios ballooned by an average of 40 percent.

Initially, Europe appeared to have escaped the worst of the crisis. But it soon became clear that the shocks emanating from the United States were reaching European shores after all. By the summer of 2009, concern over Germany's exports taking a dive had given way to anxiety over Spain's over-leveraged banks, and especially over Greece's massive public debt.

At this point, the European Central Bank should have bought and held the Greek debt, ending the crisis in one stroke. But such a move was not possible -- the ECB is not actually the lender of last resort for European economies as the Federal Reserve is to the U.S. economy. That honor falls to German and other northern European taxpayers, the funders of the
ECB. Another solution had to be found.

Generally speaking, a country has only four options for getting out of a financial crisis: devalue, inflate, default, or deflate. For any country inside the eurozone, unilateral devaluation and inflation are not possible since individual countries no longer control the printing presses or the exchange rate -- the ECB does. This leaves default and deflation as the only other options.

But if default is toxic for a heavily indebted periphery state such as Greece, it is still tricky for France and Germany; hence the repeated bailouts. Officials in Paris and Berlin like to blame states on Europe's periphery for increasing wages over the past decade when there had not been compensatory gains in productivity, but one must ask where these periphery governments got the money to do so in the first place. The answer is from French and German banks, which were all too eager to buy the periphery countries' euro-denominated debt, flooding them with cheap money that fueled consumption and construction binges.

Given such exposures, if one of these periphery states (Greece, Ireland, or Portugal) were to default on its debt, the crisis would soon spread to the large EU states. Holders of periphery debt would try to stem their losses by dumping good assets in order to cover their bad exposures, as happened in the U.S. market in 2007 and 2008. This would create a financial contagion in the form of a bank run through the bond market, which would end up back on the balance sheets of the biggest core European banks: the banks with all those periphery exposures. This would be a disaster for Europe and would at the very least require expensive bank recapitalizations, which already bloated state budgets can ill afford. Given this risk and the lack of other alternatives, austerity has emerged as Europe's preferred policy to avoid the perils of multiple eurozone defaults.

Austerity is a form of internal deflation through government cuts that reduces wages, prices, and public spending to restore the external financial balance. Such a system of financial adjustment was tried before, from 1870 to around 1914: the gold standard. It, too, was based upon deflating domestic wages and prices in order to bring a national economy into balance with its external financial position, as the eurozone is demanding of its periphery states today.

But such regimes have a fatal flaw: they cannot work in democracies because electorates
have a strong incentive to vote against imposing austerity measures, and instead seek to pass the costs of deflation on to the bondholders.

Bondholders understand this, too. They know that financially squeezed publics are likely to vote against austerity, thereby triggering a default that will devalue their debt holdings. This gives bondholders the incentive to push governments for as much austerity as possible, as quickly as possible, to reduce their eventual losses.

Austerity politics therefore not only pit citizens against the state, creating domestic instability, they also put states on a collision course with their bondholders. Notwithstanding the latest bailout, Greece today can never grow its economy fast enough to pay back what it owes, and new borrowings serve only to add debt to debt. Simply piling on more austerity measures cannot work, since voters are likely to reject such a regime at some point, triggering a default.

Europe's policy choices are thus counterproductive: periphery austerity squeezes growth while adding to indebtedness as the debt-to-GDP ratio increases. This, in turn, leads to downgrades and yield spikes, which Europe responds to with more bailouts, which simply add to the debt incurred.

All this may be bad news for Europe, but how does it involve the United States and China? Here is where unexpected links between the 2008 crisis and the current crisis come to the fore.

Since 2008, with interest rates near zero, U.S. money-market funds have had a hard time making money. Before the crisis, such funds made money by buying asset-backed commercial paper, otherwise known as mortgage debt. Research by Credit Suisse suggests that since that market dried up as a result of the housing crash, these funds have been stocking up on short-term European bank debt instead. After all, in 2009 the euro seemed a safe bet, which is probably why U.S. banks have written new credit default swap contracts on those same European banks, giving them default exposure, as well. And although the net figure for U.S. banks' credit default swap exposure to any one European country is small, if there were a bank run around the European bond market the combined exposure of U.S. banks would be quite significant.

So how does this help China? The United States will not sell China the sensitive assets it wants, and China is stuck holding dollar paper. China will not bail out Europe. The Europeans have created a standoff between voters and bondholders that will still likely end in default and the probable spread of contagion to core European banks. Exposures to periphery debt within Europe are large and have links through money-market funds and credit default swap exposures back to the already fragile U.S. financial sector.

So imagine, for example, that sometime down the line Greece has had enough of taking on loans it can never pay back and decides to take enough money from the IMF and the EU to fund its primary fiscal deficit, stabilizing things to the point that Athens can default and pass the cost to bondholders. Now a bank run begins around the eurozone that explodes debt levels and damages the European economy further. Any flight to quality, in which a euro default would lead to a rise in the dollar as a safe haven, would be offset by money market and credit default swap exposures. U.S. banks would take severe hits. The U.S. and European recessions would deepen.

At that point, Europe would be keen to find any revenue source it could to offset the secondary financial crunch. And with the United States in no position to offer any offsetting finance, as it did in 2008, all the technology, aerospace, and even financial assets that China wanted would be available at a discount -- FINSA or no FINSA -- in Europe.

The EU has laws that restrict the export of dual-use technologies and that have banned weapons exports to China since the 1989 Tiananmen Square crackdown. EU laws, however, are subject to national enforcement -- which can be unpredictable, at best, in times of crisis. Indeed, at China's request, the EU has recently begun to review these export bans. All of which suggests that U.S.-EU cooperation on the question of Chinese asset purchases is far from assured. 

This scenario may seem far-fetched, but it is possible. It also suggests a few things to think about: that the global financial system is more fragile and more interconnected than often understood, that financial fragility may be more of a national security issue than often thought, and that pursuing austerity in a democracy may not be the solution that policymakers think it is.

Regardless of whether China's rise to dominance is distant or close, Western powers have not helped themselves by turning their financial systems into a generator of unintended consequences that may prove to be very bad for the United States and Europe, and very good for China.

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  • MARK BLYTH is Professor of International Political Economy at Brown University. His book, Austerity: The History of a Dangerous Idea, will be published next year.
  • More By Mark Blyth