The New New Normal

Going South

They've helped bail out southern weaklings. Now Europe's northern countries may be doomed too.

Sean Gallup/Getty Images
Sean Gallup/Getty Images

How about this for irony: Remember the solid, strong economies of Northern Europe, the ones that signed up for one bailout after another of their less well-off brethren to the south? Remember how, together with the guiding hand of the European Central Bank (ECB), they pulled the eurozone back from the brink of disaster? Not so fast. Now it’s their turn to feel economic pressure, meaning they could soon risk going from being part of the solution to being part of the problem. That should be of interest to markets around the world.

This is exactly what’s happening in Europe today. And it speaks to a phenomenon captured brilliantly decades ago by John Maynard Keynes, the famous British economist, who observed: “If you owe your bank a hundred pounds, you have a problem. But if you owe a million, it has.”

At the outset of the eurozone debt crisis more than three years ago, everyone looked to a group of AAA-rated countries (Austria, Finland, France, Germany, Luxembourg, and the Netherlands) to anchor the European ship and throw life preservers to the struggling peripheral countries (initially Greece, Ireland, and Portugal). Their intervention was to be surgical, temporary, and reversible. They were to commit to direct lending, and they were to support additional funding from regional organizations like the ECB. And they were to do so combined with cleverly designed incentives to encourage the weaker countries to reform and, so the plan went, regain economic and financial strength.

That was, at least, the widely telegraphed intention, one that was critical to securing sufficient political and popular buy-in among the skeptical citizens of Germany and its rich neighbors. Three years later, the reality is different.

Although you might not know it from reading the newspapers, the situation in Europe remains worryingly fragile. Yes, financial markets have been calmed substantially by the “whatever-it-takes” commitment of the ECB. But underlying economic conditions continue to deteriorate at a worrisome pace. Every month Europe’s stronger economies are getting pulled deeper and deeper into a crisis they neither can control nor have fully explained to their citizens.

In the coming months, Germany and others will feel forced yet again to make additional loans — this time knowing that they will not be repaid in full. They will see their economies disrupted by a more generalized slowdown in the European trading bloc. And when these events inevitably collide, the underpinnings of the current regional economic integration, including the effectiveness and credibility of the European Union itself, will again be at risk.

There are many reasons for this unfortunate state of affairs. To start, the initial phases of the regional crisis were met with denial, bad diagnosis, and inadequate responses. As such, the region’s virus was left to spread deep and wide.

This original slip proved costly. The accelerating worsening of conditions in the peripheral economies in the first years of the crisis far outpaced the Europe Union’s ability to get its act together, and Europe fell further behind. Citizens started to question the effectiveness of their elected representatives, rejectionist political parties flourished, and pervasive joblessness became more deeply embedded in the structure of the economies.

A weakening global economy was another complicating factor. As austerity measures were foisted upon Greece, Ireland, Portugal, and other highly indebted countries, growth was rendered even more elusive, aggravating unemployment that hit youth disproportionately hard. At the same time, investment inflows and external credits dried up, further starving the economy of working capital.

But there was another less visible yet much more important factor at play too: the lack of political courage to call a spade a spade. And it’s still creating problems today.

From day one, eurozone officials have refused — at least publicly — to make the call central to any proper resolution of a systemic debt crisis: differentiating between a liquidity problem (where debtors need emergency funding to help them overcome a contained short-term issue) and a solvency one (where a fundamental economic and financial restructuring is needed).

I am the first to admit that it’s not always easy to make this distinction with a high degree of conviction. The analytics can be tricky, and the interconnections are often complex to sort out quickly. Yet making this distinction is not what paralyzed European policymakers three years ago — and it is not the problem today. There should never have been doubt about the extreme insolvency issues in the eurozone, first and foremost in Greece.

Even under optimistic assumptions about the country’s economic prospects, Greece’s debt-to-GDP ratio — 153 percent as of this writing — will be unsustainable until 2022. Moreover, this forecast assumes a sustained economic and financial restructuring that Greece and its European creditors would find difficult to deliver. As things stand now, high economic growth will remain elusive and unemployment extremely high. Poverty will spread, and social unrest will be a constant concern.

In public, eurozone officials reiterate increasingly inconsistent twin mantras: 1) that Greece will achieve growth and debt sustainability, and 2) that this will occur without official creditors suffering principal losses on the loans they have made to the country. I suspect, however, that they would privately acknowledge that at least the latter, if not also the former, is unlikely.

The argument for continuing the charade is threefold. First it’s PR, which buys time for some of the system to heal. Second, there’s real concern that negativity could bring about harmful contagion. Third, there’s simply no single national or regional leader willing to make the really tough decisions — even collectively, they’re unable to do so.

Meanwhile, things in Greece will get worse, meaning the country will sink deeper into its dependency on the rest of Europe. As the burden of future debt reduction continues to shift from the private sector to European taxpayers, the financial virus risks spreading even more as indecisive signals from eurozone officials add to the confusion regarding debt sustainability in other peripheral economies — most importantly, Italy and Spain. And of course, the longer all this persists, the greater the economic and financial headwinds facing the stronger economies.

Given all this, it should come as no surprise that France has lost its AAA credit rating and that virtually all the other AAA countries in the eurozone have now been given a negative outlook by at least one of the three major rating agencies.

The last thing Europe needs is a combination of persistent economic problems on its periphery, a weakening core, and all of it held together by experimental financial engineering on the part of the ECB. But this is the reality for 2013 if officials continue to obfuscate the dividing line between solvency and insolvency.

Success does not mean abandoning countries like Greece to manage their challenges alone. It does, however, mean that the stronger eurozone partners must ditch the muddled middle for one of two bold decisions: Either let the Greek economy out of the eurozone so that it has the ability to reset itself more quickly, or act boldly to remove Greece’s debt overhang by agreeing to deep debt forgiveness on official loans and then to a large package of new grants.

There is no easy solution for the struggling European countries. Yet the longer political leaders shy away from the tough decisions, the greater the chance that there will be a lot more of them. And soon.

Mohamed A. El-Erian is chief economic advisor at Allianz and the designated president of the University of Cambridge’s Queens’ College. Twitter: @elerianm

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