Deep Dive

Downward Spiral

Europe's crisis is morphing again -- for the third time in only 12 months -- and the implications for the global economy are even more complex, unsettling, and troubling.

Europe entered the year with an acute emergency in the periphery of the eurozone, the European Union's elite 17-member club that shares a common currency. Misdiagnoses and inadequate policy responses allowed the contamination to travel sequentially from the outer reaches of the zone (Greece, Ireland, and Portugal) toward its inner core.

In this first of three morphings in 2011, Italy and Spain were disrupted as interest rates soared, turning liquidity concerns into solvency ones. France was then impacted, with its AAA rating threatened by its exposure to the neighborhood's problems. Then Germany, Europe's strongest economy and the one that everyone looks to for a solution, had to contend with the embarrassing failure of a highly visible government debt auction.

A sovereign debt crisis is bad news for anyone with large holdings of government bonds. As European banks are the largest such holders, they quickly found themselves losing the confidence that is so central to the normal functioning of any financial system.

Credit lines were cut, making too many banks heavily dependent on European Central Bank financing for raising the liquidity they need for daily operations. Equity prices collapsed as investors worried about bank profitability, thereby limiting the scope for injections of new capital. To make things worse, some depositors got nervous.

This series of events led to the second 2011 morphing of the European crisis. Having entered the year on the receiving end of the sovereign debt crisis, banks evolved into becoming a stand-alone source of disruptions -- most acutely in the periphery, but also in some core countries. Suddenly, banks were in the grips of the threatening trio of liquidity strains, capital inadequacy, and concern about asset quality.

The alarm bells in European capitals rang even louder, prompting a subtle change in the policy emphasis. It was no longer just about saving the eurozone's periphery. It became ultra-important, to use French President Nicolas Sarkozy's words, to "refound" Europe.

As the crisis got bigger, Germany and France decided to dispense with the niceties of collective European deliberations and essentially specified the steps needed to strengthen the EU's fiscal and institutional core. These measures found support, but not unanimous agreement.

At the highly anticipated December summit of European leaders in Brussels, German Chancellor Angela Merkel and Sarkozy failed to overcome fierce opposition from British Prime Minister David Cameron, who decided to veto the proposed treaty changes, essentially removing Britain from the constraints of enhanced European governance. With Britain providing a demonstration effect, four other EU countries expressed discomfort in the week following the summit.

This was the catalyst for the third 2011 morphing of the European crisis. Europe now found itself facing an even bigger problem -- namely, a crisis of the 27-member EU as a whole. Questions multiplied as to the stability and ultimate viability of a multispeed EU.

These three distinct morphings have surprised many. They should not have. After all, the underlying dynamics are not that different from what many emerging economies have experienced in the past. Economists describe this as "path dependency." It is a process of "multiple equilibria" in which each successive outcome takes you even further away from the initial starting point.

While familiar to emerging economies, these dynamics are very different from what Western countries are used to. Specifically, for the West, it is no longer about economic cycles that involve temporary and reversible deviations from a familiar anchoring mean. It becomes a secular phenomenon that -- in a fundamental manner -- speaks to structural changes, institutional mishaps, and a whole series of the unthinkable becoming facts. In the process, policy measures lose effectiveness, consumer sentiment is disrupted, and healthy balance sheets retreat to the sidelines, thereby increasing volatility and accelerating deleveraging.

This is an unfamiliar world whose complexity increases exponentially as policymakers fall further behind the accelerating path-dependency dynamics. The engineering of a rescue becomes considerably more difficult and the politics even more intricate. That's not even counting the implementation difficulties that inevitably accompany hard policy choices.

Structural challenges require structural solutions that, usually, involve a component of immediate sacrifice for the promise of welfare enhancements down the road. This tradeoff, between short-term costs and long-term benefits, is not one that comes easily to political systems heavily influenced by the election calendar.

Long-standing social compacts are threatened for a citizenry that is already angry with what has transpired. In some cases, such as Greece, this can lead to wide-scale protests, violence, and paralyzing general strikes. Turnovers in government become the rule -- it should come as no surprise that there have been so many changes in Europe already, including two countries (Greece and Italy) that have opted for unelected "technocratic governments."

These are consequential developments whose impact will be felt for years, and the latter is not limited to Europe. Virtually every country in the world is exposed.

When it comes to the global economy, Europe is systemically important for at least three huge reasons. First, it is the largest economic area in the world and, as such, an important source of demand for the rest of the world. Second, with its banks holding large claims on nonresidents, their forced deleveraging will transmit waves of credit rationing well beyond the EU. Third, by fueling volatility and uncertainty, the European crisis has a material influence on the functioning of global markets.

To make matters worse, this crisis comes at a time when the United States is struggling to regain growth and generate enough jobs. Moreover, though the large emerging economies (Brazil, China, India, Indonesia, and Russia) are much healthier, they lack both the willingness and the ability to compensate fully.

It is critical for the welfare of billions around the world that Europe get its act together now. The continent faces an increasing probability of having to navigate a fourth potential morphing in the next few months. Should it materialize, this would take one of two forms: either a disorderly and highly disruptive fragmentation of the eurozone, or the establishment of a smaller and less imperfect eurozone that has a different relationship with the rest of the EU.

Both possibilities involve yet another set of immediate disruptions for Europe and the global economy. As such, the temptation among politicians will be to avoid making any active choices. But that would constitute a huge mistake. It would further reduce their future degrees of freedom due to an even narrower set of possibilities and, with that, erode their ability to influence outcomes.

As time passes, the option of a smaller and less imperfect eurozone is becoming the only way to "refound" a union that would have the chance to stand the test of time and, thus, constitute a key component of medium-term efforts to restore global financial stability, meaningful economic growth, and plentiful jobs. It is not an absolute best, and it would be a messy process involving the risk of collateral damage and unintended consequences. Yet, when judged in terms of feasibility and desirability, it sure dominates the alternative of a full fragmentation.


Deep Dive

Where There’s a Will…

If the founding members of the eurozone don't get their acts together, the euro will collapse.

Many journalists and economists are exasperated with European leaders and pessimistic about the fate of the eurozone. They are frustrated at the slow pace of European decision-making and the fact that the obvious solution -- purchases of sovereign debt by the European Central Bank (ECB) -- is stymied. The results of the most recent Euro summit in Brussels did little to placate the critics. The New York Times, for instance, considers the amount available for bailouts still too small to persuade debt markets, and frets that the eurozone is still left without a lender of last resort. Italy, meanwhile, may again be tested by speculative attacks in the bond market. The International Monetary Fund (IMF) and central banks have indicated their willingness to provide loans, and eurozone members have increased resources available to the European Financial Stability Facility (EFSF), but no one knows if this will be enough to avert a liquidity crisis.  

So, what is the solution? Economists believe that the basic problem of the eurozone is economic. National economic imbalances, they argue, can no longer be restored through the traditional method of currency devaluation. Conventional wisdom insists that either Germany acquiesce to some sort of bailout, or the eurozone is finished. Germany must consent to either a) the issuance of joint and severally liable Eurobonds, or b) a policy of monetary easing by the ECB. The problem is being treated as a technocratic economic matter. Hence, technocrats have come to power in Greece and Italy.   

But the problems of the eurozone are fundamentally political: a) it expanded too fast as wider won out over deeper; b) there is no commitment to common budgetary policies; and c) there is no mechanism to enforce agreements. The crisis turns on central problems of international relations theory like anarchy, sovereignty, and power. 

The Brussels summit on Dec. 8 and Dec. 9 produced a renewed commitment to budgetary discipline, but only to the original guidelines agreed to some 20 years ago in the Maastricht Treaty. There was some talk of sanctions to be imposed on member states that violate these guidelines, but such sanctions are at best problematic and can be obviated by the vote of a qualified majority. Further, "automatic mechanisms" to correct deviations from debt limits are to be designed by member nations themselves.

European leaders have done the minimum possible, and then only at the last possible moment.  Although praised as a breakthrough, the agreement by eurozone members on a "haircut" of 50 percent  on the face value of Greek debt is insufficient. Serious discipline would involve European banks, including the ECB, marking their holdings of sovereign debt to market rates, currently a 60 percent discount to face value. If banks are not made to pay for their mistakes, they have little incentive to avoid them again.

Capital requirements are another area of ambiguity. European banks are required to increase their capital, but only to an inadequate 9 percent of assets. Given the perilous risk environment, a healthy bank should probably have something like twice that amount of capital. But the definition of "capital" is already being watered down by regulators, and banks are restructuring debt to improve capital levels without raising additional money.

The referendum on Greece's EU debt deal proposed by former Prime Minister George Papandreou would have cleared the air. It would have restored a stark reality that European leaders would not be able to evade. If Greeks had voted "no" on the referendum, Greece would have had little choice but to return to the drachma. That would have been a lesson to others that they have only two choices: a) coordinate fiscal and monetary policies or b) press the "eject" button. The problem now is that European leaders may still think they can muddle through by patching up a country here and there. That will destroy the clarity exposed by a Greek default.  

As things stand today, the debate is centered around two poles: pessimists predicting the breakup of the eurozone versus optimists forecasting closer integration. The solution would seem to include both.  

On the one hand, wide economic disparity among members of the eurozone will force weaker members to leave. Greece, as well as those countries that use the euro but cannot afford it (the "PIGS"), will be cast off from the eurozone by centrifugal market forces. A Greek departure from the eurozone will be messy, and the threat of massive capital flight will prompt Greek authorities to announce the country's departure suddenly and without warning. But the risk of contagion and the accompanying collapse of the European project is too great if Greece stays in the eurozone. The recent spread of market contagion to Italy and Spain bears this out.

On the other hand, the remaining members will converge on tighter economic policy along the German model. As a corollary to more restricted membership, those countries remaining in the eurozone will harmonize their policies regarding budget deficits, pension reform, privatization, unemployment insurance, and revenue sharing. This will have the effect of bringing Europe -- or at least those countries that can achieve convergence -- closer together. It may also create a more politically coherent Europe, with those remaining in the eurozone leading the European Union both economically and politically.

The divide, as usual, is between France and Germany over monetary policy. The French, along with their southern European allies in Greece, Italy, Spain, and Portugal, favor easy money, while the Germans, along with northern Europeans in the Netherlands, Austria, and Finland, insist on a tight money policy. Any hint of German capitulation to French demands of easier money will be the end of the euro. The first sign of wavering, the first inkling that a compromise is afoot, will signal to the markets that the floodgates for a river of euros are open, that fiscal and monetary discipline are history, that inflation will be rampant, and that the euro will be worthless. That is why German Chancellor Angela Merkel will remain firm.

Germans will not pay for the profligacy of their neighbors. Otherwise, where would it stop? Any concession towards easy money will only reinforce the "moral hazard" of further risk-accepting behavior. It is a story as old as Aesop's tale, The Ant and the Grasshopper. Germany entered into the euro under assurances that all members would conduct their economic affairs responsibly. If this is no longer the case, then Germany will reserve the right to withdraw. A former British chancellor of the exchequer agrees, insisting that Germany would sooner withdraw from the euro than see its integrity compromised. Another not insignificant factor is the survival of Angela Merkel as chancellor. Any suggestion of Merkel wavering at the prospect of easy money is tantamount to political suicide. So all the speculation that the ECB or the EFSF will "stabilize" (rescue) the euro is so much folderol.

The power calculus, then, favors Germany. France will be dragged along kicking and screaming, but two points suggest eventual French capitulation. One is that Germany may otherwise threaten to secede from the euro, which would put France in a nasty competitive economic position. And the second is that, without the unity embodied in a common currency, French hopes of ever again exerting influence on the world scene will have evaporated. Europeans understand that they cannot meet global challenges as individual nations because they are no longer great powers. As President Nicolas Sarkozy conceded, "If Europe does not change quickly enough, global history will be written without Europe."

The original path to the common currency was through a convergence of economic policies. Nations would have budget deficits of no more than 3 percent of gross domestic product (GDP), and total debt of no more than 60 percent of GDP. If euro members had stuck to these criteria, they would be in dandy shape now. So a return to that mechanism, with additional penalties for non-compliance, might work. The challenge is to create binding agreements.

On the question of enforcement, some have raised the possibility of an automatic increase in taxes to offset a budget deficit beyond acceptable limits. Other devices to ensure compliance with EU oversight of national budgets are available for the same purpose. These sanctions would be imposed by a central authority that can override national budget decisions. The European Court of Justice and the European Commission have been suggested as ultimate arbiters, but such supranational enforcement has its limits in a union of sovereign states.

Sovereign governments, moreover, may oppose such measures for domestic political reasons. As long as sovereignty remains, national governments may negate previous agreements. Even within national governments, as in the U.S. Congress, existing legislatures may negate the agreements of previous legislatures. Therefore, a more severe penalty is required. 

The ultimate penalty for non-compliance is, of course, expulsion. The eurozone could expel any country that fails -- after a suitable time period -- to adhere to budgetary guidelines set forth in a new agreement. The ultima ratio of economic union is expulsion, just as the ultima ratio of politics is war. It lurks behind every decision as the final alternative.

The demise of the euro, as a proxy for the European Union itself, is not underway. Neither is a consolidation on the German federal model. A big push for more Europe is not in the cards now, either. The loss of that much national sovereignty is unrealistic, given the immature development of a European identity. That is why convergence of fiscal and economic policies is the most likely outcome, not complete structural reform.

But convergence will not save the euro if member states refuse to comply with agreed guidelines. Both France and Germany violated the guidelines in 2003, blowing through the barriers of 3 percent budget deficits and 60 percent debt for more than a year. If the founding members of the eurozone fail to comply or to remedy violations within prescribed time periods, then the euro will well and truly collapse. In a union of sovereign powers, political will is the ultimate arbiter.