Losing the Continent

Why the Obama administration's neglect of Europe will result in a more dangerous, unstable world.

With the United States facing what Defense Secretary Leon Panetta calls "a strategic turning point after a decade of war," President Barack Obama directed a sweeping review of America's military around the world. On Jan. 5, Obama delivered a statement at the Pentagon to present the administration's defense priorities for sustaining U.S. global leadership.

Obama prioritized East Asia, calling it a "critical region" and promising a "strengthening [U.S.] presence" unaffected by budget cuts. The Middle East received special attention as a place where the United States "will stay vigilant." Yet Obama neglected to mention Europe. Remember NATO? Obama relegated it to one line in the middle of the speech, damning it with faint praise as a "force multiplier." The government's 16-page official strategy review allotted just a single paragraph to European matters.

Yes, the Europe of today is no longer the epicenter of global war, hot or cold, that crowned U.S. concerns during the 20th century. But it's also not a continent of Swedens. The review justifies Europe's demotion by declaring, "Most European countries are now producers of security rather than consumers of it." Yet as European defense budgets are plunging, fresh threats to European security are rising. Europe will very likely face wrenching internal transformations -- at the very moment that its long frontier, wrapping south from Estonia to Greece and then west across the Mediterranean, once again becomes dangerously and problematically porous. Russia remains more than willing to use its control over Europe's natural gas as a powerful political lever. Fraught Turkish relations with Syria and Iraq augur a tough test for NATO unity. In Libya, a fresh round of civil war could send waves of refugees -- if not terrorists -- crashing against Southern European shores. And, as Avi Jorisch recently warned in the Wall Street Journal, al Qaeda in the Islamic Maghreb now finds itself flush with arms from Libya and cash from criminal enterprises and kidnapping ransoms. For good reason, European officials are increasingly dismayed.

What's more, Europe's economic crisis has revealed a deficit of political authority even more intractable and perilous than its fiscal one. The European Union's rush to expand to encompass the whole of Europe -- a process left awkwardly incomplete in the former Yugoslavia -- now leaves "core" member countries in Western Europe with gnawing worries over the possibility of political backsliding in the greater Balkans that would lead to renewed conflict. In Budapest, Hungarian President Pal Schmitt has ushered in a new constitution annulling Hungary's status as a republic and drawing accusations from Amnesty International that the document violates the rights of the country's citizens. Greece's latest talks with its private creditors have collapsed, and Italian Prime Minister Mario Monti has warned his German counterpart that Rome will not tolerate steeper budget cuts. Meanwhile, Britain is stepping back from the continental mess to assume a defensive crouch. That's to say nothing of the latest round of European credit downgrades issued by Standard & Poor's. Even if a swift alteration of EU law manages to impose German-style budget targets on struggling member states, European public opinion remains stubbornly and staunchly opposed to German political dominance over the policies of other countries. Memories of Nazi occupation still rankle, and today Germans are viewed by large swaths of the continent as having benefited handsomely from favorable access to markets in countries they now want to force into painful austerity.

Seems like a fine time for Washington to weigh in with a steadying hand. Don't hold your breath. The Obama administration seems to think Europe deserves to be treated with secondary importance because it is largely cordoned off from world events. But how can such a precarious hodgepodge as Europe remain, as the new strategy review describes it, "our principal partner in seeking global and economic security" now and into "the foreseeable future"? Europe's ability to maintain its security position, much less project security, is on a precipitous decline.

A weakened, conflict-averse Europe will struggle even to respond militarily to unstable or adversarial neighbors in North Africa, the Middle East, and Eurasia. The deepening terrorist threat will siphon what military resolve there is into a preeminent urge to protect the homeland -- an urge most likely exacerbated by austerity-driven civil unrest. Not only will the rest of the world continue to imperil European security, but Europe's own insecurity is apt to spread like a contagion to surrounding regions.

If there is any silver lining to these dark clouds, it is to be found in France, the only country in Europe poised to exercise joint integrated military and political leadership. While focusing more resources on the continent as a whole, the United States urgently needs to build its relationship with France.

It is France that the British turned to for their austerity-induced defense-sharing plan. It is France that played an indispensable role in NATO's Libya operation, assuming the lead "role before history," in President Nicolas Sarkozy's words, while America hesitated and Germany begged off. And it is French attitudes and policies toward fundamentalist Islam -- though certainly far from perfect -- that stand in stark contrast with the sense of helplessness and passivity on display elsewhere in Europe. While memories of German dominance crush the prospect of Berlin's leadership today, the French history of democracy and progress remains both powerfully universal and decidedly European.

Unfortunately, Obama has failed to capitalize on the warm Franco-U.S. relationship that Sarkozy has actively cultivated. Obama has declared that the United States doesn't "have a stronger friend and a stronger ally than Nicolas Sarkozy and the French people," but the cooperation he has sought with the French is at best ad hoc and tactical, whether in Haiti or Libya.

Obama's hands-off approach means that Europe will drift, if not tumble, into the arms of the French. Europeans could do far worse -- returning to the bad old days of multipolar nationalist animosity or succumbing to the political domination of Russia or the economic hegemony of China. But a France that bears the burden of salvaging Europe with a minimum of strategic support from the United States is a France that will indeed draw Europe closer politically to Russia and closer economically to China.

With Germany and Britain sidelined and second rate, France and Russia will find that their traditional strategic affinities leave enough room on the continent for the interests of both major powers. This alignment will also put Paris and Moscow on a much stronger footing in dealing with Beijing. China's economic muscle intimidates Europeans and Russians alike, but it also offers real opportunities -- to be eagerly seized, no doubt, from the position of greater relative strength that Franco-Russian cooperation brings. Will America's next defense review be ready in time?

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How China's Boom Caused the Financial Crisis

And why it matters today.

Since the 2008 financial crisis, Wall Street has been the perpetual whipping boy for the ensuing recession that has rocked the global economy. In the United States, Manhattan bankers relied too heavily on subprime mortgages, the story goes, sparking the crisis -- in bureaucratic jargon, what is dubbed a "regulatory oversight failure." In Europe, the debt crisis -- which struck again last week when the credit-rating agency Standard & Poor's stripped France of its AAA rating -- is often blamed on the fact that eurozone governments maintained outsized debt-to-GDP ratios, thereby breaking the rules laid down in the Stability and Growth Pact they signed when they joined the currency union.

U.S. President Barack Obama has laid the blame at the feet of Wall Street "fat-cat bankers," and he finds himself in the company of Federal Reserve Chairman Ben Bernanke. Even Republican presidential hopeful Mitt Romney criticized Wall Street for "leverag[ing] itself far beyond historic and prudent levels" in his 2010 book, blaming its "greed" for contributing to the crisis. The concept of runaway European profligacy, epitomized by 35-hour work weeks and gold-plated pension programs, is also firmly lodged in the popular imagination.

But these explanations for the twin crises in the United States and Europe simply ignore the facts. Subprime mortgages with exotic features accounted for less than 5 percent of new mortgages in the United States from 2000 to 2006. It is therefore highly unlikely that they were solely responsible for setting off the housing boom that ultimately went bust. The explanation offered for the crisis in the eurozone overlooks the fact that Spain and Ireland -- two of the weak links in Europe today -- were actually paragons of virtue in terms of the Stability Pact. Both countries boasted budget surpluses in the years leading up to the crisis, and both had debt-to-GDP ratios of roughly 30 percent, or only about half the level that was permitted under the Stability Pact.

The immediate cause of the housing bubbles in the United States and the eurozone periphery was not regulatory oversight failure, but the precipitous drop in interest rates in the early 2000s. And the country that bears partial responsibility for depressing interest rates is a traditional punching bag in the American political arena, one that has somehow avoided most of the blame in this round: China. The ascendance of the world's most populous country in the global economy not only changed the terms of trade, but it also had a considerable impact on the world's capital markets.

The chain of events that led to the current economic breakdown began in 2000, when the Federal Reserve began to lower the Fed funds rate, its main policy lever, to stave off a recession following the bursting of the dot-com bubble. The Fed slashed the rate from 6.5 percent in late 2000 to 1.75 percent in December 2001 and then down to 1 percent in June 2003. It then kept the rate at 1 percent for more than a year, even though inflation expectations were well above the Fed's implicit inflation target and the unemployment rate was down to nearly 5 percent, which is considered the natural rate of unemployment. All the while, the Federal Reserve dismissed warnings about a nationwide housing bubble, with then Federal Reserve Chairman Alan Greenspan even denying that it was possible to have such a thing.

The low interest rates initially sparked the refinancing boom -- or as commentators liked to say, Americans used their houses as ATMs. Between the first quarter of 2003 and the second quarter of 2004, the time when the Federal Reserve held its main policy rate steady at 1 percent, two-thirds of mortgage originations were for home refinance. Americans got themselves indebted up to their eyeballs and went on a prolific spending binge with their newly acquired cash. Spending out of home equity extraction amounted to $750 billion, or more than 4 percent of GDP, in 2005 alone.

Fed policymakers generally looked favorably upon remortgaging as a source of personal consumption expenditure. In his now infamous 2005 Sandridge lecture, Bernanke, then a Fed governor, boasted of the "depth and sophistication of the country's financial markets, which … allowed households easy access to housing wealth."

The possibility that the housing boom could one day turn to bust, leaving many homeowners penniless, seemed not to have caused any sleepless nights at the Fed. On the contrary, recently released Fed transcripts show how future Treasury Secretary Timothy Geithner scrambled in 2006 at a Fed meeting to come up with a superlative for "terrific" to describe Greenspan's tenure.

But it was China, not the U.S. economy, that prospered on Americans' spending binge. The world's most populous country grew at double-digit rates for much of the 2000s. And while the U.S. savings rate hovered around 15 percent of GDP, China's savings rate increased from 38 percent in 2000 to 54 percent in 2006. China's savings are heavily skewed toward risk-free assets, perhaps because the Chinese are culturally more risk-averse, but also because the country's financial markets are still underdeveloped and not fully liberalized.

The large buildup of savings in China and other emerging economies (mostly oil exporters) depressed interest rates worldwide from 2004 on, as too much money was chasing U.S. Treasury bonds and other supposedly risk-free securities, driving up the price of bonds and driving down interest rates. Thus, by the time the Fed started to worry about rising inflation by mid-2004, leading the Fed to try to put the brakes on the economy, it was already too late. Although the Fed started to raise the policy rate in July 2004, long-term interest rates in the United States remained stubbornly low. While the subprime mortgages with exotic features did not help, it was these low long-term interest rates that were the most important factor in enlarging the housing bubble.

Europe's story is slightly different, but the messy conclusion is broadly similar. The establishment of a common currency in the eurozone caused interest rates on Greek, Irish, Italian, Portuguese, and Spanish government bonds to converge to the much lower rate on German government bonds. While opinions differ on what caused this convergence, the fact that exchange-rate risk disappeared significantly contributed to Northern European banks' willingness to buy Greek, Irish, Italian, Portuguese, and Spanish bonds. It was, after all, only prudent for banks to invest in assets that were denominated in the same currency as their future financial liabilities.

As a result, Greece, Ireland, Italy, Portugal, and Spain saw interest rates fall from a level of about 13 percent in the late 1990s to only 3 percent in 2005. The same excess of savings in China and other emerging economies that depressed long-term interest rates in the United States played a role here, too.

The sharp fall in interest rates had a significant impact on the housing market in the eurozone's periphery. Year after year, housing prices in Ireland and Spain rose by 10 to 20 percent. That in turn resulted in exuberant consumer spending and borrowing, driving up wages as well. While labor costs in Germany rose a modest 18 percent from 2000 to 2008, labor costs in Spain and Ireland increased by 41 and 45 percent, respectively, and by 78 percent in Greece.

The low interest rates also led to excessive government borrowing in Greece, which has now effectively driven the country into bankruptcy. And though Italy was running a budget deficit below the 3 percent threshold of the Stability Pact for many years, low interest rates allowed it to run a debt-to-GDP ratio of about 100 percent of GDP. Portugal found itself in the reverse situation, running budget deficits beyond 3 percent without exceeding the proscribed 60 percent debt-to-GDP ratio much of the time.

Now that the Western housing bubbles have burst and banks have been brought to the brink of collapse, investors have suddenly realized that government debt might not be a risk-free investment after all. The mechanism that initially drove down interest rates in the eurozone's periphery has gone into reverse. Not only have banks in the northern eurozone countries withdrawn funds, but investors from the periphery have shifted their purchases to government debt in Europe's "core" countries -- driving up interest rates in the periphery while simultaneously driving down interest rates in countries like Germany and the Netherlands, where interest rates have gone negative. Despite all the acrimony in Europe about northern eurozone governments' bailing out the periphery, the actual costs of the bailouts are low if you take into account the windfall that Germany and the Netherlands have reaped due to lower borrowing costs.

If one looks back, it's fair to criticize the eurozone's architects for not sufficiently thinking through the initial fallout of monetary integration. The speculative bubbles, especially in Ireland and Spain, could easily have been avoided if strict lending restrictions had been imposed in time. The same goes for the housing bubble in the United States, where more than a quarter of residential mortgages are still "underwater" -- in other words, a home mortgage loan that exceeds the value of the underlying property.

The economic cataclysms in the United States and Europe may seem driven by their own peculiar circumstances at first glance, but both would have been much less severe without China's ascendance. Without China as a major economic player, the low interest rates at the start of the millennium would have been more effective in kick-starting the U.S. economy, and the Fed would have begun raising the Fed funds rate much sooner, with the European Central Bank (ECB) following suit. Part of the manufacturing that took place in China would have been preserved for the United States and Europe, aiding economic growth in these regions and lessening the need for low interest rates. And without China's rise, inflation in the early 2000s would have been higher, propelling the Fed and the ECB into action. But more importantly, China and other emerging economies' savings would not have depressed long-term interest rates worldwide.

But all is not lost. One consolation is that the past decade of loose living in the United States and Europe has done much to lift hundreds of millions of people in China and India out of poverty. No development aid program can stake a similar claim.

Another consolation of sorts is that economic growth in the emerging economies will likely go a long way toward buoying the global economy this decade. Apple recently experienced firsthand how ferocious Asian consumers' appetite can be when near riots broke out at its flagship store in Beijing after it postponed the launch of the iPhone 4S due to crowd size.

Other U.S. businesses are also eyeing Asian markets as a source of demand for their products and services. As China's economy continues to mature, it may just be the economic engine that the United States and Europe need to dig themselves out from under their mountain of debt.

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