The Reluctant Firewall

Can the Obama administration afford to sit on the sidelines while the European economic crisis worsens?

Few experts deny that the eurozone crisis threatens the global economy. A messy unraveling of the euro would have ferocious effects on countries that export to Europe and could produce a global liquidity crisis that would stifle growth -- even in countries with little direct exposure. For these reasons, International Monetary Fund (IMF) Managing Director Christine Lagarde has become increasingly apocalyptic in her pronouncements, warning yesterday that the crisis may trigger a repeat of the 1930s economic contraction.

In the face of this crisis, there is a remarkable reality: The world's undisputed economic and financial leader, the United States, is essentially an observer. Unless the current trajectory changes, the crisis will play itself out in discussions between European leaders.   

To be fair, the United States has been an active -- even frenetic -- bystander. The Obama administration is clearly alarmed by the course of events, not least because an implosion of the euro might tank the global economy just as the U.S. election approaches. Treasury Secretary Timothy Geithner has toured European capitals on multiple occasions, hectoring leaders and finance ministers about their responsibilities, offering advice, and serving as an informal mediator. His peregrinations have often earned him the annoyance of European finance ministers, but Geithner has persisted. The administration's involvement has reached even higher; the president himself has repeatedly buttonholed key European leaders in an attempt to engineer a breakthrough.

The vigorous hortatory role cannot mask the reality that the United States is not willing to put new money on the table to address the crisis. The consistent U.S. position has been that Europe has the resources it needs and that only political will is lacking. At the Cannes G-20 meeting last month, the United States reacted coolly to talk of a massive increase in IMF resources and insisted that the organization has all the tools it needs. In the weeks that followed, the United States hasn't budged from the position that a resolution is, above all, a European responsibility. At most, the United States seems willing to countenance an IMF role as a junior partner.

At a certain level, the American position is indisputable. The crisis is Europe's making and it can and should be resolved by Europe. But the knowledge that Europe is most guilty will be cold comfort if, as now appears likely, its leaders fail to construct the short-term firewall essential to calm the markets and stop the upward spiral in borrowing costs. Last week's European summit in Brussels made progress on addressing the euro's critical architectural flaws but did little to construct that firewall.

We have reached the point where outsiders can no longer fuss and fume about Europe's political and institutional shortcomings. The critical question is not whether Europe is to blame but whether outsiders can step in where Europe has failed. The world must do so, but it cannot without much more assertive American leadership.

Domestic politics is the key to the Obama administration's reticence. The administration faces a hostile Congress that has shown no interest in supporting an IMF bailout package. Indeed, some on Capitol Hill have talked of clawing back commitments the United States has already made to the IMF. A wary Obama administration has not even brought before Congress a previously agreed upon doubling of IMF quotas. Meanwhile, the main Republican presidential candidates have opposed any bailout of Europe and there's no doubt they would make political hay if the administration should move in that direction. In a different political environment, the United States would almost certainly have already stepped forward with resources and helped lead an international response.

The president's political advisers are no doubt telling him that new U.S. funding for the IMF is a non-starter. But it is a non-starter in large part because the administration has not started making the argument. It has plenty of ammunition to make a compelling case. Funds to the IMF are not budget outlays in the normal sense, so they wouldn't blow a hole in the deficit. IMF loans have always been repaid, with interest. A massive, market-calming IMF package for Europe could come equipped with tough conditions to ensure that the euro ceases to be a financial weapon of mass destruction.      

What's more, the administration would not have to provide the bulk of the resources needed for an impregnable defense. European central banks have already committed to contributing several hundred billion dollars to the IMF. China, Brazil, Russia, and other emerging economies with large cash reserves have also signaled a general willingness to contribute. But the Obama administration's unwillingness to consider any new U.S. contribution has hobbled its ability to lead an international response.

The result is that there is still no credible firewall. The markets have realized that last week's summit was a dud. Greece is sliding even further into insolvency. Italy's borrowing rates regularly touch unsustainable levels. Absent dramatic action, the first few months of the new year will likely push the crisis into a terminal phase. 

It is increasingly likely that action will have to emanate from Washington. The Obama administration faces a Hobson's choice: take on the very unpopular fight that will be needed to boost IMF resources and galvanize an international response, or acquiesce as the eurozone crisis metastasizes, likely tipping the world into prolonged recession. Neither option is appealing, but one is the right thing to do.

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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.

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