Fasten your seat belts. The financial crisis in Europe, going from one cliffhanger to another, is vitally important for us. Most Americans are not aware of how significant it would be if there were a breakup of the European currency, the euro, common to 17 countries. The European Union, as a whole, is the world's largest economy. A collapse of the eurozone would bring with it a cascade of bank failures, popular panic, mass unemployment, and a financial crunch that by some estimates could produce a 25 percent decline in Europe's GDP. In effect, it would be a modern version of the Great Depression that would threaten the global financial system.
The origins of the crisis are clear enough—clearer than the path to salvation. Europe simply followed the United States in over-leveraging. A decade of low interest rates, easy credit, and a binge of cross-border lending supposedly overseen by the European Central Bank fueled the accumulation of debt in households and a property boom in various countries. That bubble has now burst. The result has been a series of frighteners and the risk of unnegotiated currency defaults. The crisis began with the small economy of Greece but now menaces Portugal, Spain, Ireland, and especially Italy, the world's eighth largest economy and the third largest bond market. Nothing can change the fact that Italy has a $2.6 trillion sovereign debt. Much of it will have to be rolled over in the short term, including $54 billion in February 2012 alone, according to Goldman Sachs. If their holdings of government bonds were to be "marked to market," that is to say, valued at their current rock-bottom prices, many European banks are effectively insolvent. And they cannot look to the credit default swaps, which they bought as insurance against such a default, for they are probably not worth the paper they were written on.
Everybody has underestimated the extent of the problem, just as we in the United States underestimated the mortgage crisis. The Federal Reserve estimated that it would cost $150 billion; it ended up costing in the range of $3 trillion.
When you put together fiscal austerity, financing contraction, and a major recession, you can understand the growing fear that these governments will be unable to repay their debts. No wonder Moody's has warned of the risks of "multiple defaults" by euro-area countries. A series of defaults "would also significantly increase the likelihood of one or more members not simply defaulting, but also leaving the euro area." And now the countries under threat are engaged in austerity programs that have deepened their recessions and made it even harder to service their debts.
Everyone is caught up in trying to avoid the downward spiral of stunted growth, hence falling revenues, and a breakdown of confidence that has increased interest rates and makes default ever more likely. Especially unnerving was the poor auction of German bonds and the fact that in other countries bond yields soared above the critical 7 percent that very well might push other governments into default.
On top of the sovereign debt problem, there is a contraction of private balance sheets. Non-financial corporate and household debt in the eurozone now equals about 165 percent of GDP, roughly 25 percentage points above the U.S. peak and far above what a stagnant or declining economy can service in the context of high unemployment, high rates of idle capacity, and banks unwilling to provide new financing to households or firms with unexpected cash needs.
Germany is the key. Too hard a line by Germany could tumble all the dominoes. The first signal was when Germany was able to force the write-down of half of the privately owned Greek debt so that those investors would have to share in the losses. The result was that interest rates surged to levels unsupportable by various governments such as Italy and Spain.
At the same time, Germany needs to keep up the pressure for reform so that euro governments accept limits on their expenditures. German taxpayers will not be landed with the bill every time some EU country goes on a spending spree. Even mighty Germany cannot stand alone and support the eurozone. With a population of about 80 million and a GDP of $3.5 trillion, it is efficient. But the eurozone has a combined population of about 330 million and a more than $12 trillion economy. It is impossible to imagine that Germany could or would bail out the rest of the euro area.
European politicians understand they must either tie their economies more closely together and restrain their deficits or cope with the consequences of a breakup. European unity has been central to Europe's post-Cold War unification, peace, and prosperity. But everybody knows how complicated it will be for 17 European governments to yield some of their sovereign power over spending and taxes to a central authority responsible for all individual government debt. It would be hard enough if they had stable demographics, but they don't. On top of the financial crisis, welfare state spending in Europe will accelerate, given the aging of the population. Even Germany has to confront the reality of funding staggering welfare costs; currently they are completely unfunded given its pay-as-you-go system. But without a resolution of this fundamental long-term problem, the short-term fixes might fail and the eurozone crisis will continue or erupt again.
We too face a similar problem. The 79 million baby boomers who are beginning to retire and will continue to retire over the next several decades will result in huge Medicare and Social Security payments, which in turn will drive a huge increase in our deficit and the accompanying interest costs to finance it.
The best answer for all of these countries, including the United States, is to grow their economies. In Europe as in the United States, this means improving competitiveness by streamlining the public sector and overhauling the rigidities in their markets for labor and services, every one of which is protected by powerful domestic special interest groups. But if they or we avoid the hard choices to reduce debts and get deficits under control, the adjustments will be forced upon all by the bond market, which means a deeper recession and higher unemployment. We all have to find a way to control the deficits and at the same time not cripple growth. Or at some not so distant date we will face an even larger economic crisis and even higher unemployment—with all that means for social unrest.
Even so, it is hard to see how the eurozone can avoid a major recession. It is unable to devalue its currency and, short of major financial underpinning, it will have to control deficits by reduced spending and higher taxes, entering the vicious circle of low growth, low tax revenues, and higher deficits. Failure can only mean reopening the issue of whether it should go on trying to save the euro or revert back to individual currencies. It would certainly reduce trade, but countries might choose to exercise their sovereignty and pursue their national economic interests.
Why should the United States care? Europe may very well be a test case. We too need foreign investors to finance our debt, for about half of the debt we have in public hands is held by foreigners. If we start to inflate or depreciate the real value of the debt, this will provoke foreign investors to demand compensation for that risk in the form of higher rates when the debt rolls over. We too have to avoid the death spiral of growing debt service.
At least we have a national government, a national economy, and a central bank that can act. In Europe, these types of issues are hostage to the attitudes of 17 separate national parliaments, making a resolution ever more difficult. Even the solvent countries have lost the confidence of bond investors, so these countries may also have little latitude to reflate and inflate their way out of this crisis. Nor can they easily expand the liquidity of the European Central Bank through its power to print money, for at this stage it would violate previous agreements and probably lose the support of Germany and the other countries that have remained solvent. Germany will have a particular aversion to this, for it raises the specter that expanding the money supply will stoke inflation: a nightmare of the Weimar Republic that Germany is determined not to live through again.
Europe may well be on the verge of social disorder. Just think, there are new governments already in Ireland, Spain, Portugal, Slovakia, Greece, and Italy. This is going to be a very bumpy ride. Nobody will escape the consequences.
- See a slide show of Mort Zuckerman's 5 Ways to Create More Jobs.
- Read the U.S. News debate on who is handling its debt crisis better--United States or Europe.
- See a collection of political cartoons on the budget and deficit