Europe stands on the edge of an abyss, its most dangerous financial crisis since the 1930s. Greece, Spain, and Italy are the closest to tumbling over, but all the others in the eurozone are roped together like Alpine climbers, the fall of one threatening to bring down the rest. And the drag on the rest of the world, very much including the United States, would be calamitous. Say au revoir to our faltering recovery.
The facts of the eurozone showdown are brutally simple. Growth is stalled, even in the most successful member, Germany, and in many countries it is contracting. Unemployment is high and soaring; today Spain's unemployment rate is some 24 percent. Banks are collapsing, and over-indebted governments are running out of both money and credit.
The agreement of a number of countries in 1999 to create a single legal currency, the euro, was the most ambitious project of the European Union of 27 nations. The nations embracing the euro saw it as a way to free trade, travel, and labor mobility. The eurozone made a dazzling debut and now includes 17 nations. Money poured into Spain, Greece, Portugal, and Italy. The common conviction was that by having a single currency, the nations of the eurozone would somehow converge—that the spendthrift Greeks, Spaniards, and Italians would become parsimonious, disciplined Germans. This basic assumption that all countries were henceforth equally creditworthy was proved an illusion by the financial crisis of 2008. After 2008, capital flows suddenly stopped in the very nations that had boomed before. They then had to rely on their own devices without the ability to devalue their currency. The internal economics of these various European countries were thus starkly revealed. Germany's unit labor cost over the period of the last decade has declined by 3 percent. In contrast, the unit labor cost in France, Greece, and Spain went up by over 20 percent, and in Italy it rose by over 40 percent. Labor markets remained more national than continental, making them responsive to powerful unions and inefficient working and wage-setting systems that allowed labor costs to soar. What this means is that products from these countries cannot be made competitive, since the countries now lack their former ability to lower the price of their exports by devaluing their drachmas, pesetas, and liras. If each had a variable currency instead of sharing a single currency, they would have to decline their currencies dramatically in order to restore the competitiveness of their home products. Currency declines would then have been on the order of as little as 10 percent and as much as over 20 percent.
The structure erected in 1999 stopped short of a fiscal union; it was rather like building a fine house but neglecting to add a roof for stormy weather. The fundamental flaw of the EU was to pursue a monetary union without a fiscal, economic, or political one. Member nations would agree on common interest rates and inflation targets, but would still decide individually how much to tax their citizens, what welfare and pension benefits they would pay, and what their employment policies would be. Today a German worker retires five years later than a Greek, so Germans ask why they should be paying part of their hard-earned incomes so Greeks can work less. No wonder most Germans fiercely oppose bailing out Greece. Meanwhile, the French do not agree to scrap the EU's generous farm subsidies. What they do have in common is a reluctance to accept high taxes as the price they must pay for cradle-to-grave welfare services. They like their holidays and their lengthy lunch breaks, but unlike the United States, they do not identify with the political construct that has been created in their name, namely the European Common Market (ECM).
The consequent financial insolvency, economic fragility, and political instability is reflected in the fact that seven European leaders of ruling parties have already been forced out of office because the one-size-fits-all austerity measures to meet national debt payments have been deeply unpopular. Spain has had its demonstrations, but not to compare with the violence in Greece. The deputy prime minister, Soraya Sáenz—dubbed the most powerful woman in Spain—told Reuters: "It is not possible to explain to citizens that what they save through austerity will then be spent on higher debt interest payments."
Greece and Italy face critical barriers to any sane restructuring of either their sovereign debt or their illiquid, over-extended banks, caught by the bursting of the property bubble (just like in the United States). A few days ago, the third biggest bank in Spain revealed that there was a $23 billion hole in its accounts. The national government, as in Italy and Greece, is too weak to provide sufficient guarantees to liquefy its over-extended banking system. Italy has huge amounts of debt to refinance this year. France and other triple-A countries may be downgraded. The European banks are increasingly fragile. An incipient and deepening recession is making everything much harder. A Greek exit from the common market might trigger a chain reaction of bank runs and soaring interest rates on government bonds of weaker countries that would threaten the viability of the entire eurozone.
The leaders badly need to restore confidence so as to avert bank runs and a flight of deposits to havens seen as safer. It has reached the point that investors seem ready to pay German banks just to hold their money without paying any interest. It's fair to say that, in varying degrees, the national leaders have all woken up to want to move rapidly away from the void. But they need time. The immediate question is whether or not continued quantitative easing in the form of bond purchases by the European Central Bank (ECB) can provide enough liquidity to restrain open market interest rates—already edging to 7 percent—so that there's time for the changes in badly skewed labor and competition laws to restore competitiveness and reduce debt burdens. Spain, for instance, has raised its exports by 27 percent over three years, making it the top performer in Europe. But time is now what the paymasters—Germany and the ECB—have been most uneager to offer. The much-bruited firewall of $500 billion sounds a lot, but the best opinion in Europe is that something like $2 trillion is required for stability and confidence. There is mounting national resentment throughout the eurozone that Germany is resistant to invest in time. Chancellor Angela Merkel and the German Bundesbank are freely referred to as the Taliban. The European dream is literally on the verge of collapsing.
The crunch comes first in Greece, where there are national elections on June 17. A new Greek government will undoubtedly seek to renegotiate the terms of its debt. If Germany and France say they won't agree, the Greek government will have to be defaulted, raising the risk of financial contagion spreading to other countries. That is why everybody fears a banking collapse. The key for Greece to stay in the ECM is bank liquidity, and the Greeks say it is up to the Germans to provide it, or otherwise a Greek collapse will ensue and damage Germany too. Some now believe that the cost of the default of the Greek and Spanish banks would run in excess of a trillion euros. It is the evil of two lessers; they face a huge cost to save the banks and an even larger cost if they default.
Germany wants Greece to stay in the eurozone but it seeks to enforce an internal devaluation through reductions in Greek wages and benefits. The Germans want these other governments to cut spending more, means-test entitlements, increase taxes (especially a sales tax), and raise the retirement age. But this is difficult for democratically elected leaders. For example, labor costs in Spain are still rising although almost one in four workers do not have jobs. How deep would unemployment have to be for wages to start to fall? It would amount to a cut in the average Greek family's standard of living by 20 percent or more. That severe a shock is probably beyond the democratic limits as to how far any individual government can go without a political upheaval of unpredictable consequences. Nobody in Europe easily forgets what rose on the ashes of the Weimar Republic.
The challenge then is how to save the euro and limit contagion spreading from Greek defaults without seeding turmoil and revolution. Greece has such a small economy that the eurozone might just be about able to survive. But Spain is the fourth largest economy. A default would threaten the whole European Union. The public equity markets are not open to the Spanish banks, since they are faced with a huge collapse of residential real estate on which they have hundreds of millions in loans. The government has stepped in and effectively nationalized Bankia, one of the country's biggest lenders. Spain's proposal ultimately used the European Central Bank as the supplier of cash; it was subsequently rejected by the ECB. There are no buyers for Spain's sovereign debt. In fact, all the banks in the eurozone are too highly leveraged. Their average of bank leverage, the ratio of debt to equity, is 22 times, compared to the United States, where the leverage is down to about 10.4 times, given that the U.S. banks have been able to raise over $200 billion of equity in the public equity markets.
Is there enough political commitment to keep the eurozone together? Pessimism is growing. As one commentator put it, "The idea that a political unity could arise among geographically contiguous people handling the same coins is akin to believing that two proximate strangers can be joyfully married merely by sharing a checking account."
The most surprising result is that the EU has failed to convince voters in most of Europe that it brings added value. In recent opinion polls, fewer than half of the respondents in the eurozone said they thought membership in the union was a good thing. Most Europeans have little idea of what the EU stands for, what binds its peoples together, and where it is going. Unlike the United States, it still has no common narrative, no common culture or language, and its people do not identify with the political construct that has been created in their name. No country will send its sons and daughters to fight for European values. As Timothy Garton Ash wrote, "Europeans today are not called upon to die for Europe. Most of us are not even called upon to live for Europe." It is a European Union without Europeans.
The ECB is cast as the chief villain but it is also the only potential savior. It well knows what would follow the liquidation of many of Europe's top banks. A bailout would cost taxpayers hundreds of billions of euros. So far the ECB has refused to step in as a lender of last resort to strapped governments, in part because political leaders have not agreed even on basic moves for a more cohesive eurozone structure. Yet the economies of the southern European countries are in such disastrous straits it is hard to see how any of them can grow their way out of their deficits. The alternative notion that the ECB could keep printing money, lending it to weak Mediterranean banks so they can buy the bonds to shore up weak Mediterranean governments, has been demonstrated to be a fantasy. The strategy of lending ever more money to countries that have exhausted market sources of credit, and saddling them with severe fiscal austerity programs on top of it all, has proven to be a failure.
With time running out before panic widens, no one has yet figured out how they can recapitalize the overburdened banks so that they can at least absorb the losses in their bond portfolios and retain the confidence of their customers, investors, counterparties, and the regulators. The EU bureaucracy cannot do it. It lacks the necessary legitimacy to impose solutions. It has amassed extraordinary powers, but mostly without consulting the people. Neither the European Commission nor its president is directly elected and they cannot be directly voted out. Perhaps the impossible challenge is the Spanish bailout, given the almost unresolvable crisis of redressing a 9 percent of GDP fiscal deficit with 0 percent nominal growth in the economy and a 6.4 percent rate of interest. Without the support of the ECB, the country will face even higher rates to meet its incredible funding needs.
Is this conclusive evidence that the euro is a failed experiment?
The only hope therefore remains massive quantitative easing in the form of bond purchases by the ECB (which represents all the central banks of the eurozone). Only the ECB has the financial resources that can save the financial system of Europe from the punishing bond market and the potential breakdown of confidence. This is a mechanism to provide liquidity and bring down interest rates. It would give time to restructure the absolute debt burdens of the banks and reduce them, and thus bring about a recapitalization. The bank is wary of acting as a lender of last resort for fear this will ease the pressure on debtor countries to embrace the necessary reforms. It also wants to see agreement on some new fiscal mechanism to impose fiscal responsibility and avoid the sovereign debt risk. The ECB president, Mario Draghi, spelled out the urgency in Brussels. The leaders must move quickly to dispel doubts about the currency's future because the bank could not fill the policy vacuum.
The prospect of an exit by countries on the danger list may look less scary for domestic tranquility than the ECB/German conditions. Nobody knows how such a departure would unfold. But the risks are beyond measure and unpredictable. The only predictable thing is that everything is unpredictable. If there was a full breakup of the eurozone, you could have the imposition of (illegal) exchange controls, runs on the banks, legal uncertainties, asset price collapses, unpredictable shifts on balance sheets, freezing up of the financial system, the collapse of spending and trade, and dramatic shifts in the exchange rate of the new currencies that may emerge. No good choices exist. The great achievement of the European Union would be cast into legal and political limbo. Once investors realize that countries could leave the euro, interest rates would soar on the next most likely candidate and there would be a huge capital flight out of other countries, especially from the peripheral countries and into Germany, as savers try to protect the euro from potential devaluation. Banks in a number of these countries could collapse as companies abruptly lose access to funds.
The question is who will blink first. Will the ECB shrink—as it should—from seeing the euro die and risk the unpredictable consequences to teach a lesson? Hardly a prudent policy. Will the vulnerable governments accept rigorous structural reforms in exchange for greater transfers from Europe's federal level of funding to cushion their austerity? Will citizens, hit hard in their living standards, risk law and order and turn to those promising to take radical steps if power is put into their hands, be they from the left or the right?
Of course these questions go beyond the Greeks. If the euro dies, who did it? One commentator put his finger on it: It is like Agatha Christie's Murder on the Orient Express. Hercule Poirot is initially confused by the fact that everyone has both motive and opportunity until he realizes that everyone participated in the murder.