The Perverse Side Effect of the Euro

Having due respect for the origins of democracy in ancient Athens, I suppose we shouldn't grumble that the prime minister of Greece had proposed asking the people what they think of the latest European bailout for their country. That private bank debt lenders in other countries voluntarily agreed to take a 50 percent haircut to help them out seems not to inspire majority feeling in Greece.

The prime minister eventually backed down on the referendum, but still it is galling for the leaders of the eurozone countries. They have risked their own political fortunes in putting together the cash to fling another rope to indebted Greece, hanging by its fingernails on the precipice of default. If the referendum vote had occurred and voters rejected the rescue effort, Greece would be bankrupt. And not only that. Like Alpine climbers roped together, a plunge into the void by the Greeks risks taking others down with them. Observe too the falling body of former New Jersey Gov. Jon Corzine, whose MF Global is now bankrupt thanks to the $6 billion gamble he took on European sovereign debt, which had plunged in price. Many banks in Europe are similarly in hock to shaky sovereign debtors and vulnerable to collapsing bond prices.

[See a collection of political cartoons on the economy.]

The eurozone itself, launched on Jan. 1, 1999, had nobler goals as the child of the determination of continental Europe that never again would it descend into the total wars that had traumatized Europe in the 20th century. Half a century of peace and prosperity in freedom ensued as the nations built a European political and customs union. They have taken big strides toward Winston Churchill's dreams of a United States of Europe comparable to the United States of America. But a currency union, born of the mantra "one market, one money," seems to be proving a bridge too far. A currency union is tough to maintain without a union of fiscal and economic policies on a continent that, to this day, is made up of separate nations of hearts and minds. As well as having a common language, culture, and identity, America is a fiscal union with high, though imperfect, mobility of labor and capital.

The Europeans were not blind to the fact that their economies were more divergent than the economies of the American states. The hope was that weaker economies such as Greece, but also the four other PIIGS (Portugal, Italy, Ireland, and Spain) would be pulled along by members that enjoyed stronger economic growth, mainly Germany, France, the Netherlands, and Belgium.

It hasn't happened. Hence, today, the European Monetary Union (EMU) is facing an unprecedented financial crisis and a shattering of the confidence needed to sustain its financial system. The PIIGS went their own way, with property speculation taking its toll in Ireland and Spain, Italy suffering turmoil in government, and economic development lagging in Portugal. Throughout the continent there is a vast public sector of payments and pensions to civil service workers. Many of the recipients of government largesse fail to pay their taxes, so the indulgent countries have to borrow from abroad and borrow and borrow and then beg and beg and beg for bailouts. These days, their creditors are deciding that many of these borrowers are no longer creditworthy and are cutting them off, leading to recessions, bigger fiscal deficits, and growing financial instability. This is especially marked in banking, where losses on private and sovereign debt mirror the losses of those who loaned money to them. The economies of the debtor countries have been kept alive by an underreported bond bubble in government debt, which is now on the verge of bursting, threatening recessions far deeper than anything they have known in decades.

[See a collection of political cartoons on the Euro Crisis.]

We are witnessing the perverse side effect of the single currency, the euro, in the context that Europe's fiscal policies were left completely uncoordinated. As the Economist has noted, when the exchange rate risk was eliminated, this unleashed cross-border lending, which built up large exposures among the banks and the lending countries. Simultaneously, the debt has piled up on the borrowing countries. For all the countries of the Organization for Economic Co-operation and Development, general government debt as a share of GDP, having taken 15 years to go from 63 percent to 73 percent when the recession began in 2007, has now soared to about 105 percent. As the CEO of TD Bank, Ed Clark, put it recently of political leaders, "Many formed their views and values during the Age of Aquarius, but struggle to apply them in the Age of Austerity," as promises made around healthcare, pensions, and support systems that once seemed affordable now cannot be kept. And papering this over with more debt is no longer possible. Once the credit machine goes into reverse, the underlying weaknesses in these economies are exposed and threaten a downward spiral.