Deep Dive

Bitter Medicine

Bailing out the banks may be hard to stomach, but it's the only way to prevent a global economy predicated on financial institutions from plunging into recession.

Over the past few months, the European sovereign debt crisis has become a looking glass for the Anglo-American economics establishment. In Europe, we see warnings of what is to come in the United States: A crisis born of out-of-control deficits, a ballooning welfare state, an innovation slowdown, abysmal monetary policy, foolishly timed austerity, crony capitalism, and a bloated banking sector.

Crises, however, are not fables. They do not exist to teach us lessons or help us learn to mend our ways. The forces at work are utterly indifferent to the narratives we attach to them. Like everything else, they are simply a chain of events. One damned thing after another. Our task is to understand how this chain is likely to unfold and uncover what, if anything, we can do to mitigate the damage.

The most damaging threat out of Europe is clear: a global financial crisis that dwarfs that of 2008, a worldwide recession worse than the Great Depression, and the risk that modern liberal capitalism itself could collapse. That's an ugly list of bad options.

But is it really likely that we could wind up there from here?

Unfortunately, yes. Though most U.S. policymakers seem to think that the United States is insulated from the European economic crisis, the reality is that contagion is just around the corner. A default by a major European government -- say Italy -- would spell the insolvency of all the major banks in that country. Those banks would be unable to meet their obligations to other banks around Europe, causing those banks to go under. In turn, those banks would then be unable to meet their obligations to U.S. and Japanese banks, causing them to go under as well. As banks collapsed, so would the supply of credit, choking off the tremendous daily flow of trade and other transactions dependent upon it. In the resulting scramble for liquidity, firms would be forced to sell assets at whatever price they could get, leading to collapse in worldwide stock and bond market values. This dissolution of wealth would mean that very few households or private organizations would be technically solvent. The value their assets commanded on the open market would not match their liabilities. The crash could be worse than 1929.

These are all paper balance-sheet losses. In theory, the world could go on if everyone acted as if nothing had happened. History, however, suggests they won't. Faced with a collapse in asset values and negative net worth, households and firms will dramatically cut their spending. This, in turn, erodes the income of other households and firms, which makes further defaults more likely, balance sheets ever more negative, and contractions in spending even greater.

This ever-accelerating collapse in spending and income is what we experience as an economic depression.

It is this process that took hold after the collapse of Lehman Brothers in 2008 and the collapse of the Austrian bank Credit Anstalt in 1931, which is widely blamed for the "Greatness" of the Great Depression. Italy's largest bank, Unicredit, is, however, roughly four times larger than Lehman, and France's BNP Paribas nearly eight. And these financial institutions are bound up in each other's success or failure; Unicredit holds Italian debt and BNP Paribas has exposure to Unicredit. The simultaneous collapse of multiple large European banks would set off a shock an order of magnitude greater than what the world experienced four years ago.

Fortunately, this series of events can still be prevented. Unfortunately, it will require measures that have proven exceptionally distasteful in the past.

Before anything else, the banks must be saved, most likely through an open-ended lending facility like the Federal Reserve's Term Auction Facility (TAF). They must come before taxpayers, before pensioners, before the reforms that might transform southern Europe into a dynamic player in the global economy.

Not because it is fair or just or right. It is none of these things.

It must happen because we have constructed a global economy that has massive international banks at its heart. Money, banking, and credit lubricate the billions of transactions that happen around the world every day. If the global financial system collapses, so will trade.

Stopping that collapse will involve central banks around the world loaning enormous sums of money to their private banks at very low interest rates. It will also mean that they do this as the private banks constrict their lending to businesses and families. Cash will pile up in global banks as a war chest in case things take a turn for the worse. As with the U.S. bailout, it will seem awful and it will be awful. But it will be necessary.

At this point, it is probably impossible to prevent Europe from going into at least a mild recession, as European Central Bank President Mario Draghi himself has warned. Much of the world -- including emerging economies and the BRICs -- will likely follow in a "growth recession" where growth is so slow that more jobs are lost than added, though we can be hopeful about the United States. While a mild global recession would cut the demand for U.S. exports, pent-up demand for automobiles and apartment construction is so high that the United States could still eke out a narrowly positive growth rate.

Austerity measures in Europe will likely only increase. Taxes will rise. Benefits will be cut. And, all the while, the banks will grow fat on cheap cash.

The euro will likely survive, at least for now. A combination of international bailouts and private "haircuts," or forced principal write-downs for private-sector bondholders will be used to manage the debt burdens of southern Europe. The losses caused by these write-downs will be offset by more public monies.

If European Central Bank officials hold to their policy of price stability in the face of economic devastation -- and by the looks of it they will -- then southern Europe will also experience another decade of high unemployment. It will not be pleasant for anyone. People will ask if it could possibly have been worse.

Of course, it could have been worse.

One day it will be worse. For over 400 years we have been fighting asset bubbles and financial panics, and in 400 years no one has yet found a way to stop them. Eventually, a crisis will come along that's bigger than anything we have ever seen, and we will be either unable or unwilling to stop it. This is probably inevitable.

Our task today, however, is to make sure that that the event chain doesn't unfold tomorrow.

Damien Meyer/AFP/Getty Images

Deep Dive

It's the Politics, Stupid

The eurozone crisis isn't about debt or deficits -- it's about a dysfunctional political system.

Europe is not suffering from a debt crisis. It is, rather, a political crisis. With the arguable exception of Greece, the EU countries under attack by financial markets are basically strong, wealthy, and productive. Yet from the early tepid responses when the crisis started in Greece two years ago to the most recent agreement German Chancellor Angela Merkel forced on EU member states, European leaders have been shockingly unwilling to face up to the political facts. The treaty revisions outlined during last week's summit focus solely on debt and do little to address the underlying political uncertainty that is driving the financial contagion at the heart of the crisis.

Indeed, the restrictive straitjacket of fiscal orthodoxy agreed to at the Brussels summit on Dec. 9 is only likely to hasten the demise of the euro, not save it. Enshrining deficit and debt rules in treaty language will not deter international bond markets from charging unsustainably high rates to EU states attempting to borrow money. Nor is it the right medicine for European polities under stress, which need to grow their way out of debt, not strangle their economies with ludicrous public finance rules. EU leaders, and Merkel in particular, need to demonstrate commitment to a true political and fiscal union that offers support, not just sanctions, for its members. Only by pooling together the strength of the eurozone in a collective debt instrument while offering a process of real decision-making over the direction of the European economy will the monetary union survive. Technocratic pleas for fiscal restraint fundamentally misunderstand markets, the nature of the problem, and its solution. Financial contagion is about beliefs, perceptions, and testing political will, and markets are not likely to buy what Merkel -- and the member states who must follow her dictates -- are selling.

So what is really going on in Europe? Is it really about debt? No. Debt and deficit figures diverge widely across the European Union and indeed across the industrialized world, yet debt levels do not reliably track with the amount bond markets charge sovereign borrowers in Europe or elsewhere. Debt-to-GDP ratios, as recorded by the IMF, vary from 87 percent (France) to 67 percent (Spain) to 121 percent (Italy), yet all these European states are being charged rates above what states like Germany (83 percent), the United States (100 percent), or Japan (an astounding 233 percent) are charged. The IMF estimates that Japan's debt will reach 250 percent of GDP in 2015. By comparison, the IMF forecasts that Greece's debt-to-GDP ratio in 2015 will be 165 percent, Italy's 116 percent, and Spain's 76 percent. Yet no one is talking about Japan's bond-financing problems. The bottom line? Arguing that Europeans need to "live within their means" is nonsense in a world where there is flexibility in how markets perceive what appropriate debt levels mean.

Perhaps debt matters because of another economic factor. Is the problem that European countries are simply too economically divergent to be in a currency union, making investors more worried about debt in the eurozone than in national settings? Once again, the evidence does not support this facile answer. Currencies are, without historical exception, determined by national borders -- by politics -- not convergent economic zones. The United States is a case in point. From a purely economic standpoint, it should not have a single currency, as regional economic cycles across the United States inevitably give rise to different fiscal and monetary needs despite the Federal Reserve's one-size-fits-all monetary and exchange-rate policy. Scholarship examining the optimum geographic areas for single currencies suggests that the United States should have several currencies -- a Pacific Northwest dollar area, a Sun Belt dollar, a Midwest industrial dollar, and a Northeast dollar. Yet no one worries about the breakup of the greenback because of this.

The reason? Political unity. The United States survives its uneven regional economic cycles because it has a true fiscal and political union. Treasury bonds pool risk at the national level while automatic stabilizers dispense funds where needed in hard-hit areas and bring in revenues from booming areas where times are good. Through the current crisis, America's stability as a unified political entity has never been in doubt, sending confidence and certainly to markets despite the wrenching effects of the Great Recession.

Instead of recognizing the importance of political commitment and political mechanisms in stabilizing monetary unions, however, those interested in austerity are using the crisis to shore up their own agendas, with seeming disregard for the consequences.

While last week's agreement was framed by Merkel and French President Nicolas Sarkozy as the basis for a fiscal union, the system established bears no resemblance to any functioning fiscal union in history. Governing solely by rules and sanctions, imagining that national polities will somehow adhere to the goals of keeping public debt at 60 percent of GDP and budget deficits at 3 percent of GDP is fundamentally at odds with everything we know about how politics work in real life and smacks of magical thinking. The agreement is a rewarmed version of the existing Stability and Growth Pact (SGP), based on guidelines set down two decades ago when European leaders decided to move forward with the euro.

Let's recall that Germany and France both eventually violated the SGP (as they should have) when their economies needed a boost. Romano Prodi famously called the pact "stupid" when he was president of the European Commission, and economic theory has never found a rationale for the specific target numbers. What's needed is not the automatic application of mindless rules meant to be broken, but rather the discretion to decide what is right in any given situation, determined collectively by democratically elected EU leaders within the governance institutions of a real fiscal union.

Single currencies have historically been forged in war as part of larger state-building projects that wrestled power to the center through taxing, spending, and debt instruments grasped by leaders in search of the tools to survive in the face of military conflict. The European Union has been an exception, but its time may be up. As politically difficult as it may be for Merkel to recognize the need to pool sovereignty by agreeing to a Eurobond and true fiscal union, it is myopic at best for her to destroy the considerable economic and political benefits that Germany has gleaned from the euro and the broader EU project. If austerity and nonsensical rules on deficits and debts in a faux fiscal union are the only way forward for the eurozone, we should all prepare for its demise.