U.S. shuttle diplomacy seeks to pull Europe back from brink

…She told Greek parties running in fresh elections on June 17 that Greece faces no choice but to make the difficult economic reforms laid out in its EU/IMF bailout package, or its financing will be cut off…

By Stella Dawson

WASHINGTON | Thu May 31, 2012 11:27pm EDT

(Reuters) - The Obama administration is engaged in a fresh round of shuttle diplomacy to nudge European Union leaders into decisive action to prevent Europe's widening crisis from undermining the U.S. and global recoveries.

Officials in Washington believe the U.S. banking system is in sound enough shape, but they know from the collapse of Lehman Brothers in 2008 and the Asia crisis a decade earlier that financial crises have a nasty habit of delivering massive shocks they cannot anticipate and that ricochet worldwide.

The message to EU politicians from U.S. Treasury and International Monetary Fund officials hopscotching among European capitals and holding meetings in Washington is two-fold: recapitalize your financial system quickly to stabilize banks, and then lay out a clear plan for the political future of monetary union.

The officials fear that a messy Greek exit from the euro zone or a bank run in Spain or Italy could unleash unknown consequences, weakening an already tepid U.S. recovery just months before Obama faces a tight U.S. presidential election.

U.S. officials are tight lipped on specifics of their advice to Europe. But international financial officials and experts in Washington who are in regular contact with the IMF and the U.S. Treasury said there is a sense here that time is running out for Europe.

"They're saying - Whatever you do, fix it, and this time fix it right," said one financial industry official.

This urgency was echoed in Brussels on Thursday when Europe's highest ranking finance officials, European Central Bank President Mario Draghi and European Commissioner for Economic and Monetary Affairs Olli Rehn, issued blunt warnings that EU politicians must act boldly, or risk collapse of monetary union.

Spain too is pulling no punches. "It's about the future of the euro," Deputy Prime Minister Soraya Saenz de Santamaria told Reuters in an interview on Wednesday.

Spain has become the new focal point of the euro zone debt crisis. Its banks face 184 billion euros in losses and Madrid has botched attempts to shore them up while it struggles to rein in its budget deficit. Markets have taken fright, pushing yields on Spanish government debt ever closer to 7 percent, the level that forced Greece, Ireland and Portugal into EU/IMF bailouts.

Saenz was making the rounds in Washington on Thursday. IMF Managing Director Christine Lagarde sent assurances that there were no plans afoot or any Spanish request for IMF financial support. Rather the focus of Saenz's talks appear to be on how to persuade Brussels to inject capital directly into its banks, an issue she said she had discussed with U.S. Treasury Secretary Timothy Geithner.

For months, U.S. officials have been telling their European counterparts that recapitalizing banks directly with federal money was an effective strategy it used to stabilize the U.S. banking system in the 2007-2009 financial crisis. The IMF in April called for direct EU capital injections.

Germany has balked at the EU shouldering any more liabilities, aware that as Europe's largest economy, it would foot the bill. But the alternative that U.S. and IMF officials paint, deep recession and monetary collapse, could persuade them otherwise.

CLOCK TICKS

Time is clearly running short.

Money has rushed out of stocks globally and into the safety of U.S. Treasuries, pushing yields this week to historic lows, and the euro currency has tumbled over 7 percent against the dollar in the past month in a flight to safety.

Investors have lost confidence that EU leaders can muster the political will to fix two fatal flaws in monetary union - no centralized banking authority to prevent a bank run and no central fiscal authority to backstop banks or countries.

Without these powers, the message coming from Washington is that a single market and a single currency will remain vulnerable, and that no amount of fiscal austerity, the preferred medicine from Germany, can save monetary union.

"The day of reckoning is arriving," said one Washington insider with deep experience in international finance.

After the G8 summit in Camp David two weeks ago, U.S. President Barack Obama hailed a broad consensus among European leaders around a four-pronged strategy for resolving the European debt crisis.

In perhaps the clearest path laid out publicly to date, he said Europe must recapitalize its banks; adopt a growth strategy to reinvigorate their economies; provide monetary support to help countries like Spain, Italy and Greece implement tough austerity measures; and continue with fiscal discipline.

Since EU leaders returned home, however, there has been little visible progress. A high-profile dinner in Brussels last week to discuss the path forward delivered no tangible results. Meanwhile the banking crisis in Spain has escalated.

No wonder markets have turned volatile, said Hung Tran, deputy managing director of the Institute of International Finance, the lobby for major banks which negotiated the EU/Greek debt restructuring.

"What is needed now is for leaders to agree on basics steps. They need to use the European Stability Mechanism (its new bailout fund) to recapitalize the Spanish banks. If that happens, it could calm market conditions," Tran said.

Obama held a conference call on Wednesday with Germany, France and Italy to follow up on the G8 talks. And U.S. Treasury Under Secretary for International Affairs Lael Brainard is visiting Athens, Frankfurt, Madrid, Berlin and Paris this week in a pre-planned trip to offer U.S. advice on the crisis.

"We are there largely because this is a very active, live debate and people who are navigating their way through an extraordinarily complex range of challenges want us there," Brainard told Reuters in an interview this month.

In Athens, her message was stern. She told Greek parties running in fresh elections on June 17 that Greece faces no choice but to make the difficult economic reforms laid out in its EU/IMF bailout package, or its financing will be cut off, according to political and financial sources in Athens and Washington.

If Greece runs out of money, it would be forced to quit the euro, unleashing huge market uncertainties.

Such a deep crisis might prove the catalyst for Europe to make big political changes needed to save monetary union, Washington insiders say. However, the shockwave would be substantial, and something the White House, Treasury and Federal Reserve would rather avoid.

In a foretaste of what could come, JP Morgan estimated on Thursday that since March alone, Europe's problems have spooked investors to the extent that stocks have fallen six percent, wiping out $1 trillion in U.S. household wealth. This loss of buying power, plus a stronger U.S. dollar, which hurts exports, has shaved roughly half a percentage point from U.S. GDP growth this year, it said.

"If the euro zone continues to unravel, not only will it have serious consequences for the euro zone, but it will have serious and even severe consequences for the entire global economy, including the United States," former Treasury Secretary Robert Rubin told the Council on Foreign Relations this week.

(Additional reporting by Lesley Wroughton, Jason Lange and Rachel Younglai; editing by David Brunnstrom)