After nearly two years of political grandstanding, market panics and botched bailouts, Europe’s debt crisis is rapidly approaching resolution. After 14 summits and thousands of hours spent in fetid rooms, the single currency is still in crisis but there seems to be a way forward. The capacity of the European Financial Stability Facility – the eurozone’s bailout fund – has already been pumped up to 780 billion euros; teetering banks loaded up to the eyeballs in Greek and Italian debt will be re-capitalised (again); and up to 60 per cent of Greece’s debt mountain will be written off. But will the euro survive and, if so, how?
While everyone seems to have plenty to say about the crisis, few are prepared to face the painful reality of the solutions. In the past, the solution for such enormous indebtedness would have been simple: go bust, get an emergency loan from the International Monetary Fund and devalue your currency. This was the path taken by Mexico and Argentina in the 1990s. Their creditors, mainly banks, lost a lot of money but little damage was done to other countries. Both Mexico and Argentina have since recovered.
This relatively painless option does not exist for Greece or other EU countries. With 17 countries sharing a single currency and monetary system, and with a highly inter-linked European banking system, no country can get into financial difficulty in isolation.
One of the oddities about this debt crisis is that the eurozone as a whole is, in relative terms, not in bad economic shape. It has much lower debt levels than the United States or Japan and a better balance of payments. The problem is that neither markets nor politicians view the eurozone as a whole, but as a set of nations – some of which have unmanageable debts.
But the eurozone crisis is not about the 17 eurozone countries or the wider EU. It is, potentially, the second global banking crisis. EU banks have exposure of $2.8 trillion in Greece, Ireland, Italy, Portugal and Spain. The total level of financial sector exposure is a whopping $3.55 trillion. US banks are also frighteningly exposed to default.
A Greek bankruptcy would bring the three largest French banks close to collapse overnight – BNP Paribas, Societé Generale and Credit Agricole hold more than 40 billion of Greek debt between them – which would, in turn, put the French economy into recession. It would also severely hit German, British and Benelux banks, many of which still lack the capital to be able to absorb heavy losses. Meanwhile, Europe’s other heavily indebted countries, such as Italy and Ireland, would see their borrowing costs soar. This whirling vortex of market panic, debt and political disarray could lead to financial meltdown.
Are the eurozone’s problems simply because a few countries ran up excessive debts? No, this was a crisis waiting to happen. It has been made much worse because politicians have not been honest about what is at stake. Much newspaper coverage over the past 18 months has concerned supposed multi-billion euro bailouts for feckless, work-shy southern Europeans. But these glib references to the supposedly “virtuous north” and “profligate south” are wide of the mark. It is more accurate to say that the debt crisis in the banking sector has mutated into a generalised crisis of sovereign, banking and private sector debt. Not a single cent of these emergency loans is going to Greek, Irish and Portuguese citizens. They have been used to pay bank debts.
What does all this mean for the euro? It surely cannot survive with its current design. If the right emergency measures, including a pooling of debt and eurobonds, are used to relieve the market pressure and speculation, then the eurozone countries should decide on its future. On the one hand, this could involve a broad north-south split, with the stronger economies remaining in a tighter economic union with strict rules on budget deficits and debt, with the weaker countries going back to their old currencies.
The more ambitious alternative would be to beef up the eurozone’s rulebook with a common EU debt agency, allowing countries to issue a fixed proportion of their debt burden in eurobonds, with an EU treasury and Finance minister with the power to oversee country’s tax and spending. Alongside this would be some harmonisation of tax policy. Such ideas were dismissed as wild-eyed nonsense just a few months ago. Now fiscal union seems highly likely if not inevitable.
However, the trappings of fiscal union are not, in themselves, the answer. The likes of Greece and Italy have massive debt burdens because, compared to
the likes of Germany, France and the Netherlands, they are chronically uncompetitive.
The productivity gap between Europe’s rich and poor has widened since the adoption of the single currency. For the eurozone to encompass as many countries as it does now will require recognition that the gap between its weakest and strongest economies will not be bridged. The only way to keep them on board would be by using credit transfers to re-distribute wealth within the eurozone. If eurobonds are deeply unpalatable to Germany and others, credit transfers would be unthinkable. But they are the price of maintaining the single currency in its current guise.
Unfortunately, the architects of the eurozone hoped that if they got the politics right then the economics would follow. This is why, despite having debt levels way above the 60 per cent limit set in the Stability and Growth Pact, Italy, Greece and Spain were all allowed to join the euro. But the real damage to the credibility of the SGP was done in 2003 and 2004 when Germany and France – which now preach the values of balanced budgets – breached the 60 per cent debt ceiling but flatly ignored the EU excessive debt procedures that were taken against them.
Politicians are also guilty of failing to tell their electorates what the single currency meant. The Germans thought they were getting a strong currency union – with the European Central Bank keeping a tight watch on inflation and interest rates – that would allow their labour market to get stronger. The Italians, Greeks and others thought they were getting low interest rates that would allow them to keep borrowing. No one was told that the eurozone was about economic as well as monetary union and that this meant that countries could not get into difficulty without dragging others with them.
However, the principle of the single currency is still strong. In the 1980s, German Chancellor Helmut Schmidt asked: “Whoever heard of a single market with 11 currencies?” The logic is strong, especially considering how inter-dependent and closely tied together most European economies are.
Those who hope that grand EU summits will provide swift and easy answers will be disappointed. The first priority must be to arrange a workable debt settlement for Greece,; the second to safeguard the banks. Treaty changes must wait until then. But we should be under no illusions that the euro’s survival is in the interests of all EU countries, including Britain.
In 2008, the collapse of Lehman Brothers led to the deepest recession since the Second World War and the near collapse of the financial system. Less than four years, later Europe is teetering on the brink of a deeper recession.
The price of rescuing Greece and the banking system will be painful and high, but it is the cheapest option available. It is time for politicians to show the bravery and honesty they have lacked throughout the crisis by acting to avert meltdown.
