Think Again: The Eurocrisis
Markets are crashing. The euro is hurting. Here's why the continent's financial crisis is even messier than it appears, and how the blowback could hit the United States in the face.
"The Euro Is Heading for a Crackup."
Don’t bet on it. Sure, things look bad. The crisis, well into its third year, has forced Greece, Ireland, Portugal, Spain, and now Cyprus into various forms of international financial rescue programs, and it shows no signs of abating. After two years of denial and half-measures, market participants have little faith in the ability of Europe’s policymakers to reach a solution. Spanish bond yields are frighteningly wide and those of Italy, the continent’s most prolific borrower, are following closely behind. This summer’s announcement a fuzzy-at-best plan to recapitalize Spanish banks and create new mechanisms to channel pan-European resources to Europe’s stricken financial sector relieved market pressure for all of a few hours. Perhaps most alarmingly, no one seems to have a plan, with British Prime Minister David Cameron warning that the eurozone must either "make up or break up" — with the implicit threat that the latter is increasingly likely.
But before writing the euro’s obituary, let’s remember: The driving force behind a European currency union was never purely or even principally financial. It was political — and these binding forces remain strong. After centuries of bloodshed on the continent culminating in the last century’s two world wars, the European Union (EU) and ultimately the euro arose from a deep-seated desire to abolish the risk of state-to-state conflict. A slide back to nationalism is a constant fear in the minds of European political leaders and peoples. And so, in spite of growing concerns about the benefits of sharing a single currency across 17 countries, member states and their publics remain highly supportive of the European project and the euro. While the crisis has caused this support to decline a bit, studies consistently show that Germans, French, and Spaniards favor remaining in the euro. Even upwards of 70 percent of Greeks, who are in their fifth year of recession and looking forward to a decade of grinding austerity, claim that they want to stay in the currency union. They may not get their wish (boundless hope can overcome an awful lot, but not the cold mathematics of Greece’s debt burden) but their robust support illustrates the basic fact that the political will to maintain the euro remains strong.
It’s true that Europe doesn’t yet have a comprehensive plan to balance sensitive and increasingly difficult issues of national sovereignty, financial resources, and disparate economic models and strength among eurozone members. It’s also true that this marks a decisive break from the post-World War II trajectory of European integration, which was built on grand visions both successful (the common market and common currency) and less so (the Lisbon Treaty that set the foundation for today’s host of supranational European political institutions).
What Europe does have, though, beyond sheer will, is a process, however tortured and painful it may look to those on the outside, to ensure that the euro and the EU hold together. The political and economic costs of a eurozone implosion remain too high and the benefits of maintaining the common currency too real for the countries involved, as self-defeating as they appear at times, to allow a crack up. Europe will likely make steady, halting, and at times apparently counterproductive steps toward a banking union, limited fiscal federalism, and a path to political union. The path from here to there won’t be smooth, just as the past two years haven’t been — but it will likely be enough to keep the currency union.
To be clear: We could very well be heading for a deep crisis, and we might even see the exit of one or more member states, with Greece the most likely. But other peripherals won’t see a Greek exit as a signal to leave themselves; in fact, measures taken as a consequence may well strengthen their own prospects within the currency union. The likelihood of the eurozone imploding and the reintroduction of national currencies across a broad swath of Europe thus remains exceptionally small.
"It’s All Greece’s Fault."
Nope. Greece definitely shares a great deal of blame for Europe’s current predicament (and, of course, its own). Athens lied about its budget and finances to get into the euro back in 1999, lied about them to stay in the euro in the decade since, and continues to bob and weave as it pretends to comply with the terms of its bailouts, agreeing to absurdly high projections for anticipated growth rates, tax revenues, and privatization revenues. Greece took Europe for a ride, and now both are paying the price.
But Greece’s seemingly miraculous overnight transformation from profligate to responsible required willful blindness from European authorities. And the reason that dissimulation was even available to Greece in the first place lay in the faulty construction of the euro itself, in which all eurozone sovereign risk was made to be a thing of the past.
In the pre-euro 1990s, markets widely and correctly assessed Greece as a poor credit risk. As a result, Athens was able to borrow only infrequently, and had to pay high rates to do so. Over the years, when Greece had problems paying back its highly priced debt, it defaulted, devalued, borrowed more, and the cycle continued.
Joining the common currency was assumed to eliminate both Greece’s credit risk (that it wouldn’t pay back its creditors) and currency risk (that it would pay them back in a different currency worth far less than the one in which they borrowed). These may have been noble aims, but the economic logic rested on assumptions that were faulty at best. Milton Friedman cited these flaws, among others, when he predicted that the euro would be lucky to survive the decade. As he and others warned at the time and is all too apparent now, adopting the euro didn’t magically transform countries like Greece into paragons of financial probity. Yet European banks took the elimination of sovereign credit risk at face value and lent Greece huge sums at historically low interest rates, comfortable in the knowledge that the European Central Bank (ECB) would provide virtually instant liquidity for newly issued Greek bonds, so that the lenders could start the whole process again shortly thereafter. And not only did the process continue, but it grew over a decade until the amounts involved became unsustainable, and the crisis as we now know it hit.
The flow of cheap funds was supposed to lead to investment and commerce in Greece and other "peripheral" European countries, which would eventually lead to an economic convergence with the eurozone core. When Greece borrowed money by the truckload, it was doing precisely what the eurozone architects and the ECB intended. Greece undeniably spent its windfall poorly — taking few steps to fix systemic problems like tax evasion, corruption, and public sector bloat. But the only reason it had money to spend so poorly was due to the overly optimistic (and at times inherently delusional) assumptions that underlay the common currency system. Polonius had it right: "neither a borrower nor a lender be." In Europe, both parties share the blame for ignoring that advice.
"It’s all Germany’s Fault."
Wrong again. It’s easy to blame German stubbornness in preaching austerity, reform, discipline, and penance for the continued metastasis of the crisis. Many fault Germany for helping to create the crisis in the first place, as the ECB was modeled on the Bundesbank and the euro, in effect on the Deutsche mark. German policymakers accepted the single currency zone’s incomplete construction and many willingly turned a blind eye to its first decade of tinkered budget numbers in the periphery, which helped them capitalize on a captive export market that benefited German firms enormously. Rhetoric from German politicians about the distressed peripherals too often has been ugly, with some calling for the sale of Greek islands and the Acropolis to help them pay their international debts; even German Finance Minister Wolfgang Schaeuble pointedly reminded the Greeks that "membership in the EU is not compulsory." Perhaps most daunting has been Chancellor Angela Merkel’s seeming inability to grasp the direness of the Europe’s predicament — she acknowledges that the eurozone is "in a race with the markets," and then limits how fast Germany will run — frustrating friends and foes alike.
The truth is, though, that Germany has made an enormous commitment to the European project, and one that has not wavered. From the creation of the European Coal and Steel Community (the EU’s forerunner) less than a decade after World War II to the present day, Germany has staunchly supported and even driven a series of steps that have had the net effect of subordinating German power to broader pan-European ends. The EU’s godfather Robert Schuman was French, but no country has embraced the spirit of his eponymous declaration more than Germany, and that hasn’t changed.
What’s more, Germany has over the past year undergone an unbelievably rapid shift in its role in Europe. Casting aside reluctance rooted in its fraught 20th-century history to assert control in Europe, Berlin has assumed the mantle of leadership at a time when it is the only European entity seemingly willing or capable of doing so. To its credit, Germany has shown unforeseen flexibility on a wide array of ideas and initiatives that only a short time ago were completely verboten: multiple relaxation and renegotiation of the conditions required for Greece to receive its rescue funds, direct recapitalization of the Spanish banking system, the creation of European bailout mechanisms like the European Financial Stability Facility (EFSF) and the European Stability Mechanism (ESM), consideration of common eurobonds, banking union, fiscal union, and tacit approval of the ECB’s unorthodox market interventions.
Germany receives blame largely because many, in the United States in particular, look to Berlin to play a role akin to the one Washington played in financial crises past: formulating a comprehensive crisis-response plan and committing a substantial amount of money to implement it. Germany can’t and won’t do this, and its inclination to move incrementally, and only after distressed countries agree to significant reform measures, remains dangerous as the crisis moves exponentially. Overall, however, Germany and Merkel have been far more pragmatic and effective as crisis managers than has been generally acknowledged.
"The Eurozone Crisis Is One Crisis."
Hardly. It’s at least four, and possibly more depending on how one counts. Europe’s peripheral states have a host of problems, and to some degree demand similar short-term responses. But seeking a one-stop solution by lumping them together (as the "PIIGS," a common acronym for Portugal, Ireland, Italy, Greece, and Spain) ignores the very real differences that separate them and that will over the longer term require different policy interventions. Even referring to a singular eurozone "crisis" is something of a misnomer; the label actually encompasses sovereign debt, banking, growth and competitiveness, and structural crises — all of which, unfortunately, feed on one another.
Take Ireland, for example, which suffered from a banking crisis in 2010 that became a sovereign-debt crisis. Irish banks financed a real-estate-driven domestic bubble, and when the bubble burst the Irish government moved quickly to nationalize some banks and take the financial risks of others onto its balance sheet. As a result, the Irish debt-to-GDP ratio ballooned from 34 percent to well over 100 percent, crippling Ireland’s ability to borrow.
Spain’s problems are somewhat similar to Ireland’s, but with a twist. Like Dublin, Madrid finds itself confronted with a banking problem born of a real estate bubble. But the Spanish autonomous communities or regions, which under the devolved Spanish federal structure manage their own budgets, systematically over-borrowed and overspent during the past decade, all while apparently lying about it to the center. When the real-estate bubble popped, the regions felt the pinch as much as the banks, and now the Spanish federal government may have to prop up both.
Portugal, by contrast, had and has a competitiveness problem. Lisbon feasted on cheap euro financing and for a while enjoyed the benefits. But instead of investing in its economic future, it plunged its European windfall into an unsustainable services-sector boom that masked, for a time, the need to undertake structural reforms. When economic reality hit and demand for services fell, Portugal’s economy was crippled. Its path to competitiveness remains an enormous question mark, though its banks remain generally healthy.
Italy’s current predicament likewise stems from structural and competitiveness issues. Italian growth has declined in an almost directly linear fashion for 60 years, from 5 percent in the decade after World War II to a virtual flat line in the 21st century. Corruption is endemic, higher education is mediocre, and antipathy toward reform is high. In spite of its strong and industrious north, Italy’s growth prospects as a whole are bleak without structural reforms. The country was the largest issuer of euro-denominated sovereign debt, with total indebtedness of 2 trillion euros placing it at the very edge of what the IMF deems "sustainability." Although the country’s annual budget deficit is relatively healthy, without reform the country could find itself unable to fund itself and spiral downwards quickly.
Greece is the closest to a perfect storm of the various gales lashing Europe. It has structural and competitiveness issues, and Athens’s serial dishonesty over the state of its finances remains in a class of its own. The country has already undertaken one messy and painful debt exchange and with its second troika program at risk, another may follow. Greek financial institutions only became an issue, however, once the value of their holdings of Greek government bonds was slashed and the downturn crushed economic activity in the country, so much so that recent projections see a nearly 7 percent contraction in GDP this year. In some ways, Greece is a reverse of the Irish situation: a sovereign-debt crisis begat a banking crisis, rather than vice versa. Add to that the ongoing risk that Greece may be the one country that really might be forced to leave the euro, and the country and its banks suffer from almost all that ails the eurozone.
The crises of the eurozone’s peripheral countries undoubtedly share commonalities, but that doesn’t mean that their causes or potential solutions are the same. What it does mean is that Europe’s way out of this morass promises to be even more complicated than it appears.
"The Europeans Have Finally Thrown Big Money at the Problem."
Not if you look closely. Proponents of Europe’s response to the crisis point to two acronym-laden rescue funds, the EFSF and the ESM, with combined financial firepower well in excess of $1 trillion — far more than the U.S. Troubled Asset Relief Program (TARP). These rescue vehicles, they say, represent serious commitments of cold hard cash to eliminate the systemic risk in the European banking system. Sadly, there’s relatively little real money being ponied up and the actions of Europe’s central bank, the ECB, may have only made things worse.
The EFSF has no actual money. Zero. It’s really nothing more than a pool of promises from eurozone countries to pay creditors sometime in the future if there’s still no cash in the till. Relying on these promises, the EFSF was supposed to raise its entire funding on capital markets, but it doesn’t have a great track record in doing so. As a result, though the EFSF is authorized to borrow up to 440 billion euros, it has only raised around 30 billion euros so far.
With no actual cash and limited investor appetite for their bonds, the EFSF simply declared its own bonds to be as good as cash, and provided them to recipient countries, banks, and investors instead of the real money they couldn’t actually raise in the markets. It’s anyone’s guess how the bonds will ultimately be repaid in the end.
The second vehicle, the supposedly new and improved ESM, is a similar story. For starters, while its money is already being committed, the treaty authorizing it has yet to be ratified in several member states. The all-important German courts have even raised serious questions about its legality. But even assuming the ESM is found to be legal and is ratified, its ostensible 500 billion euros in funding will be mostly a mirage. The ESM is structured so that 80 billion euros will be contributed by eurozone countries over 30 months. The remaining 420 billion euros is supposed to be raised in the capital markets, with investors expected to buy bonds relying on guarantees provided by eurozone countries — several of which themselves may end up being the recipients of any money that the fund actually ends up raising.
On top of all this, market investors are increasingly concerned that the one entity seen by many observers as the ultimate savior, the ECB, is part of the problem. They fear that the ECB will be able to ensure that it has repayment priority, therefore limiting the prospects for other investors if a country runs into trouble and can’t pay on time — or at all. These concerns are well-founded: that’s just what happened in Greece last spring.
So Europe’s "rescue" funds are largely unfunded. They are based on hopes that markets will provide enormous amounts of cash on the back of financially engineered government promises not recognized on their sovereign balance sheets, with investors’ wariness about their treatment at the hands of the ECB only making matters worse. In an already difficult funding environment, it is hard not to be just a little skeptical that the rescue funds won’t necessarily have all the money they need exactly when they need it.
"The U.S. Response to the Crisis Has Been a Failure."
It’s complicated. Washington’s reaction to the eurozone crisis was almost certainly too slow, too small, and too stove-piped. Not only did U.S. policymakers fail to initially recognize the severity of the crisis, but they focused for far too long solely on purely financial, not strategic considerations. With Treasury taking the lead under Timothy Geithner and in spite of Secretary of State Hillary Clinton’s laudable efforts to include economic tools in our foreign policy toolkit, the U.S. approach was purely "economic" without the "statecraft." Some U.S. officials seemed complacent, assuming that the European crisis was not of their making and the impacts likely to remain largely localized on the continent. The Europeans would, as they themselves insisted, figure things out for themselves at the end of the day. As a result, President Obama’s personal involvement was not seriously sought until the summer of 2011, and when it did come, it was largely limited to high-level political efforts to cajole his European counterparts to reach a solution. The crisis had by this time evolved, and his interventions were neither universally welcomed nor terribly effective.
But there are mitigating factors that explain, though don’t fully excuse, U.S. failures to play a more constructive role in solving the crisis. For one thing, the size of Europe’s mess is far larger than anything we have had to help clean up before, and the United States alone simply does not have enough money to lead a robust international response with the vast sums of cash required to backstop Europe. With the U.S. economy recovering slowly from the 2008 financial crisis, the government deeply in debt, and some in Washington increasingly skeptical about U.S. support for international financial institutions, the Obama administration’s ability to intervene decisively was hamstrung from the inception of the crisis. That hasn’t changed, and in an era of fiscal retrenchment, it won’t.
When the Europeans finally dropped their opposition to IMF involvement in May 2010 and agreed to allow the Fund to play a central role in the crisis response, the United States made it clear that it would not be providing more funding to the IMF to boost its war chest. Earlier this year, when the IMF announced an increase in its emergency funding to the tune of some $450 billion, the United States was conspicuous in its absence, arguing both that Europe should use its own resources to solve its own crisis and that the U.S. Federal Reserve has been quietly providing enormous amounts of dollar liquidity to the European financial sector, averting a much worse crisis. All true, but U.S. absence was glaring.
But let’s be honest — the Europeans have been less than eager to accept any U.S help. Certain that their collective wisdom, processes, and minimal financial commitments would be sufficient and mindful of the stigma that supplicant status would bring, Europe has kept Washington at arm’s length for most of the last two years. When the United States did finally move publicly and decisively to help broker a solution, at the eurozone finance ministers’ meeting in Poland in September 2011, Secretary Geithner was greeted with dismissal (Eurogroup President Jean-Claude Juncker huffily sniffing that Europe would not "[discuss] the increase of expansion of the EFSF with a non-member of the euro area"), ridicule (Austrian Finance Minister Maria Fekter: "I found it peculiar that, even though the Americans have significantly worse fundamental data than the eurozone, that they tell us what we should do") and outright rejection (Belgian Finance Minister Didier Reynders said Geithner should "listen rather than talk"). In private discussions, European ministers were more receptive than the heated rhetoric suggested, but their public rejection sent a clear message: Washington should butt out.
In past financial crises, such as the 1994 Mexican peso crisis, the United States kept publicly quiet and worked behind the scenes to provide necessary financial backstops, while building global coalitions to address the situation at hand. But when Europe began to come apart at the seams, Washington adopted a new strategy: speaking a bit more loudly and hoping that the markets would carry the stick. The United States, perhaps a bit wishfully, believed that expressing public concerns would drive market activity to increase pressure on European leaders for speedier and expeditious action. Europe wanted a quiet and quiescent America that would offer funds; what it got was an America offering lectures. But while it’s tempting to pin the ineffectiveness of this approach on U.S. policymakers, they had few other choices; it’s a more a sign of the times and the size of the crisis than an outright policy failure.
"The Eurozone Crisis Is a Disaster for the U.S. Economy."
Not yet. The eurozone crisis has undeniably damped economic growth across the globe and helped slow the U.S. recovery. And yes, if the crisis worsens, it could do severe damage to the U.S. economy and President Obama’s re-election chances. From early 2010, when Greece shattered the façade of the euro’s unshakeable foundations, European instability has driven down U.S. consumer and investor sentiment, reduced spending, and heightened uncertainty for firms, reducing investment. The risks of financial contagion have reduced credit and posed new threats to U.S. banks and other financial actors with significant exposures to Europe. The EU and the United States have the world’s largest bilateral trade relationship, and as the continent stagnates or contracts, U.S. exporters may be hit especially hard. This summer’s domestic corporate earnings testify to the drag that Europe is exerting on the U.S. private sector.
It’s not all bad news, though. First, reduced consumer sentiment and decreased economic activity exerts downward pressure on commodity prices, particularly gasoline. With summer typically the season of peak U.S. energy demand and with the sheer number of geopolitical developments buffeting energy markets — from U.S. and EU sanctions on Iran to chaos in Syria to instability in Libya and pipeline disputes in Sudan — the gasoline market could use a little slack. While many analysts predicted prices at the pump to exceed $5 per gallon this summer, prices have dropped to below $3.40 nationwide, and may fall still farther.
Second, Europe’s financial turmoil reinforces America’s safe-haven status. A lack of alternatives means that investors looking for assets to stuff under the proverbial mattress still outbid one other for blue-chip U.S. Treasuries, keeping interest rates low (even negative in real terms) and inflation manageable. Those same low rates translate into lower borrowing costs for businesses and homeowners.
Finally, as long as Europe appears near (or in) crisis, the United States won’t face sustained market pressure over its shaky fiscal trajectory, and thus there’s not likely to be market pressure to force action by Congress and the president on difficult decisions like the extension of the Bush tax cuts or softening the automatic spending reductions that hit at year’s end — thus preventing a self-induced hit to the U.S. economy before it is able to recover. While it is obviously necessary that we grapple with our very real fiscal challenges, it is certainly nicer to do so on a timetable of our own, and not one set by markets forcing our hands and risking the onset of a double-dip recession.