If you’ve been listening to the pundits expound on the financial “crisis” in Europe—teetering on the edge, the eurozone facing a possible break up—the entire situation sounds dire and unsolvable. But like most stories that get caught up in mainstream media hype, there is much more to take into consideration in order to fairly assess what is at play. How did the crisis come to be? What are the implications for the United States? What are the potential solutions?
As I was telling a good friend recently, gaining an understanding of what’s at play in Europe is complex. It will take some explaining—far beyond that which has been provided in the sound bytes and reporting of most media outlets.
In the burning building, feeling the heat, are the President of the French Republic, Nicholas Sarkozy and German Chancellor Angela Merkel. Merkel is looking at a book titled “Which Fire Extinguisher”. Outside the building, on the left, is a very, very fat cat, representing bank creditors and a prancing David Cameron, Prime Minister of the United Kingdom (UK)–smugly happy that the UK opted-out of the eurozone. To the right are PIGS—Portugal, Italy, Greece and Spain, the countries that are at the center of the European economic crisis. Over the door of the building the European flag is burning.
How did the crisis come to be?
For historical background and to put the issues in perspective, you have to go back several decades.
The European Union (EU) can trace its roots to 1950 when French Foreign Minister Robert Schuman proposed integrating the coal and steel industries of Western Europe. One reason for creating the European Coal and Steel Community (ECSC), established in 1951, was to help in rebuilding heavy industry following WWII. Another reason for establishing a consortium was to form economic alliances that might help to thwart conflicts between nations that had plagued Western Europe for centuries. The original six member countries were Belgium, France, Italy, Luxembourg, the Netherlands and West Germany. It is important to note that a supranational body, the High Authority was also created in 1951 to manage the coal and steal industries.
In 1957, with the signing of the Treaties of Rome, the same six countries created the European Economic Community (EEC) and the European Atomic Energy Community (ERATOM). The EEC essentially created the Common Market, which allowed for free trade area.
Fast forward to 1993, the Treaty of Maastricht creates the EU and allows for a single currency, the euro. Under the Maastricht Treaty members of the EU had to agree to limit deficit spending and debt levels.
By 2007, the EU is the world’s largest economy. There are 27 member nations with a total population of around half a billion people. The euro has replaced national currencies in 15 (now 17) countries of the EU. The EU had established several structures similar to that of a sovereign state. A European parliament, which meets in Brussels, serves “the second largest democratic electorate in the world (after India) and the largest trans-national democratic electorate in the world.” (Wikipedia, the free encyclopedia – European parliament) The European parliament has certain legislative power, but it cannot exercise legislative initiative. This last piece figures prominently in the current crisis.
On July 18, 2008, the value of the euro was at an all-time high at 1.5843 to the U.S. dollar. However, as the year wore on Europe began to feel the effect of the worldwide recession. By June, 2010, the euro is at a four-year low, going below 1.19. In the interim, Greece’s debt has been downgraded to junk status and eurozone finance ministers approve a €110 billion loan to Greece. Concerns are raised about the economies of other European countries resulting in additional downgrades in credit ratings.
You may ask, why is there a debt problem within the European Union if the Maastricht Treaty included an agreement by members to limit deficit spending and debt levels? Many countries took advantage of complex currency and credit derivatives structures designed by U.S. investment banks, notably Greece and Italy, and were able to get around the Maastricht Treaty rules to cover the true deficit and debt levels.
The entire blame for the debt crisis does not lie at the feet of investment banks, (even though they did profit handsomely and took little to no risk). The worldwide recession contributed to increases in debt levels in European countries as many industries were hit hard, for example, tourism. Other reasons also played into the crisis:
Greece – High defense spending to guard against Turkey, based on historic conflict.
Italy – A decade of lower than the EU averages for economic growth.
Spain – Weak economic growth, which has prompted more scrutiny, as one of the largest eurozone economies.
Portugal – Four decades of very poor management by government officials (exorbitant consultancy fees, unnecessary public servants, risky credit decisions).
Ireland – State guarantees to banks that financed loans to property developers and homeowners which were defaulted on.
Downgrades in sovereign credit ratings, previously mentioned, have been made to many EU countries. This has a significant negative impact because a downgrade makes it more expensive and more difficult, sometimes impossible, to finance debt which serves to exacerbate problems.
When Standard & Poors downgraded the credit rating of the United States on August 5, 201, unlike Europe, the downgrade of the US did not cause a debt crisis. The US controls its own currency and US debt is issued in our currency. Countries of the eurozone issue debt in euros. The euro is a currency that the individual countries of the eurozone do not control.
What are the implications for the United States?
Robert Reich, former Secretary of Labor under President Bill Clinton and also in the administrations of Presidents Gerald Ford and Jimmy Carter, recently wrote an article that indicates that “financial chaos” will occur if Europe fails to get it financial house in order.
Based on Reich’s analysis of the situation, Wall Street has lent the eurozone about $2.7 trillion. A large share of this amount has gone to German and French banks that have in turn lent to Greece and other nations. Default by Greece or any other nation could seriously impact the German and French banking system, perhaps even causing bank failures. If this happens, Wall Street is likely to suffer yet another hit.
Banks that have made loans to the banks in France and Germany have stated that they have no exposure. This likely means that they have “insured” to eliminate exposure, but if we look back in the not too distant past, Wall Street believed they were insured against loss—American International Group, Inc. (AIG), didn’t have the ability to pay. To put the European crisis in context, before Lehman Brothers failed in 2008, it was leveraged 31 to 1. German Banks are leveraged 32 to 1.
Therefore, if a solution is not developed for the European debt crisis, the United States will likely feel the pain, as will the rest of the globe. To say that Wall Street is holding it collective breath waiting to see how this will play out is an understatement.
What are the potential solutions?
Issuance of bonds, called eurobonds, has been advanced as a potential solution to the debt crisis. The bonds would be guaranteed by all 17 eurozone countries. At present each country issues its own bonds. It is believed that bonds guaranteed by all member countries would attract investment. The debt of the combined eurozone, as of August, 2001 was 60% of GDP. For Italy, for the same period, debt was 116% of GDP. Therefore, Eurobonds issued by the combined entity are far more attractive. Money from the sale of the bonds would be available for weaker countries to borrow at lower rates of interest, thus improving the country’s financial position.
Germany and France are balking at the bond proposal with good reason. As two of the more fiscally responsible economies in the region they have much to lose if the plan doesn’t work out. If the weaker countries borrow, but still fail to get their debt under control, they could bring down the entire zone. Not to mention that issuing the bonds would likely increase Germany’s borrowing cost as it will assume the risk of the weaker countries. Chancellor Angela Merkel of Germany and President Nicolas Sarkozy of France might be on board, but only if a plan for imposing greater legally binding fiscal discipline can be accomplished for eurozone members.
The “soft power” stance of the EU, which originally attracted countries to join has proved to be too loose. With 27 countries, soon to increase to 28, governance has become unmanageable and the rules have been too east to circumvent or have not been enforced. When the common currency now utilized by the eurozone was established the stakes became much higher for just the reasons that are now playing out. Chancellor Merkel has stated that she would like to see that any changes in the treaty would be approved by all EU countries. But, given the critical nature of the crisis—something has to been done right now and bringing treaty changes before all EU countries could take months—that seems to be unlikely. The United Kingdom has already signaled that they would probably exercise a veto.
As an aside, obstructionist tactics by the UK seem to only serve in getting the UK to have some relevance in the debate since they are not part of the eurozone. They are accustomed to having a more prominent role on the world stage, so having a marginalized role in the crisis is bothersome for them.
Other potential solutions to the crisis—the United States could perform a rescue, or Germany and France on their own could probably perform a rescue. The citizenry in all of these countries would probably revolt. And, as we have seen with Greece, a bailout does not get to the root of the problem.
The solution that seems to have the greatest likelihood of success is one involves treaty changes at the eurozone level that force fiscal discipline on the eurozone. It would then be much easier to attract investment. While this will eat into national sovereignty and may not be entirely popular at the present time, the upside potential is significant.
Swallowing the pill now may just make the EU, particularly the eurozone countries, a formidable powerhouse in the future. Germany is leading the way, an irony that is surely not lost on the rest of Europe, particularly the UK—but that’s a topic for another blog.
Acting for the greater good is what is really at play here. Let’s all hope, that goes for everyone worldwide, that Europe sees it that way.