By Robert Samuelson - October 28, 2011

WASHINGTON -- There's an Orwellian quality to Europe's latest financial rescue. Words lose their ordinary meaning. Greece, for example, has clearly defaulted, but no one says so. In July, private lenders agreed "voluntarily" to accept an estimated 21 percent reduction in their loans to Greece. Now, that's been pushed to 50 percent, and private lenders' consent is still described as "voluntary." Well, it's about as "voluntary as when one hands over one's wallet in response to the choice of 'your money or your life,'" notes Douglas Elliott of the Brookings Institution.

What constitutes a default? Here is Standard & Poor's definition: "We generally define a sovereign default as the failure to meet (the) interest or principal payments ... contained in the original terms of the rated obligation." Not much doubt there: A 50 percent "haircut" wasn't part of the original bonds. But for political and legal reasons, it's inconvenient to declare a default. Instead, the Europeans call the write-down "private-sector involvement," or PSI. How reassuring.

Europe's problem is preventing Greece's fate from befalling any of the other 16 countries using the euro -- most obviously, Ireland, Portugal, Spain and Italy but also Belgium and France. If investors believe that default (or PSI) is unavoidable, they will desert the debts of these countries. A financial implosion could become unavoidable. Markets would dump government bonds, sending their interest rates soaring. European banks -- big investors in government bonds -- would suffer huge losses that might trigger a panic.

Europe's banking system is much larger than America's and gets three-fifths of its funds from the "wholesale" market of big deposits, commercial paper and the like, writes Oliver Sarkozy, head of financial services for the private equity firm the Carlyle Group, in the Financial Times. If these big investors fled en masse, Europe's financial system would collapse. "The parallels to 2008" -- when Lehman Brothers' failure caused a panic -- "are too stark to be ignored," he says. (Sarkozy, an American, is the half-brother of French President Nicolas Sarkozy.)

To prevent this, Europe's leaders adopted a new package of measures. In addition to the 50 percent write-down of Greek debt, the plan would:

-- Expand the existing rescue fund, called the European Financial Stability Facility (EFSF). It would provide insurance against losses of about 20 percent on purchases of European government bonds, presumably those of Spain and Italy. This protection would supposedly reassure investors, who would continue to lend at low interest rates. An estimated $1.4 trillion of bonds might be covered. (The EFSF is already lending directly to Greece, Ireland and Portugal.)

-- Require European banks to increase their "core tier-one capital" -- generally stockholders' equity -- to 9 percent of assets. Greater capital acts as a buffer against losses and is intended to reassure banks' depositors and wholesale investors. According to Brookings' Elliott, the extra capital would total about 100 billion euros (about $140 billion) over the existing capital of 1 trillion euros.

-- Create "special purpose vehicles" (SPVs) that could seek investments from cash-rich countries, such as China, and private investors.

Initial reaction to the package was favorable. Americans stocks soared after the announcement. But details are murky (the bond insurance and the SPVs, for starters), and skeptics abound. "I'm surprised that the markets are so relaxed," says economist Desmond Lachman of the American Enterprise Institute. Two large problems loom.

The first is the specter of default. Greece crosses a line, because many Europeans leaders long maintained that no euro-using country would be permitted to default. Now that this has happened, some investors may sell other weak European bonds and set up the feared chain reaction. The extra bank capital may not provide much protection. Elliott fears the added 100 billion euros is too small to be reassuring.

The second problem is austerity. Like Americans, Europeans face a contradiction: To reduce budget deficits, they need to cut spending and raise taxes; but more taxes and less spending may depress their economies, increasing budget deficits. Higher bank capital ratios pose a similar problem. One way to increase those ratios is to raise capital from private investors or governments. Another way is to cut lending; the size of the existing capital increases in relation to loans. But less lending would hurt the economy. "They're setting themselves up for a credit crunch," says Lachman.

What Europe really needs is a massive, though temporary, global bailout that would give it time to adjust. Lacking that, it's unclear whether the latest package is a genuine solution or just a stopgap.