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Forgive Us Our Debts

Europe runs out of money.

Nov 7, 2011, Vol. 17, No. 08 • By CHRISTOPHER CALDWELL
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London

Cartoon of a euro bill going down the drain

Gary Locke

As they do every few weeks, the leaders of the European Union met in Brussels on Wednesday, October 26, to solve their finance problems once and for all. As the sun rose on Thursday they emerged with a document that resembled an Obama budget—crystal-clear about its aims and aspirations, opaque about how it intends to achieve them. There is a reason for that. It is that these aims and aspirations are growing less and less realistic.

Back in 2010, when the crisis seemed confined to the Greek government’s inability to repay its lenders, the Europeans thought they could fix things by having its various neighbor countries chip in 45 billion euros ($65 billion) to throw at the problem. Eighteen months later, the crisis is as complicated as a Rube Goldberg machine and more dangerous. The particular corner of it they dealt with last week has three intertwined aspects, and to solve one of them is to exacerbate the other two:

(1) Greece is so totally bust that it required not only a fresh bailout totaling $185 billion but also a 50 percent “haircut” imposed on its creditors. In other words, if you lent the Greeks money by buying their government’s bonds, you lost half of it. (But don’t feel too bad—a lot of Greeks got to retire at 60 with pensions you paid for.) That “solves” the Greek solvency problem for a time, but it is a dangerous remedy.

(2) It is dangerous because it means that loss of confidence in Europe’s institutions moves from the periphery (Greece and Portugal, say) towards the core (France and Italy, say). If Greece can stiff its creditors and stay in the euro, might that not be a tempting option for other countries? Consider Italy, the third-largest economy in the eurozone, with a debt-to-GDP ratio over 100 percent. “Contagion” is the word for the presence of nervous thoughts like these in bondholders’ heads, and the only way to protect against its spread is to build a “wall of money” around the least reliable-looking debtors. Unfortunately, Europe is out of money. The only “wall of money” it can erect is a virtual wall of borrowed money.

(3) And that adds to a danger that is already present in the Greek bailouts. European banks hold a lot more sovereign debt (government bonds) than U.S. banks do. If some of that is going to get paid back at 50 centimes on the euro, then these banks are neither as wealthy nor as stable as they appear to be. That means banks are going to have to revise their business models. What European authorities insisted on this week was that they raise their capital ratios to 9 percent. There are two ways banks can do this. They can either hold more money or lend less. Europe’s leaders pretend they’re going to hold more. But since Europeans have already tapped every domestic source of capital, there is no place to get more. That means banks are going to lend less. Which in turn means the risk of recession has just risen significantly.

A lot about this deal makes it likely that Europe’s leaders will be back at the negotiating table before their seats have cooled.

For one, the debt of Greeks and others seems to be, as the Germans grumble, a “barrel without a bottom.” A European economist told me in the summer of 2010 that a Greek default was inevitable, and that the European bailout was designed to keep the country afloat until it could get back into “primary balance”—i.e., paying its bills except for its interest payments—in 2013. But this new bailout, haircuts and all, does not envision Greece reaching primary balance for a decade, and then only with the help of the most grinding austerity program enacted in our lifetime. At that point, in the 2020s, the country will be back to a situation where its debts are “only” 120 percent of GDP. Is that politically sustainable in a riot-prone democracy like Greece’s? One suspects not.

Another problem is that the deal is not having the desired effect in Italy, the primary candidate for contagion. Bond yields in most European countries fell in the immediate aftermath of the agreement, but not in Italy. Italy has the third-largest bond market in the world—almost $3 trillion—and over the summer the European Central Bank bought tens of billions’ worth of Italian bonds to keep Italy’s borrowing costs down.

Working up an austerity plan for the Italians was a top priority at last week’s summit. Silvio Berlusconi’s coalition partners have resisted it, and in one sense they are right to see the demand as unfair—at about 4 percent, Italy’s budget deficits are low by comparison to the rest of the European Union (and far lower than the United States). And there is one boast that Italians can make that few other countries can—its finances are roughly in the same shape they were a decade ago. Under Berlusconi, Finance Minister Giulio Tremonti was a highly capable economic steward. His reputation in Italy has something in common with that of Paul Volcker in the United States. What spooked bond markets over the summer was Berlusconi’s quarreling with Tremonti, not the “bunga-bunga” (to use his term) that he indulged in with young women.

At last week’s meetings, Europe invited a new player into its finance crisis: China. Europeans have talked about “levering up” their $625 billion European Financial Stability Facility (EFSF), established last year to prevent a Greek contagion. It has been topped up and tapped into since and now has only about half its original lending power. In order to obtain the funds necessary to shore up Italy’s bond market, the Europeans reckon they need to more than double the size of the EFSF. Levering up means using the money they have in the EFSF as security to raise even more on the capital markets. In the present depressed state of the world economy, “the capital markets” means China. With an astonishing lack of sangfroid, Klaus Regeling, the head of the EFSF, landed in Beijing on Thursday afternoon to press his case. He must have headed straight for the airport the moment the agreement was signed.

Years ago, China might have fallen for the trick that Europe intends to pull, basically trying to get money for Greece and Italy by waving around the triple-A credit rating of Germany and other countries that have stocked the EFSF. But today it is likely that China will insist on guarantees that it be paid before European taxpayers in any default scenario. In an interview with the Financial Times the day after the agreement, Li Daokui, a member of the central bank monetary policy committee, gave evidence of a real canniness. “The last thing China wants,” he said, “is to throw away the country’s wealth and be seen as just a source of dumb money.” Li indicated that the Chinese might ask European leaders to refrain from criticizing Chinese economic policy as part of the deal.

Perhaps Europe has reached the point where its only route out of bankruptcy is this kind of vassalage. To escape a debt crisis, an economy needs to be capable of growing. It is far from clear that Europe can do that. It has two problems. One is technological. Much of Europe lacks the technological wherewithal to claim an ever-increasing share of the world economy. Spain, for instance, during its long, construction-based boom, developed a good deal of national expertise in .  .  . what? Pouring concrete? 

A second problem is demographic. Italians have one of the lowest birthrates known in any society since the dawn of time; what it will look like in 40 years is anybody’s guess, but one fairly conservative demographic projection shows its population decreasing by 10 percent, to 54 million, at midcentury. Debt, alas, is contracted on a per-country, not a per capita basis, and this kind of population loss (especially when accompanied by rapid aging) can render debt impossible to pay down. 

Europe’s leaders are welcome to congratulate each other on finally resolving their debt crisis. They will likely have many more opportunities to come up with such “final resolutions” in the months and years ahead.

Christopher Caldwell is a senior editor at The Weekly Standard.

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