06/17/2011 12:25 pm ET | Updated Aug 17, 2011

As Fears of Greek Default Ease, Markets Rally

Fear of a Greek government default, which gripped international markets earlier this week, started to ease Friday as European leaders gained more time to grapple with the Greek debt crisis.

German prime minister Angela Merkel and French prime minister Nicolas Sarkozy -- the duo leading the European Union -- announced after a two-hour negotiation that Germany would soften its position to private investors. Rather than force them to bear a substantial part of the burden of a rescue, Germany agreed to ask investors to participate in a bailout on a voluntary basis. Merkel and Sarkozy also said that they are planning to work with the European Central Bank to craft a second bailout package to save Greece from running out of money.

“There shouldn’t be any dispute with the ECB [European Central Bank] on this,” Merkel said, the New York Times reported.

Meanwhile, Greek prime minister George Papandreou has named his current defense minister as the new finance minister, forcing out George Papaconstantinou, who has become the public face of the government’s reviled budget cuts. The new finance minister will need to be able to force through new budget cuts and tax increases to secure $155 billion in relief from the European Union and the International Monetary Fund, and to qualify for a second bailout from the European Central Bank to keep Greece afloat. The task is daunting: Hundreds of Greeks have continued to gather in the streets to protest what they view as unfair demands for the people to bail out international banks and the government itself.

“They took everything, and we have to pay,” Katerina Fatourou, 30, an elementary school music teacher in Athens, told The New York Times.

As a result, stocks and currencies rose in value around much of the world on Friday, as the possibility of a sudden slew of government bankruptcies and bank failures in Europe faded. The Dow Jones Industrial Average rose 80 points, or 0.67 percent, to 12,042 points in the late morning on Friday. In Europe, the British FTSE 100 rose 0.28 percent, the DAX Germany rose 0.76 percent, and the CAC France rose 0.83 percent. The euro -- the key currency in danger if Greece defaults -- rose in value to a session high of $1.42 against the dollar. Bets against the Greek government fell in value, indicating a rise in investor confidence in Greece.

Stock markets in Asia and the Middle East mostly fell on Friday. They had closed before Sarkozy and Merkel announced their continued commitment to trying to help save Greece in earnest.

Investors, European leaders and investment research analysts recognize that Greece is not out of danger yet. If Greece defaults, it could trigger a string of government defaults and bank failures across Europe, plunging Europe into a recession. A recession in Europe would decrease European demand for American exports, which could hurt production and investment in the United States, with the possibility of hurting American economic growth and raising unemployment even more.

“One thing is for sure, time is ticking and prompt and coordinated action needs to be taken,” Markus Ernst, a strategist at the Munich-based bank UniCredit SpA, told Bloomberg News. “Contagion to other over-indebted EU member countries is still considered high and cannot be ruled out.”

A report released Friday by Aladdin Capital LLC in Stamford, Conn. warned that the ECB may not be able to save Greece after all, and that the U.S. Federal Reserve may need to step in as the lender of last resort for the ECB itself. The report called a default by the Greek government “inevitable,” predicting that as long as Greek debt remains cheap and bets against the solvency of the Greek government continue to yield high returns, Greece could be forced to guarantee investors only a fraction of what was invested: A move that would be interpreted by the markets as a default.

The Aladdin report warned that Greece eventually may be forced to leave the euro, since it may need to be able to devalue its currency to bring down its debt. That would devalue the euro, since it would warn investors that other European Union countries also could leave the euro. If the euro becomes devalued, the Aladdin report concluded, then the ECB would not have enough money on hand to save Greece or any other countries.

Nonetheless, Alan Ruskin, a strategist at Global Markets Research, wrote in a report released Friday that even though continued uncertainty will hang over the markets and prevent investors from taking risks, there likely will be no massive sell-off of stocks in the coming weeks, and Greece likely will not leave the European Union.

The trillions of dollars at risk, Ruskin wrote, makes any plan to let Greece leave the euro “too ghastly for rational policymakers to consider, which is why it would only happen under the most extreme political scenarios (which we are nowhere close to)."

It seems that the markets agree more with Ruskin for now, although the slightest sign of uncertainty from Greece, Germany or France could shake the markets again in the coming weeks. It remains unclear whether the new Greek finance minister will be able to force through new budget cuts and tax increases, and whether investors will remain confident both that Greece can cut its budget in time -- as Greek protests against austerity measures intensify -- and Europe will continue to bail out Greece.