‘Tell me how this ends’: European edition

"Tell me how this ends," David Petraeus famously asked back in 2003, referring to the U.S. war in Iraq. Today, I’d like somebody who knows more about international finance than I do to answer that question regarding the eurozone. Today we learned that with the exception of Germany, the rest of the eurozone is slipping ...

Walt-Steve-foreign-policy-columnist20
Walt-Steve-foreign-policy-columnist20
Stephen M. Walt
By , a columnist at Foreign Policy and the Robert and Renée Belfer professor of international relations at Harvard University.
Sean Gallup/Getty Images
Sean Gallup/Getty Images
Sean Gallup/Getty Images

"Tell me how this ends," David Petraeus famously asked back in 2003, referring to the U.S. war in Iraq. Today, I'd like somebody who knows more about international finance than I do to answer that question regarding the eurozone.

Today we learned that with the exception of Germany, the rest of the eurozone is slipping back into recession. Take a look at this graphic here, and you'll see that problem countries like Spain and Italy are in particularly bad shape, with economies that are not only under their 2008 levels, but beginning to shrink at an accelerating rate. And the OECD forecasts for next year -- see here, here, and here -- are not exactly encouraging.

Why does this matter? Because countries like Spain, Italy, and Greece all need genuine economic growth in order to get out of their larger debt problems. In fact, they need economic growth that is sufficiently strong to provide a surplus over their existing debt service (and other expenses), so that people holding their debt (or expecting to buy new bonds when it's time to roll the current set over) have reason to believe that the debts will eventually be repaid. This is why everybody gets nervous when interest rates on new debt rise about the canonical 7 percent mark. 

"Tell me how this ends," David Petraeus famously asked back in 2003, referring to the U.S. war in Iraq. Today, I’d like somebody who knows more about international finance than I do to answer that question regarding the eurozone.

Today we learned that with the exception of Germany, the rest of the eurozone is slipping back into recession. Take a look at this graphic here, and you’ll see that problem countries like Spain and Italy are in particularly bad shape, with economies that are not only under their 2008 levels, but beginning to shrink at an accelerating rate. And the OECD forecasts for next year — see here, here, and here — are not exactly encouraging.

Why does this matter? Because countries like Spain, Italy, and Greece all need genuine economic growth in order to get out of their larger debt problems. In fact, they need economic growth that is sufficiently strong to provide a surplus over their existing debt service (and other expenses), so that people holding their debt (or expecting to buy new bonds when it’s time to roll the current set over) have reason to believe that the debts will eventually be repaid. This is why everybody gets nervous when interest rates on new debt rise about the canonical 7 percent mark. 

The issue is ultimately one of confidence. If the institutions holding Spanish or Italian debt and the lenders who have to issue new debt (to cover the service on the old debt) are convinced that the Spanish and Italian economies will eventually start growing and that the money to pay these debts will be there in the future, then interest rates will remain low and the danger of default will recede. But if these same lenders begin to suspect that these economies aren’t going to grow enough (and might even continue to shrink) they will rightly conclude that the money to pay their existing debts (including the debt service) will be lacking. At that point, they will only be willing to lend more money at interest rates that are even less sustainable. And that’s when states have to start thinking about bailouts, or about leaving the eurozone and solving their problems through a new (and highly devalued) local currency.  

The happy ending to this story, if there is one, is that the various structural reforms now being imposed on these countries will simultaneously cut government costs (thereby freeing up money for debt service) and eventually trigger robust economic growth (thereby increasing tax revenues and providing even more money). But thus far this doesn’t seem to be happening. Instead, we get recurring crises, each dealt with by some sort of hastily improvised mechanism mostly designed to kick the can down the road and wait for a miracle to occur. But unless the curves in the graphic cited above hit an inflection point and start heading upward, I don’t see how this favorable outcome ever gets reached.  

But international finance isn’t my real gig, so there may be aspects of this situation that I’ve failed to grasp. If any of you think you understand what’s really happening, tell me how this ends.

Stephen M. Walt is a columnist at Foreign Policy and the Robert and Renée Belfer professor of international relations at Harvard University. Twitter: @stephenwalt

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