The Perverse Side Effect of the Euro

By Mortimer B. Zuckerman

 

We may be looking at the possibility of a worldwide financial meltdown

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.

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.

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 Economisthas 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.

Ironically, the euro now impedes the ability of member nations to get back on their feet. Previously when European nations lost competitiveness, they let their currency depreciate, making their exports cheaper and their imports more expensive. Locked in the euro, they cannot do that. They can only hope to revive their competitiveness and establish a fiscal balance by reducing costs through cutting domestic pay and benefits.

And many European countries neither have the will nor are able to accept the economic disciplines that once were imposed in the currency market. As Greece looked as if it was in a fiscal death spiral, with a budget deficit over twice as much as reported by the old government, the financial world came to fear a default, which in turn caused interest rates to soar. Greek bond spreads blew out from about 1 percent to 10 percent above German bonds. The fear of an incipient contagion effect began to grow in the form of copycat crises in Portugal, Spain, and Italy that would undoubtedly lead to a disastrous European financial crisis. Witness that the cost of Italy's borrowing has now shot up to a record 6.33 percent for 10-year bonds.

European countries no longer have central banks to back their sovereign bonds. The European Central Bank (ECB) is now the lender of last resort to various banking systems in the eurozone. Previously it had treated all sovereign debt equally, permitting banks to turn government bonds from across the eurozone into cash at the ECB. But this encouraged excessive borrowing and allowed banks to rely on short-term funding to an extent now proving to be financially disastrous. The fear of a self-fulfilling panic over defaults has shattered the idea that all euro area sovereign debt is equally risk-free. This at a time when Greece and other European governments and banks seek hundreds of billions of dollars of fresh capital. The dilemma is that without growth, the current austerity programs shrink tax revenues in both debtor and creditor countries. The trap is that fiscal stimuli to improve national economies could result in more debt and much higher interest rates that would further exacerbate their deficits.

After the last crisis, authorities set up the European Financial Stability Facility (EFSF), their version of a common treasury, as a lower-cost fundraising mechanism for cash-starved banks and countries. Unfortunately, as George Soros has pointed out in the New York Review of Books, it was not sufficiently capitalized to provide a safety net for the eurozone as a whole beyond the rescue packages for three small countries (Greece, Portugal, and Ireland) and lacks the capacity to support the multitrillion-euro deficits of larger economies like Spain and Italy. These larger countries are burdened by large welfare programs and the ensuing deficits that can no longer be financed. They are faced with a growing inability to pay off sovereign public debt and other private debt without the subsidized interest rates extended to Greece. In response, the EMU intends to expand the funding capacity of the EFSF by flirting with cash-rich China and by allowing its core capital to be leveraged by up to several times the current level of €440 billion ($605 billion). Now Germany, the main force behind the debt bailouts, faces a public that resents the cost and refuses to transfer German wealth to these other countries beyond previous agreements.

The only issue now is where will the next bubble pop among the countries that massively overextended themselves during the boom years. If the credit risks on the balance sheets of banks morph into sovereign default risks, Europe will face massive currency depreciation and huge haircuts for banks that own the problematic government bonds. Nor do the debtor countries have the option of resorting to an increase in the money supply as a way of diluting the value of their outstanding obligations through inflation, the traditional fallback position for many countries, for the euro can only be printed by the ECB.

As a result, the once unthinkable option of default on external obligations is now a shadow on people's minds in debtor countries. Defaults would save a huge proportion of yearly budget deficits consumed by soaring interest payments; public sector wages and other politically popular spending programs would be less vulnerable. But it's been unthinkable because the blow to confidence and trade would be enormous. Europe would be set back 20 years and the contagion would not be confined to Europe. We would be looking at the possibility of a worldwide financial meltdown. Who would step in if a major financial institution fails? This all comes at a time when a weakened American economy is particularly vulnerable to a major downturn in Europe; it might well push the United States back into a recession.