The Coming Euro Crack-Up
A currency divided against itself cannot stand.
May 9, 2011, Vol. 16, No. 32 • By IRWIN M. STELZER
A spectre is haunting Europe—the spectre of the disintegration of the eurozone. All the powers of old Europe have entered into a holy alliance to exorcize this spectre: German chancellor and French president, the Brussels eurocracy and the bonus-laden bankers. Let the ruling classes tremble. The debtors have nothing to lose but their burdens.
So Karl Marx might have written were he watching unfolding events in the eurozone. In a sense, it is like watching a slow-motion train wreck.
A quick review: Some 17 of the 27 nations that constitute the European Union have abandoned their own currencies in favor of the euro. This means they have given up control of their exchange rates and their interest rates, the latter set by the European Central Bank on a one-size-fits-all basis. In fact, it is the state of the German economy, the area’s largest, that dictates interest rate policy for the entire 17-country group. When Germany was suffering under the weight of the costs of reunification, its sluggish economy needed, and got, a low-interest rate policy from the European Central Bank. That eventually proved too stimulative for, say, Ireland, which was in the midst of an inflating property bubble.
The creation of the eurozone also led lenders to assume that the credit of every member was just about as good as the credit of Germany and France. So Greece, Portugal, Spain, and Italy could sell sovereign debt at very low interest rates and use the borrowed money to finance an expansion of their welfare states—Greeks, for instance, could retire at 50 if they were in a hazardous occupation such as hairdressing (all those chemicals). More important, countries like Portugal, with a poorly educated workforce, and Spain, with politically run regional banks making imprudent loans to local property developers, became noncompetitive with their eurozone colleagues and international rivals. No problem: Fiscal policy was not controlled from the center, and investors hadn’t yet realized that lending to the so-called PIGS (Portugal, Ireland, Greece, and Spain) was a hazardous occupation. So the latter could tap the credit markets to fill the gap between tax receipts and spending, and benefit from German-level interest rates.
Then the rating agencies rose from their torpor and downgraded the sovereign debt of Greece, helping to drive interest rates on its government bonds to unsustainable levels. Enter Brussels with a bailout for Greece. And when Ireland’s deficit soared to 32 percent after the government decided to guarantee the debts of its insolvent banks, enter Brussels with a bailout for Ireland. Now Portugal, burdened with an economy that has not grown for a decade, also is rattling its begging bowl, and another bailout is being negotiated with a conclusion along the lines of earlier bailouts imminent, never mind that the previous two have done more harm than an honest confession of insolvency would. If at first you don’t succeed, repeat the mistake.
The main bailer, of course, is Germany, its economy growing smartly on the back of an export boom—it does not make what China makes, but makes what China buys. Chancellor Angela Merkel has two reasons to play Lady Bountiful. The first is her belief, shared by the German elite, that if a euro country declares bankruptcy, the currency will lose credibility and the entire European project will come unhinged. That would leave Germany alone at the top of the European heap, Europe’s most powerful country with its most powerful economy. History makes many Germans less comfortable with a German Europe than with a European Germany.
Second, there is the small matter of the German banking system. The German banks, especially the state-run Landesbanken, are so woefully undercapitalized that some are planning to opt out of the new stress tests because they know they will fail. These banks are sitting on 220 billion euros of sovereign and bank debt of Greece, Portugal, and Spain, and if those IOUs become worthless, the German financial system might come tumbling down or at minimum require a taxpayer bailout. To make matters worse, France sits on another 150 billion euros of this dicey paper.
To the intrinsic flaws in the euro system—a one-size-fits-all interest rate and the inability of the eurozone bureaucracy to control the fiscal policies of members—add the news from tiny, previously europhile Finland. In last month’s election, the anti-euro, anti-bailout True Finn party’s share of votes jumped from 4 percent to 19 percent, and its parliamentary seats from 5 to 39 in a 200-seat parliament, enough to insist on inclusion in a coalition government. Just as the Tea Party sent a message politicians can’t ignore, so the True Finns sent a message to the incoming government that it should think hard before casting a vote—unanimity is required—for the impending Portuguese bailout. As Tony Barber put it in the Financial Times, “Finns are angry because, like the Austrians, Dutch, and Germans, they dislike rushing to the aid of countries that in their eyes have cheated, idled, lied, lived beyond their means, and let reckless bankers run amok.” Finland’s “no” vote is all that is needed to leave Portugal drowning in debt.
All of these bailouts, and those to come, are premised on the notion that the troubled countries are having a liquidity problem, and a bit of cash will enable them to get back on their feet and repay their debts in full and on time. It is now clear that these countries are not merely illiquid but are insolvent, and that they will one way or another have to renege on their debts, at least in part. Unless, of course, Germany agrees to convert the eurozone into what is called a transfer union, in which funds from the rich countries are regularly shipped to the poorer ones. That route seems to be blocked by the unwillingness of German taxpayers to agree to such an arrangement and the German constitution which prohibits it.
The cold facts are these:
• Greece, Ireland, and Portugal are now frozen out of credit markets. The yield on Greek two-year bonds is 24 percent and on both Irish and Portuguese bonds of similar maturity around 12 percent. No country can afford to borrow at those rates. Of interest to the White House and Congress might be the speed with which the markets move: Interest rates charged on Greek debt increased by 10 percentage points in the past month.
• The debt burden on these countries is in excess of the 90 percent of GDP that scholars now agree stifles growth. Portugal’s debt is at 90 percent of its GDP and rising, Greece’s is approaching 150 percent, and “Ireland’s debt now appears to be bigger, in relation to its economy, than the reparations imposed on Germany after the First World War,” according to economist Anatole Kaletsky.
• These economies cannot grow their way out of the problem. The Greek economy shrank at an annual rate of 4.5 percent last year and is forecast to decline this year at 3.2 percent. Portugal’s will shrink at an annual rate of 1.5 percent, guesses the International Monetary Fund. And Ireland, despite a robust export industry and a corporate tax rate of 12.5 percent that, at half the EU average, remains attractive to foreign investment, might eke out growth of 1 percent. No way these growth rates produce enough tax revenues to meet debt obligations.
There’s more, but you get the idea: These countries are bankrupt and will have to default on their debts—“restructure” them, to use the term spoken in polite European circles. Germany’s finance minister Wolfgang Schaüble was among the first to mention the possibility of default, and more recently Clemens Fuest, chair of the German finance ministry’s advisory committee, said a Greek restructuring is not merely possible, it is inevitable. “Most intelligent people know there has to be a significant restructuring to ease the burden on Greece, and we’re not talking about a painless extension of maturities, but wiping away a large portion of the debt,” said Charles Grant, the highly respected director of the Centre for European Reform in London.
Such a default would be no trivial event for creditors: Estimates are that it would take a “haircut”—a write-down—of 40 percent to 70 percent to get debt into repayable territory. José Manuel González-Páramo, a member of the executive board of the European Central Bank, warns, “A restructuring would have legal and systemic consequences that are difficult to calculate right now, but would in all probability be bigger than after the collapse of Lehman Brothers.” And a “messy euro debt implosion . . . not only would . . . hurt the euro, it also has the potential to derail the global recovery,” conclude economists at Fathom Consulting. The more time that passes without a long-term solution, the more likely the consequences of the current mess will go from merely serious to dire.
So much for the least important stuff. The more important question is whether Spain, its economy twice as large as those of Greece, Portugal, and Ireland combined, will be next when the bond vigilantes again saddle up. So far, the contagion has not spread. But Spain has an unemployment rate of over 20 percent (40 percent for young workers) and rising, its regional banks (cajas) have so many IOUs from property developers gone bust that some failed the rather lax first round of stress tests, and Moody’s says the nation’s banks will have to raise as much as 120 billion euros in fresh capital (the government puts the figure at 15 billion euros, despite the fact that Spain’s banks and companies have 70 billion euros invested in Portuguese assets, 7 percent of Spain’s GDP). Throw in forecast growth of “close to zero” according to Citigroup Global Markets and the inability of the central government to persuade the regions to rein in their huge deficits, and it is not inconceivable that Spain will soon need a handout of such size that even the euro-enthusiasts will not be able to come up with the needed cash. “Spain’s room for maneuver is limited,” say the economists at Fathom Consulting.
Spain is only one of the important problems facing Europe. Voters are beginning to ask why they should suffer through painful austerity programs to spare imprudent bankers from the consequences of their foolishness. The Greeks have taken to the streets and are refusing to pay tolls on bridges; the Portuguese parliament refused to agree to an austerity program and the government fell, as did Ireland’s after putting an enormous burden on taxpayers to prevent the failure of its banks; and the Spanish prime minister had to agree to fall on his sword after pushing an austerity program through parliament. More important, Angela Merkel has had to postpone putting up more bailout money because the Bundes-tag is dragging its feet. Meanwhile France’s Nicolas Sarkozy, a proponent of bailouts accompanied by a Brussels seizure of control of a nation’s finances as part of a centralized European “economic government,” has a popularity rating in the low 20s.
This seems to be just one part of the increasing pressure on the entire concept of a united Europe. When Germany refused to go along with Britain and France in attempting to stop the slaughter in Libya, it called into question the concept of a European Common Foreign and Security Policy, notwithstanding the enormous resources being poured into the newly established European External Action Service, a euphemism for a full-fledged foreign service. And when France resurrected border controls and check points to prevent a flood of Tunisian immigrants from Italy, and Italy retaliated by issuing travel documents to some of the 25,000 immigrants who were passing through Italy en route to the EU country thought to have the most generous benefits, it put a serious dent in the concept of the free movement of peoples throughout the EU. Finally, a chasm has opened between the prosperous north and the less-hard-working south; between the 17 EU members that comprise the eurozone on one side and the 10 other EU members who have their own currencies and want no part of the bailouts; within the gang of 17, between Germany and Finland; and between the exporting machine that is Germany and protectionist France.
The vision of a united Europe still has a powerful hold on the elites of Europe, who see the transfer of power from nation-states to an unelected bureaucracy as insurance against future wars and, if truth be told, a relief from democratic pressures. In addition, the prospect of a euro that would replace the dollar as the world’s reserve currency, or at least weaken its role in world trade, has a powerful hold on the French, who make no secret of their antipathy to Anglo-Saxon capitalism.
The “European project” won’t go quietly into the night. But it just might go noisily into the ashcan of history if the Germans decide they cannot convert the Greeks into hard-working, tax-paying euro-citizens worthy of continuing handouts. Or, at minimum, we might end up with a euro-nord and euro-sud, as Martin Feldstein once suggested. Such a distinction, rooted in differences between the stronger and weaker economies and banking sectors, would allow Greece and -others to do what the team of Obama and Bernanke seem to be planning: get rid of all those annoying debts by paying them off in a depreciated currency.
Irwin M. Stelzer is a contributing editor to THE WEEKLY STANDARD, director of economic policy studies at the Hudson Institute, and a columnist for the Sunday Times (London).
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