The European Sovereign Debt Crisis

Tonight I should be on the Lang & O’Leary Exchange, the CBC’s prime-time national business program, at 7PM ET. We are going to be discussing the European sovereign debt crisis for about 5-7 minutes. Canadian readers, tune in. For everyone else, here’s the background to what I intend to say.

The euro zone is not an optimal currency area given the pre-euro differences in fiscal and monetary policy as well as the language barriers and differing socioeconomic levels in the zone. Nevertheless, to ensure political cohesion after German reunification, Europeans felt the euro was a must.  After the Berlin Wall fell in 1989 and the talk of a reunified Germany began, there was widespread angst about what the new Germany would look like and whether to even permit its coming into being. The Germans were forced to make a number of political concessions for re-unification to proceed. Germany was to accept the Oder-Neisse Line as the unequivocal legal eastern frontier with Poland; any discussion of Germany’s 1937 borders had to be stopped. Germany was to pay the Russians 55 billion deutsche marks in order to remove Russian troops from German soil. And the Germans had to anchor themselves into the western European monetary-political system via a common currency.

When the euro was designed, the question for the Germans and the Dutch in particular was how to make the euro a strong currency that replicated the strengths of the Deutsche Mark and the Guilder. The Stability and Growth pact, which sought to keep government debt below 60% of GDP and deficits below 3%, was seen by many as the best way – a great fiscal union was not. One of the euro’s chief architects, Tommaso Padoa-Schioppa, who tragically died just days ago, called for greater fiscal cohesion in order to prevent the sort of tension we now see within the euro zone. When the euro finally came into being in 1999, Padoa-Schioppa famously called it "a currency without a state".

The problem at the time was that Belgium and Italy both had national debt well above the 60% hurdle, and, politically they had to be included in any currency union. Thus, a swag was introduced whereby the national debt could be "60% of GDP or approaching that value". This swag also allowed the Greeks, the Spanish and the Portuguese entry into the currency. See my German-framed post "How Belgian debt, Italian anarchy and Greek profligacy lead to economic chaos in Europe" for a complete re-counting.

Unfortunately, the divergent fiscal and economic policies in the unharmonised pre-euro group led to wildly differing growth rates and economic outcomes. While Germany laboured under the strains of re-unification and the bust of the speculative mania which followed it, Spain and Ireland grew at fantastic levels. Germany suffered from chronic budget deficits while the Spanish and Irish rushed ahead. See the post "Spain is the perfect example of a country that never should have joined the euro zone" for more detail here. With boom times came wage increases in the periphery. As labour competitiveness eroded there, external imbalances opened up, with Germany, Austria and the Netherlands running capital account deficits to match Spain, Greece and Portugal’s current account deficits – meaning banks in the first group of countries became excessively exposed by lending to the second group and to countries in eastern Europe. Any economic hiccups in the periphery or eastern Europe would reverberate back to the undercapitalised banks in places like Germany, Austria, or France.

Now that crisis is upon us, the currency trilemma  of a currency union that is the Impossible Trinity of fixed exchange rates, independent monetary policy and free movement of capital has reared its head. Hands are tied; in a currency union, there is no devaluation to recoup competitiveness, no room for fiscal freedom, and no control over monetary policy.  This leaves so-called internal devaluation and/or sovereign default as the remaining ways to escape crisis.  The political will to go through this is impaired because internal devaluation (across the board wage and price cuts) leads to a long and arduous depression (see Michael Hudson’s comments on Latvia). And default leads to massive creditor losses – not just in Ireland but also in Germany. So the Eurozone is trying to figure out how to keep its union together while minimizing costs – with the ECB and IMF integrally involved.

To date, the indebted periphery has accepted internal devaluation and austerity as the way forward. Greece and Ireland have been forced into IMF programs at onerous interest rates which leave open whether either country can avoid default down the line. Meanwhile, sovereign creditors have not been forced to take losses. And the Germans have controlled the political debate by insisting on adjustment via fiscal austerity without brokering discussion on the so-called eurobond or other fiscal transfer mechanisms despite their being in violation of the stability and growth pact themselves. Germany is not the only one facing a backlash for the two bailouts; discontent with the crisis solutions is widespread.

Internal devaluation and austerity is not a solution. They are politically unsustainable. It is obvious to most that defaults are coming. For Greece, sovereign default is a foregone conclusion. For Ireland, by dint of its socialisation of bank losses onto taxpayers, sovereign default is a real possibility. In Spain, bank losses have not been socialised and so the sovereign remains relatively healthy. However, Spanish banks have been slow to recognize losses and that means many contingent liabilities keep the market for Spanish government bonds in a state of stress. Portugal is well above the Maastricht 3/60 hurdles and contagion has spread to Belgium, Italy and France. Meanwhile, the public in countries like Slovakia and Finland want no part of future bailouts, while the public in countries like Greece and Spain are fed up with double digit unemployment and the prospect of a decade more.

That’s the backdrop for the euro crisis. There are Three options for the euro zone: monetisation, default, or break-up. The political costs of break-up are still impossibly high. So I expect some combination of monetisation and default. The timing of events will be critical in minimising contagion.  But it is not clear to me the Europeans can keep this from spiralling out of control without a credible integrated fiscal approach.

See you at 7. Comments appreciated.