A specter is haunting Europe – the specter of default. And all the powers of Old Europe have entered into an alliance to exorcise this specter. The result has been a kind of wishful Euro-optimism. As Time International Editor Jim Frederick reported on Friday, one of the key themes at the World Economic Forum in Davos last week was the growing belief that “the Eurozone may actually be starting to heal itself. The Eurozone crisis will continue to muddle along, but muddling may be enough.” Unfortunately, the facts argue for the opposite conclusion.
It may be true that the European Union, taken as a whole, is in better financial shape than the U.S. But Europe is not a single entity. Financial burden sharing works in the U.S. largely because it is automatic. People in New York and San Francisco do not ordinarily get to vote on whether their taxes will go to pay for Social Security in Detroit or unemployment benefits in the Carolinas. Indeed, when financial crises do require overt political action, solidarity can suddenly disappear, as it did when President Ford denied assistance to New York City during the 1975 financial crisis, an event immortalized by the NY Daily News headline “Ford to City: Drop Dead.”
We may never see the headline “Germany to Greece: Drop Dead,” but political realities limit the policy choices available to European leaders. And simply by gauging the success of the policies actually in force, one sees the slow but inevitable degeneration of the Eurozone. Here’s where things stand:
Some heavily indebted countries have been stabilized, but the worst cases are not responding. The great success story of the past two months has been the ability of the European Central Bank to push interest rates in some countries down below the 7%-8% range that typically leads to default. In Italy 10-year bond yields have dropped from 7.25% in late November to a current 5.9%. In Spain, they have fallen from 6.7% to 5% over the same period. But 10-year yields remain above 15% in Portugal and Greece. Moreover, some bondholders may resist restructuring plans because they have a kind of bond insurance and would therefore prefer an actual default, like someone with an old car who parks it on the street in a lousy neighborhood hoping that it will get stolen.
Austerity alone is not sufficient to restore a country’s financial soundness. Excessive debt is not just a matter of the amount owed, it also depends on whether a country can grow fast enough to shrink the size of the debt relative to the economy. Austerity policies may reduce the amount of new debt a country takes on, but they can be counterproductive at the same time by limiting growth and thereby making existing debt more burdensome. This point has been made by everyone from International Monetary Fund head Christine Lagarde to commentators such as George Soros and Paul Krugman. But policymakers have no alternative solution to offer.
Overindebted economies can be fixed in the long run, but not in the short run. If a country’s debt is 60% of GDP or less and the economy is growing, the annual deficit can be reduced without much short-term disruption. But when an economy goes into recession carrying debt of more than 100% of GDP, the policies needed to keep the debt under control conflict with those needed to revive the economy. At that point, there is no escape from a period of crippling austerity. Greece and Portugal are already in that situation. And Ireland’s bond yields, at 7.3%, are high enough to be worrisome.
The ECB will run out of money before the problems are fixed. Since the middle of last year, the ECB has been pouring hundreds of billions of euros into the markets to provide relief to troubled banks and to hold down bond yields. Even so, some countries still have cripplingly high interest rates. In addition, recent improvements in Italy and Spain are basically holding actions that require the ECB to keep throwing money at the problem. Spending more than half a trillion euros every three months just to keep matters from getting worse is not sustainable indefinitely. And none of the optimists has a plan that would speed up the solution. In fact, just the opposite is true: Policymakers are basically playing for time – not the greatest strategy when your burn rate is huge and the financial resources available are limited.
This situation does have some redeeming features. The current crisis is forcing the weakest European economies to become more efficient and more competitive. This process would be a lot easier if they could devalue their currencies – reducing their effective labor costs at one stroke in a way that is a lot less painful than slashing wages. That could be done most easily if Germany and a few other countries were to leave the Eurozone, so the value of the euro would be able to drift down. But they would resist such a move for political reasons. It might also permanently weaken the European Union.
Eventually the dust will settle. Debts will be renegotiated and banks that have suffered big losses as a result will be recapitalized. European economies will then be in a position to begin a sustainable long-term expansion. And when they do, the economies that were weakest a few years ago will be more efficient, more flexible and generally more competitive. But it is difficult if not impossible to see how the Eurozone gets to that point without first passing through a very nasty time of troubles. The idea that Europe can just muddle through is one of those things that people believe simply because the alternative is so unpleasant.