Understanding the European Sovereign Debt Crisis

Introduction

Will the Euro survive? Is it destined for the chopping block? Or maybe, will crisis ensue indefinitely? While there’s no simple answer to any of these questions, there’s little doubt that the European project is flawed by design and needs countless rounds of reform that will restore confidence.

Summary

With inception of the Euro, structurally flawed southern European countries like Greece joined the common currency and took advantage of artificially low interest rates to grow at record rates. This growth soon artificially inflated their economies and created an economic bubble that subsequently increased unit labor costs and led manufacturers to outsource their production to less developed countries (LDCs). Exports soon fell, and a trade imbalance ensued. Lack of fiscal restraint soon combined with this trade imbalance and created record levels of debt. This debt ultimately proved unsustainable when markets collapsed in 2008, and bond yield rates shot up as a result. Without the European Central Bank (ECB) as a lender of last resort, there was no way of guaranteeing this debt, and a crisis of epic proportions ensued.

Coming out of this crisis will require a number of measures. While populist revolt against an ever widening democratic deficit might frustrate some efforts at reform, policymakers should focus on top-down, continent-wide stimulus in the form of quantitative easing and increased public spending to help restore growth. The European Commission should also demand drastic structural reforms at the member-state level to ensure that any progress will last. Member-states should then consider transitioning toward continent-wide Euro-bonds to lower bond yield rates and spread risk across transnational lines. Protecting banks against capital flight will be important as well, and policymakers should do everything in their power to set up a deposit-insurance mechanism. Aside from that, they should also use their resources to recapitalize banks and ensure that they are solvent. Finally, the European Commission should set up its own financial regulatory agency to make the European regulatory apparatus more uniform and robust. All of these measures amount to the beginnings of a banking union, which will ultimately lay the foundations for a fiscal union and a return to growth.

Causes of the Crisis

Was Greece’s growth all that remarkable or was it really dependent on its membership to the European Union, and more importantly the Euro itself? There’s no definitive answer to this question, but nonetheless it’s very clear that Greece, like many other less structurally sound southern European economies saw its own economy artificial inflate during the 2000s. What appeared to be genuine economic growth was really the creation of an economic bubble that eventually burst at the end of 2007.

The Bubble

However, instead of this bubble just being the housing market like in the United States or only a certain subset of the economy, Greece’s bubble was its entire economy. When it burst, air in the form of capital escaped far more quickly than in the United States, plunging the country into a depression on the scale of the 1930s.

While it’s impossible to isolate one factor responsible for the creation of this countrywide economic bubble and subsequent depression, there are certainly a number of factors responsible. As Greece and other southern European economies joined the more prosperous and structurally sound north around 2000 to form the Euro, the monetary union initiated a process that had the effect of balancing out the economies of north and south. The south began to appear to itself be more prosperous, and what seemed to be remarkable growth soon followed.

Labor and Trade

With this growth came an increase in wages and a subsequent increase in unit labor costs. By 2005, wages in southern Europe had risen by nearly 25%. This meant that it had become considerably more expensive to manufacture goods in countries like Greece, and outsourcing, which had already been going on for decades, increased dramatically as result.

At the same time, the illusions of growth gave people a false sense of prosperity and mass consumption in the form of goods and services accelerated. Since wages had increased and southern European economies had become less viable, these new goods weren’t coming from domestic production. Rather, the vast majority was coming from China, Indonesia, and other, less developed countries (LDCs) outside of the Eurozone, creating a trade imbalance. All of Greece’s economic and furthermore, that of southern Europe was based on this unsustainable consumer spending and when the global economy collapsed towards the end of 2007, all domestic demand for foreign goods evaporated into thin air. What followed was a collapse in growth as well, one far more severe than in northern Europe, where the likes of Germany were still economically viable and were still running trade surpluses with strong manufacturing sectors.

Interest Rates

Still, trade imbalances can’t be the only cause for blame. Greece’s membership to the Eurozone played just as large a role as well. Membership in the seventeen state partnership provided Greece with a common currency and with it, a common monetary policy controlled by the European Central Bank (ECB). During the 2000s, the ECB like other central banks worldwide kept interest rates relatively low and markedly lower than what market forces in southern European countries like Greece would have had under normal conditions. With lower interest rates, borrowers in Greece were more inclined to borrow large amounts capital from banks, and banks soon followed suit by lending out large sums of money. This accelerated southern European economic growth, or rather inflation of the southern European bubble. Still, lower interest rates were much less a cause than a catalyst of the collapse, increasing the size and scope of Greece’s economic woes.

Public Spending and Debt

Public spending and fiscal responsibility, or lack thereof, was also to blame. When it was revealed in 2009 just after George Papandreou’s socialist government had taken office that Greece’s annual deficits were far larger than officially published, bond markets reacted with fury. Fears of Greek default essentially shut the country out of the bond markets and forced it into a flurry of austerity. Greek austerity, like that of other southern European economies, however, would be much deeper than David Cameron’s spending cuts or Nicholas Sarkozy’s belt tightening. International factors, both private (lack of access to the bond markets) and public (demands of the troika consisting of the International Monetary Fund (IMF), European Commission, and ECB) made spending cuts far more severe than in northern Europe. Secondly, political stagnation and diffusive interests at the ECB made it impossible for the central bank to be a lender of last resort.

With its inability to borrow money and subsequent spending cuts, Greece saw its prospects for growth vanish, and perpetual recession ensured. While austerity was necessary to ensure investors that government can repay its debts, austerity has simply destroyed growth.

Impending Solutions

Restoring any growth not only to countries like Greece, but also across Europe won’t be simple. A series of steps must be taken in order to ensure that more than just austerity is pursued. That being said, growth in the form of stimulus can’t come at the member-state level as lack of access to the bond markets makes it impossible for the likes of Greece and other southern European countries to borrow money.

Stimulus

Therefore, any economic stimulus must come at the supranational level. The ECB has already begun this effort with quantitative easing, but just keeping interest rates low is far from enough to restore growth. Furthermore, fears of inflation as well as political divisions have limited what the ECB can accomplish, necessitating new, more innovative approaches.

These new approaches should take the form of legislation similar, but possibly larger, than President Obama’s American Recovery and Reinvestment Act, commonly known in the United States as the stimulus bill. Similar to America’s stimulus bill, Europe’s fiscal stimulus should be union-wide, and should be carried out by the European Commission. This will ensure that any injection of public funds is not only targeted, but also uniform and collaborative on a continent-wide scale.

Politically speaking, pursuing such policies is somewhat problematic. The already present democratic deficit would only enlarge, fueling the fires of populist backlash. In Greece, this backlash has come in the form of the far left SYRIZA and far right Golden Dawn, both of which experienced electoral breakthroughs in this year’s parliamentary elections. Their newfound presence has not only realigned the entire political landscape; it has also fragmented any future policymaking and has polarized the Greek electorate.

Structural Reforms

This political fragmentation will only complicate any recovery. No matter how problematic top-down authority is, lack of political cohesiveness in countries like Greece shows just how necessary leadership at a continent-wide level is. While euro-wide stimulus will certainly begin the process of growth, structural reforms, both at the national and supranational level will be needed. The Fiscal Stability Treaty (FST) is the first of these structural reforms, and its strict budgetary rules will be helpful in preventing future crises, but implementing the agreement might require more than blind threats of losing access to the European Stability Mechanism (ESM), the union’s bailout fund. Demanding more than just deficit reduction will also be necessary, and the troika must also use its role to ensure that structural reforms on the scale of the FST are actually carried out by member-states.

Euro-bonds

Long-term reform at the national level will only help so much, however. Supranational measures will need to be taken in order to preserve the Euro. Among these is the creation of a continent-wide banking union, and with it continent-wide Euro-bonds, which would help spread borrowing risk across transnational lines. This would have the effect of equalizing bond yield rates, raising the borrowing costs of northern countries and lowering them for southern European countries. With lower borrowing costs, southern European countries and their governments would have an easier time regaining access to the bond markets and reassuring investors that their economies are safe for investment.

Deposit Insurance

But reassuring investors will take more than just Euro-bonds. The European Commission must also create a Euro-wide equivalent of the American Federal Deposit Insurance Corporation (FDIC) to protect against capital flight. During times of economic crisis, people often times withdraw their money from banks, fearing that they will collapse and their investments will disappear. While small scale withdrawals during a mild downturn often pose no problem, during prolonged times of crisis, these withdrawals increase substantially, putting considerable strains on banks to continue lending money. Should these withdrawals continue unabated over a long period of time, banks will lose large sums of capital and will not only be unable to lend out more money; they will be unable to guarantee the deposits of all of their investors. Should public fear overwhelm a bank, a bank run will ensue, and the bank will lose all of its capital, and with it, all of its investors money. Thus, guaranteeing any deposits is absolutely necessary, and the Commission must act decisively to create its own FDIC that will help quell public concerns.

Bank Recapitalization

While long-term reforms, like protecting investors, are essential to any recovery, more immediate measures must also be taken as well. Among these is recapitalizing the banking sector. In 2008 when the banking sector first collapsed, governments worldwide rushed to shore up insolvent institutions, infusing hundreds of billions, if not trillions of dollars into the banking sector. In Europe, this occurred at the member-state level where member states, rather than the ECB or Commission decided how banks were “bailed out”. What followed was a set of policies that lacked any cohesiveness, and this lack of coordination complicated any continent-wide recovery. Furthermore, the already large public deficits in southern European economies led investors to believe that southern European governments, like much of the banking sector, was itself on the verge of default. As southern European governments then lost access to the bond markets, they were unable to continue recapitalizing banks, and fear in the form of capital flight ensued.

Little over four years later, the problem still remains unsolved. Luckily, Europe has another good American model it can follow that has proved successful. The Troubled Asset Relief Program (TARP), America’s own private bailout mechanism, immediately stabilized the banking sector and put the entire country back on the path of growth. Unlike in Europe where each country implemented its own bailout without conferring with its partners, TARP was a top-down policy coming from the highest level of authority: the federal government. In fact, state governments weren’t involved at all in its implementation, and the Federal Reserve and Treasury Department played the largest role in dishing out funds to troubled financial institutions.

Suffice to say, Europe needs its own version of TARP, and over the past year, it has begun to move in that direction. Recent agreements amongst European leaders to permit the ESM to buy troubled assets are certainly a good sign, but leaders must also move swiftly to separate sovereign public debt from banking debt. Having both coupled together will only increase strains on cash strapped member states and will push many steadily away from the bond markets. Should member states leave the bond markets, they will need access to the ESM to stay afloat. But if the ESM is also diverting some of its funds away towards buying up troubled assets, it might not have enough capital to bailout troubled member states. Furthermore, having both bailout mechanisms coupled together will only perpetuate market fears of public and private default. Therefore, the Commission must also separate its sovereign bailout fund from its banking one. Doing so will help stabilize the banking sector and more importantly, the public bond markets, and will finally create just what Europe needs: its own version of TARP.

Financial Regulation

Preventing a future crisis will also be important as well. With neoliberal ideas thoroughly discredited, the need for more financial regulation, and more specifically, more continent-wide financial regulation is clear. Therefore, not only will the Commission need to streamline financial regulations across the entire Eurozone; it will also have to make its own regulatory agency.

However, unlike in the cases of deposit insurance or bank recapitalization where the United States provides a very good model for Europe, in the area of financial regulation, the United States too has failed. Its plethora of regulatory bodies has created something of a pluralism of agencies, making regulation of the financial sector rather difficult. Furthermore, neoliberalism has sucked away considerable regulatory authority from agencies like the Securities Exchange Commission (SEC) over the past three decades. To put it simply, lack of uniformity in financial regulation and prevailing economic theories in the United States as in Europe helped bring on a crisis of massive proportions.

Thus, the Commission must create its own regulatory agency aimed at strengthening financial controls and centralizing regulatory authority. Making regulations more robust will restore a degree of confidence and assure future investors that the financial sector is secure. While more political centralization will no doubt increase the ever widening democratic deficit, making the European Union’s regulatory apparatus more uniform will put the Eurozone on a path of long-term stability. Placing a single figurehead atop the new agency will be key as well and will give it the increased power it needs to achieve its goals.

Conclusion

Still, the fact remains that any solution is far from simple, and with interests so diffused across Europe, it’s nearly impossible to predict what will happen in the near future. Germany’s upcoming elections early next year have put any reforms at a standstill and will likely impede any progress. While opinion polling gives Angela Merkel’s Christian Democratic Union (CDU) a strong change of winning, should she go down in defeat, the European project may very well go down with her. Regardless of what happens, the idea of Europe will always exist and remain a fixture of civilization everywhere.