The EuroCrisis: An American View

I know many of you have been asking yourselves, what does Frank think of all this crisis stuff going on in Europe?Train_wreck_at_Montparnasse_1895_2 Is he worried about it? Should I be?

The trouble in Europe has been going on for rather a while now, arguably since the financial crisis began in 2008, although it took a while for everybody to really notice. So quite a lot has already been written and said about it. If you have not been paying close attention, then 1) good for you and 2) maybe my comments will help fill you in.

It is really a pair of twin interrelated crises on the very slow burn in Europe. There is a banking crisis. And there is a sovereign debt crisis.

The European bank problems are similar to the ones we had on this side of the Atlantic. Indeed, in as much as European banks bought surprisingly large amounts of American mortgage backed securities, it is the exact same problem. But European banks, particularly Spanish and Irish ones, also lent heavily into their very own hometown real estate bubbles.

That was bad enough, but the banks also lent to European governments. Enter the less understandable to Americans of the twins, the sovereign debt crisis. Four European governments (Greece, Italy, Ireland, and Portugal) owe more than the equivalent of 100% of GDP. Greece owes 153%.

Thing is, Uncle Sam is in the 100% club too. But debt ceiling histrionics and debt rating downgrades aside, we do not have a sovereign debt crisis over here. On the contrary, rich Chinese, panicked Europeans, and just about everybody else have been eagerly loaning the US Government money, driving rates down to the point where they are very nearly paying for the privilege.

There are several key differences. Believe it or not, the US economy is stronger and richer. And, believe it or not, US politicians are comparatively understanding and respectful of the markets. Europe has a few elected officials who openly advocate not paying some of the sovereign debt back. Bring up the idea of a US default with any American politician and you will get a reaction as if you had suggested that the Statue of Liberty be dynamited. (Of course, the American politician may point out that blowing up Lady Liberty is exactly what his opponent wants to do.)

But the biggest difference is structural. Our government owes dollars. In the worst case scenario, it can pay what it owes by simply printing more dollars. Not so the indebted members of the Eurozone, the subset of the European Union that uses the Euro as currency. (It is most of the EU, less the UK, Sweden, and several ex-communist states on the eastern edge.)

Greece (and Italy, Portugal, and the others) owe what might as well be a foreign currency. They cannot print more Euros to satisfy their debts and they cannot devalue the size of the debts down. That may not sound like a big problem, but that the US Government could do those things if it really needed to is what makes US debt “risk-free.”

In better times, the inability of countries like Greece to weasel out of their problems by printing money seemed like a good thing. It served as sort of a guarantee that an investor would actually get paid back in currency units that were worth something. Some investors might even have imagined that it would impose some kind of discipline on governments.

Of course, these are not better times, and the inability of Eurozone governments to control the currency they borrowed in now looks like a missing safety valve. Instead of worrying about being paid back in less valuable currency units, investors are now worrying about not being paid back at all.

Weirdly, the idea that the debt of certain Mediterranean governments is not even approximately risk-free was apparently a revelation to many. From the introduction of the Euro in 1999 until 2008 the interest rates paid on the bonds of the various Eurozone  governments was very nearly identical. In hindsight, that seems like it must have been the result of some form of mass hypnosis.

Euro Rates - Spitzl

 

Certainly, some convergence in interest rates made sense, as inflation expectations for such things as the Italian Lire and Greek Drachma were removed. But the fact that the Euro coin had another side, that governments were now borrowing in a currency they might have trouble paying back, seemed not to occur to very many people.

Which brings us to Greece. The first thing to know about Greece is that it always was a marginal, if not exceptional, case. It was late to the party, joining the Euro in 2001 because it failed to get its financial house in order in time for the 1999 launch. (It is not clear it was really any better two years later.) Greece is comparatively small and poor, accounting for less than 2% of EU GDP. Its GDP is less than that of Denmark, with twice the population. And it lacks a strong tradition of political stability. It was ruled by a military junta as late as 1974. It did not share a land border with any other EU member until Bulgaria joined in 2007.

So why all the fuss over such a peripheral European player?  Because Greece is the canary in the coal mine. Of course it would be the first to get into trouble and be the one in more trouble than the others. All the more reason for the other Eurozone governments to find some kind of non-disaster resolution to its problems. Because if Greece can be saved, then Italy, Spain, France, and the others must be safe.

Alas, the saving Greece thing has not been going as well as might have been hoped. The core of the problem is that the Eurozone (and the EU) is an airplane being designed and built in mid-air. Entire areas of its operation, where a tidy person like myself would expect to see agreements and rules, are covered only by good intentions and vague principles.

One of those vague principles is the idea that European governments are in some way responsible fiscally for each other, both in the sense that they backstop each other’s debt and that they police each other’s behavior. This is a (partial) explanation of the convergence of interest rates in the good old days.

I have to say this is something I do not quite get. This is likely because I cannot get away from the American analogy that portrays the EU members as American states. It would never occur to me that other states, or the Federal Government, would cover the debts of an insolvent state. If Massachusetts declared bankruptcy the first reaction of the governors of Rhode Island and New Hampshire would be to look for jobs they could poach.

(Interestingly, in the aftermath of the panic of 1837, in which about half the US states defaulted or stopped making payments on their debt, the mostly European owners of that debt were outraged that neither the other solvent states nor the Federal Government would do anything about it.)

But while an American would expect the rest of Europe to let Greece go under, write off its debt and attempt to start over, it is not apparent that this even occurred as an option to political leaders in Europe. To most European politicians, allowing Greece to fail would be a collective failure for Europe and a serious blow to the grand project of European integration.

So there is plenty of motivation for the leadership of the rest of Europe to bail Greece out. Saving Greece would increase confidence in the not-quite-as-bad countries such as Italy and Portugal. Saving Greece would keep European integration humming along and save the Eurozone. And saving Greece ought not to be too expensive, given the comparatively small size of the place.

As the largest, healthiest, and most creditworthy of the Eurozone members, the lead savior-designate for Greece is Germany. And I believe that if left to themselves, the leaders of Germany and Greece could quietly come up with a deal. Inconveniently, leaders of both countries are democratically elected and must be able to justify any deal to their respective electorates.

And it is there that it all starts to unravel. It is not clear that there exists any possible arrangement to bail out Greece that would be acceptable to the majority of both Greeks and Germans. Greece just elected a new government that ran for office supporting the previously agreed pacts, provided they were substantially re-negotiated in Greece’s favor. It narrowly beat an opposition that wanted to just junk the whole thing.

It is not hard to see why the current terms of the bailout are objectionable to the Greek-in-the-street. Among other things, it calls for the government to lay off 150,000 employees this year. In a country of 11 million people. That is as if the US Government agreed to give the pink slip to more than 4 million workers. The Greek economy is already in tatters, with unemployment at 22% and GDP expected to shrink by 7% in 2012. And ordinary Greeks do not feel particularly responsible for the debts run up by their opaque and patronage-driven government.

But that deal may be as generous as the Germans are willing to be. To the German-in-the-street, much less enamored of the Great European Project than their leaders, German ants bailing our Greek grasshoppers does not seem like a bright idea. Why should the Germans, after decades of hard work and responsible fiscal behavior, pay off the debts of the decadent Greeks who essentially ran up the national credit card until it was maxed out and they could not cover the monthly payment?

So what happens now? Nobody knows, but it seems to me that the odds-on favorite is that Greece and Europe will continue stumbling along on the path they have been following for the past two or three years. Which is to say that surprisingly little will happen. Short term deadlines will be met at the last moment with adequate half-measures, compromises, and band-aid solutions. Big picture problems will not be addressed, because solutions of that scale would require the consensus agreement of too many governments.

As discouraging as that might sound, more dramatic and worse outcomes are easy to imagine. The bad outcome that the European press threatens us with is that “Greece will leave the Euro.” That makes it sound like the event would be a thoughtful, if grave, government action.

It seems to me that if things go badly, it will not be driven by the decisions of elected officials or bureaucrats. Events will run out of their control and things will just happen, possibly literally overnight. There will be a run on the Greek banks, causing them to collapse. Or Greek government workers will strike and riot until the austerity deal is impossible to implement. Or, more likely, some other series of events not presently foreseeable will bring the whole fragile thing down.

What happens post-Greek-Disaster is also not as predictable as the press might lead you to believe. It is often assumed that the Greek Drachma would reappear, that is, that Greece would stop using the Euro and go back to a locally printed and controlled currency. That is possible, but I think it is less likely that not, for the simple reason that nobody, not even a Greek government worker, would accept a Drachma in payment for anything.

More likely, the Greeks would continue to use the Euro. Their government would just repudiate, de facto if not officially, their debt. The Greek budget is currently within striking distance of primary balance, which is to say that with some effort it could cover its bills, if it were not for the crushing interest payments.

What this would mean for the rest of Europe is anybody’s guess, but it will not be good. At least not short term. If you were really optimistic you might hope that it would galvanize the political leaders into taking the hard and unpopular decisions necessary to create a credible and durable EU and Euro. I am not an optimist.

And what would it mean for us Americans? On balance, the European Crises are not good things for us, and their likely unhappy endings even worse. But the expected impact on this side of the pond should not exaggerated either.

Yes, it is one big global economy, so what happens over there will matter over here. But by the same token, there is a lot of the world that is not the EU. It accounts for only 18% of our exports. And there are some positive side effects. Low demand in Europe, and expectations of future low demand, is helping to keep oil prices down. Our interest rates have been as low as they have been without inflation partially because of European investors feeling a special urgency to get their money out of Europe and Euros.

Also, a collapsing Euro means the US dollar will buy a lot in continental Europe. Might be a good time to visit. They have nice old buildings to look at and cafes to sit in. And the Cokes are made with real sugar. Some of their exports might also become cheaper, but I would not hold my breath on BMWs and Mercedes.

In sum, Europe really is just as messed up as you assumed. This is, I believe, the all-time longest BMA post and I have hardly scratched the surface. The bottom line is that while nobody knows what will happen, it does not look like it will be good. Be thankful you are American. Or better yet, Canadian.

No Comments

  • By Patrick, June 28, 2012 @ 12:47 pm

    Fantastic article, Frank. This almost could have come straight from The Economist.

  • By jim, June 28, 2012 @ 2:20 pm

    The whole thing fells to me like if Alabama was single handedly ruining the US economy.

    Its frustrating to see the US markets drop 1% because the headlines say that we’re worried about Greek debt. Particularly since 1% drop in US markets is about $250B total and Greek debt is maybe $380B range. I’d almost rather we just pay their debt and stop worrying about it. Course I don’t really want to pay Greece’s debt any more than the Germans. I’d just like the Euros to figure out their mess finally so that our markets can stop worrying unnecessarily about it.

    The Eurozone is supposed to have rules about individual government deficit and debt levels but most of hte nations aren’t hitting those goals and I don’t know what the consequences were supposed to be (if any). I remember a bit about Goldman Sachs helping Greece play a shell game with their debt at one point to help deceive the rest of Europe into thinking it wasn’t as bad as it was. Not to blame GS or anything, apparently secretly hiding a nations debt is perfectly legal so good for them. (?)

  • By Devil's Advocate, June 29, 2012 @ 11:22 pm

    Nice article Frank! Very well written as always.

    DA

  • By Craig, July 5, 2012 @ 11:44 am

    Reintroduction of the Drachma would be simpler, I think, than your analysis suggests. The usual formula is that the Greek government announces that taxes are payable in New Drachma, so there’s plenty of demand for them right there. Everyone who can will hoard Euros, sure, but bad money drives out good, and Drachmas will be circulating everywhere within days. Government workers and pensioners will be very angry, but given the choice between Drachmas and nothing, my guess is they will take Drachmas. Could be wrong on that score; freely admit it. They do love a good riot in Athens.

    But that said, I think your prediction is most sound: that Greece will starve itself down to primary balance (which has been happening over the last couple of years), restructuring and/or defaulting on debt as needed. The trouble, as you quite correctly point out, is that these people are playing with matches and gasoline here, hoping for a muddle-through but risking outright collapse.

    And even a successful muddling through does nothing to address the problem: that the Euro was a terrible idea. The silent hope here is that they have time to build a United States of Europe before the next big crisis hits. Who’s optimistic?

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