When the Greek government suddenly revealed in late 2009 that it might not be able to honor its debts, a wave of panic spread through the European market: Other countries in distress—Ireland, Spain, Portugal—could suffer the same fate, and the euro and eurozone themselves could possibly collapse.
To avoid sovereign default and financial collapse, Greece needed the help of the European Union—reluctantly granted in a dramatic meeting of the European Council of May 2010, in exchange for a program of strict austerity measures by the Greek government. This meant slashing salaries and pensions, raising taxes substantially, and pushing unemployment to dramatic levels. As the Greek Parliament approved those measures in the spring of 2010, police battled enraged protesters outside in the streets of Athens. It served as a perfect snapshot of Europe’s rude awakening.
Wobbling but not yet falling, Greece has raised questions that can’t be put off any longer. What can we expect for the eurozone? Can the euro survive, and at what price? What kind of Europe is this crisis going to produce? How did we reach this point?
In the wake of the Second World War, leaders of victorious and defeated European countries alike faced an inescapable realization: If the nations of Europe could not find a way to cooperate, share resources, and prosper together, they would probably find themselves, sooner or later, in another—and this time possibly final—civil war. Thus the postwar integration of Europe began.
The lesson of the “beggar thy neighbor” policies of the 1930s, which turned into the “slaughter thy neighbor” policy of the 1940s, left an indelible image in the minds of all who had lived through it, particularly the founding fathers of modern Europe: Jean Monnet, Robert Schuman, Konrad Adenauer, and Alcide de Gasperi. A new and different Europe was no longer a dream; it was a necessity.
The goal was both strategic and political: to create a supranational entity watching over the destiny of Europeans. The means were economic, because it was by improving economic conditions that the self-interest of Europeans could be promoted without reawakening periodically the destructive nationalism of the various countries bunched so closely together on the continent. This was a strategy that Jean Monnet spelled out clearly when he said, “Europe will not be made at once, nor through a comprehensive architecture, rather it will be made through concrete achievements, creating first of all a sense of objective solidarity.” The way to build the new union was through incremental steps toward economic integration that one day would lead to political integration.
The process was sparked by the United States, which made the implementation of the Marshall Plan for the postwar reconstruction of Europe conditional upon the creation of a European common authority to distribute the aid, according to criteria agreed upon by the recipient countries.
This successful collaboration emboldened visionaries like Monnet and Schuman to push forward new cooperative initiatives, most notably the creation of the European Coal and Steel Community, which put management of the iron ores of the Franco-German border under collective control, and which led to the milestone Treaty of Rome in 1957, which in turn set up the Common Market in an effort to establish a Customs Union among the treaty’s six original signatories: France, Germany, Italy, Belgium, the Netherlands, and Luxembourg.
The Common Market created economic growth and social progress of unprecedented dimensions. (Italy saw its GDP grow by a stunning eight percent a year between 1958 and 1963.) Its success brought the founding countries closer, generated second thoughts among countries who had originally decided not to join—most notably Britain—and helped seed the collapse of Communism and the birth of globalization.
The process that started with the Treaty of Rome set in motion a constant drive to expand the areas and agenda of collaboration among the member states, producing what Walter Hallstein, the first president of the European Commission, has called “the bicycle theory of the European Union,” according to which integration must always keep moving forward, becoming broader and deeper, at the risk of otherwise losing momentum and falling over.The bicycle’s forward motion led to important developments regarding the size of the union, the number and scope of its institutions, and the depth of its economic integration. It also encouraged the various countries and European institutions to expand first and find a solution to the problems created by that expansion later.
By 1985, this brand of integration and expansion led to the signing of the Single European Act, which took effect in 1992, introducing the principle of free circulation of capital, services, and people within the union. But the further integration at the level of trade could hardly be achieved without some sort of coordination between the currencies of the countries involved. The open currency markets and the wide fluctuations those markets introduced, coupled with the tendency of the less diligent countries of the union to resort to competitive devaluations, made it increasingly necessary to improve the level of monetary coordination.
Early attempts to create this coordination, following the demise of the Bretton Woods system, had only been partially successful. The European Monetary System, put in place at the end of the 1970s, was seen as too subordinate to the interests of the Deutsche mark, creating serious difficulties for other currencies, which were easy prey to speculative attacks, as in the case of the British pound and the Italian lira in the early ’90s. The creation of a single currency became the decisive means of keeping the European bicycle moving along.
T he decision to create a single European currency, implemented by the 1992 Treaty of Maastricht, was one of the most fateful steps taken by Europeans in their history. This decision, in principle strictly a financial one, had enormous political and social implications because it bound together in an unprecedented way the destinies of many European nations, who relinquished one of the most important functions of sovereignty—the control of their own currency and monetary policy—to a supranational entity located outside their national borders. There were two important provisions in the treaty. The first was that members of the European Union had in principle an obligation to join the euro system (except for certain countries, like Great Britain, that received a specific exemption), and that once in the eurozone countries could not leave the euro without also leaving the European Union. The second was that the process of financially bailing out individual countries was expressly forbidden, apart from “exceptional, most serious and temporary circumstances.” This was a legal obligation that seriously limited the flexibility of the EU in dealing with potential financial problems.
The creation of the euro created overnight the largest trading area in the world, took away the uncertainty of national currency fluctuation, and made intra-European transactions much easier and cheaper, while also creating a friendlier borrowing environment. The euro also sent a clear message of political commitment and stability: major European countries now accepted a common monetary fate.
At the same time, however, the euro was based on some tenuous assumptions, e.g., that it would be enacted in an “optimal currency area,” allowing for the seamless transfer of goods, labor, and capital from one area to the other—an assumption that turned out to be much too optimistic. Furthermore, a common currency among very different national economic realities ran the risk of creating a one-size-fits-all monetary policy, creating tensions between countries positioned along different phases of the economic cycle. In times of crisis, this could clearly lead to “asymmetric shock” that would significantly strain the system.
Whatever the potential problems, however, European countries understood clearly that failing to enter the monetary union would have condemned them to a destiny of instability and bar them from a massive market. The euro was a train they could not afford to miss, and many of these countries made truly heroic efforts to meet the criteria for entrance into the exclusive club. The more profligate candidate members made a commitment to follow a path of rigor and restructuring in order to meet the criteria set in the Maastricht Treaty: inflation up to no more than 1.5 percent a year, a maximum budget deficit of three percent of GDP, and a debt-GDP ratio of less than sixty percent. To reach these goals, many countries had to embark on a strict budgetary policy, cutting waste, reining in government expenditures, privatizing public companies, and extending taxes. The political price for those moves was too high for countries like Italy, Spain, and eventually Greece, and they entered the euro without that deep restructuring.
But the need to enforce the original “Maastricht criteria” was very high on the agenda of more diligent eurozone countries like Germany and the Netherlands, who feared that weaker countries, once they were in the euro, might not maintain the rigorous fiscal behavior they promised as an entry ticket. To mitigate this risk, Germany demanded and was granted a Stability and Growth Pact, which introduced rigid penalties for those states that deviated from the original admissions criteria. The meticulous control by the bureaucracies of Brussels and Frankfurt with respect to these fiscal criteria, which proved difficult to enforce, generated a false assurance in the union that as long as the criteria were respected all was well. In this they failed to see other structural problems that were potentially far more dangerous to the economic stability of the eurozone: the lack of control over the regulation of national financial institutions, the emphasis on demand-side economic expansion connected with financing bubbles, the subservience of national governments to the interests of strong national groups, the inexorable expansion of benefits, and finally the scant attention to the strengthening of productive, competitive sectors of the various eurozone economies.
W hatever the problems lurking down the road, the birth of the euro in January 1999 had the immediate effect of leveling borrowing rates in the various countries. Suddenly countries like Italy and Portugal, which had been able only to borrow at rates tied to those of Germany, found themselves able to borrow money at rates quite similar to those of their more diligent neighbors. The rationale was that, being eurozone countries, they had the weight of the entire continental superstructure behind them.
This created an unprecedented possibility for increased liquidity, with banks happy to lend money to countries selling bonds denominated in euros, gaining a small spread compared to Germany, and discounting those bonds at the European Central Bank. The euro, moreover, benefitted by emerging during a period of strong growth in the world economy, which, following the collapse of the Nasdaq bubble and the 2002 recession, witnessed a massive infusion of liquidity into the international financial system, with the major central banks bringing the cost of money close to zero.
This reinforced substantial global lending, and proved a bonanza for one of the main European growth areas: the banking sector, which in the eurozone is a national affair, regulated and managed on a country-by-country basis. The various national banks went on a lending spree, to the point that eurozone bank-controlled assets have grown 3.5 times faster than GDP since the inception of the euro, leading to an amazing exposure of the European banking system, an exposure that has yet to be fully digested by the market. (According to Leto Research, as of February 2009, the eurozone banks had a financial exposure of $1.6 trillion to Eastern Europe, $2 trillion to other export-driven countries, and $4.1 trillion to Spain, Italy, Portugal, Greece, Ireland, and France.)
This massive infusion of liquidity and extensive borrowing had important effects for the economies of the eurozone. In particular, it led to a big confidence boost and an ensuing demand boom in the peripheral euro countries, accompanied by a significant rise in wages and benefits. However, the productive capacity of those countries remained imprisoned by rigid labor markets, low productivity, and a growing reduction of their economic competitiveness. Their increased economic activity was instead fueled mainly by the housing sector, which in countries like Spain and Ireland saw the formation of truly spectacular bubbles, with rising private indebtedness and skyrocketing real estate prices.
The end result was increased borrowing by many countries and an exponential growth in government spending aimed at satisfying the demands of labor for wage increases and retirement benefits. This strong, demand-led economic growth insured an increase of taxation that prevented governments from suffering from excessive deficits, allowing politicians to expand benefits to electorally important social groups, all financed by a toxic influx of capital liquidity.
T he onslaught of the financial crisis in 2007 and 2008, along with the drying up of liquidity that followed, had devastating consequences for the more exposed eurozone countries. The housing boom ended overnight, leading to massive defaults and leaving European banks with enormous debt exposure and little hope of regaining their loans. The crisis led to a precipitous recession in those economies, a serious shrinking of economic activities, and a slim likelihood of solving the problem by increasing exports, since high labor costs and poor competitiveness made those goods far too expensive. The more vulnerable countries quickly found themselves with double-digit government deficits and public debt greater than their GDP.
The United States had reacted to the drying up of liquidity with a massive infusion of cash into the system to stabilize the financial institutions with much-needed capital. Toxic assets were eliminated from the banks’ balance sheets. This was not how Europe reacted to the crisis. Faced with the collapse of the national financial systems, Europe lacked a culture of solidarity that could have made possible the massive influx of liquidity in problem areas; nor did it have a Department of Treasury to pump money into the system. Actually, the worry of the Central Bank at the height of the crisis had more to do with keeping Germany free from inflationary pressures than restoring liquidity to the rest of the eurozone.
Most important of all, because troubled countries could neither devalue nor inflate themselves out of debt, the euro turned out to be a straitjacket. The only way out of debt was thus through fiscal policy, i.e., the reduction of wages and benefits and of government spending, which meant a sharp reduction of demand and a growing recession. The austerity packages that had to be approved led to massive popular demonstrations, general strikes, and at times social unrest.
Although the current use of the acronym “PIGS” has had the effect of treating Portugal, Ireland, Greece, and Spain as various examples of the same problem, the paths those countries took to their financial crises were quite different, namely in terms of the weight of their respective economies within Europe, the dynamics which led to their crises, and their future economic prospects. Ireland is suffering a bank default crisis due to the collapse of the housing bubble and its decision to bail out its banking system with taxpayer money (a decision that led to shock on the part of bond investors who were trying to get rid of their bonds at fifty cents to the dollar). This particular choice has significantly damaged Ireland’s fiscal health, quite strong until the crisis, and sent the country into a deep recession.
Spain is also paying the price for a burst housing bubble, along with heavy indebtedness and a consequent banking crisis associated with it—all on top of the loss of its economic competitiveness of the past decade. Portugal is suffering the consequences of a bloated public sector, which tended to buy social peace through debt, and a consequent lack of exporting competitiveness.
In a way, Greece is the extreme case of fiscal irresponsibility—indulging in a spending and consumption binge and granting rises in wages and benefits that were way beyond the economic capacity of the country. This led to spiraling government deficit and public debt, kept hidden through accounting manipulation. It’s no wonder that news of Greece’s true economic woes, and the government’s cry for European help as the only way to avoid national financial disaster, sparked a market panic. Greece provoked the sudden realization that a default of sovereign debt by eurozone countries was possible, if not probable.
As the need for a bailout in Greece came to the table in early 2010, with other distressed countries soon to follow, the reaction of the European Union, and of Germany in particular, was one of great hesitation and internal political division. The idea of bailing out the “PIGS” was seen as a violation of the Lisbon Treaty and the beginning of the “monetization” of debt in the eurozone with the introduction of collective financial responsibility—exactly what the founding euro treaties had sought to avoid. As a former Bundesbank officer said, “A bailout would be like jumping in a swimming pool without water.” Important German ministers were starting to question the possibility and desirability of avoiding the Greek default (in this, echoing the opinion of the German public, which had no interest whatsoever in paying the bills of untrustworthy Southern Europeans who should not have entered the euro in the first place) and began drafting scenarios of a two-tiered European Union, one inside the euro and the other outside.
But the response of the markets to eurozone wavering in the face of potential collapse was hard to misinterpret. The euro declined precipitously, as markets quickly lost confidence in its long-term prospects; and there was a sharp increase of borrowing rates for the peripheral countries, with rates for Greece three times those of Germany.
The prospects of a eurozone breakup, and a taste of the financial consequences this would entail, quickly swept away any hesitation on the part of European leaders, in particular the German chancellor. Germany, with roughly 700 billion euros in loans to the distressed countries, had to put its money where its mouth was. At its historic May 2010 meeting, the European Council and the European Central Bank (ECB), in coordination with the IMF, set up a bailout fund of 750 billion euros, consisting of 440 billion euros in guarantees from eurozone states, an IMF contribution of 250 billion euros, and a 60-billion-euro European debt instrument, allowing the ECB to buy bonds on the open market. To run the operation, the EU set up a new organism, the European Financial Stability Facility (EFSF), with the authority to issue bonds based on those guarantees, and the mission “to provide loans to eurozone countries in financial difficulties, recapitalize banks or buy sovereign debt.”
The first loan went to Greece for a total of 110 billion euros, at a rate of five percent a year (rather high for a bailout), in exchange for significant fiscal tightening and budget cuts by the Greek government—truly draconian measures aimed at bringing the country’s fiscal deficit in 2011 from thirteen to seven percent. This was stiff medicine for the Greek economy, sending the country deeper into recession and leading to widespread workers’ demonstrations and civil unrest.
The enactment of austerity measures was carried out by all the eurozone countries in distress. Italy, Spain, and Portugal took important steps to cut their spending and bring their deficits within sight of the three percent limit by 2012. These measures sent these countries into a recession as well, but a much shallower one than Greece will face in the coming years, and proved sufficient to avoid the need for bailouts, at least for now.
Ireland also undertook a series of steps to cut down its public debt, which had skyrocketed following the government decision to bail out its own banks after the burst of the housing bubble and the bankruptcy of its banking system. The government enacted an unprecedented austerity plan aimed at reducing its fiscal deficit from thirty-two percent of GDP in 2010 to three percent in 2014. This seemed a recipe for misery that led many observers to question the decision to bail out the banking system, but it did not keep Ireland from becoming the second country to demand a bailout, in this case one of 85 billion euros.
The willingness of the larger countries of the eurozone to diverge from a policy of non-intervention in the sovereign debt of the individual members, however, did not come without stern and far-reaching demands.
Germany and France demanded that in return for the new 750-billion-euro aid package, the EU had to put in place much more effective controls on fiscal and broader economic discipline. The enhancement of financial support for member states in distress and increased fiscal and economic coordination and controls have been the two parallel evolving designs of the eurozone summits throughout 2010 and into 2011.
Thus, while there was an agreement to create the European Stability Mechanism, which will work as a sort of European Monetary Fund and will substitute for the EFSF starting in 2013, at the same time Germany and France have increasingly demanded stricter rules of control not only of national fiscal discipline, but also of wider economic policies and national financial institutions. They have seen that worrying about a three percent fiscal deficit while allowing national banks to produce private debt many times greater than a nation’s GDP can lead to disaster. To avoid these problems in the future, the European Union in December 2010 created the European Systemic Risk Board to oversee risk in the financial system as a whole, including banks, funds, and other types of financial intermediaries.
At the February 2011 Euro Summit, Germany and France, while reiterating their unwavering support of the preservation of the euro and of honoring sovereign debts, presented a list of far-reaching reforms that gave the full sense of where they want to take the eurozone and the price they attach to their commitment to the financial stability of the European Union. They demanded rules not only for fiscal discipline but also for price competitiveness, including wage stability; minimum rates of investment in research, education, and infrastructure; European-wide rules for dealing with financial institutions at the national level; and a drastic request for a debt brake provision in national constitutions.
T he EU has finally accepted, albeit still in a limited fashion, collective financial responsibility as a fundamental instrument to fight fiscal and economic crises. At the same time, the mere creation of a mechanism to offer limited guarantees for debt support might not be the comprehensive solution that Europe needs.
Countries like Greece, Ireland, Portugal, and Spain face a serious problem: now that the consumption and housing bubbles have ruptured, these countries will undergo a long period of recession while being forced to pay high interest rates on their sovereign bonds. This will make their debt situation even worse. It is thus vital for them to see those interest rates reduced. The prospect of spending many years without any hope of growth and better living conditions, while working very hard to send money to foreign creditors as debts keep piling up, will likely produce an untenable political and social situation in these societies. They might simply be forced out of the euro and the EU by sheer exhaustion and loss of hope, and this would be a tragedy for them as well as for the rest of Europe.
At the same time, default and unilateral debt restructuring cannot be tolerated by the eurozone, as it would introduce a level of mistrust and panic that would generate a run to the banks in all the countries of the zone, no matter what their solidity on paper.
The solution lies in finding a middle way between these two imperatives—creating a financial and political mechanism that will make it acceptable for the people of Europe to reduce the debt of countries in distress by replacing high interest bonds with cheaper ones and transferring the cost of this orderly operation to European taxpayers.
It is certainly hard to believe that Europe will allow the present crisis to lead to a demise of the euro. Greece and Ireland, and more recently Portugal, each face a very difficult situation, and the jury is still out on their capacity to weather the storm politically and economically, but Spain has been able to avoid bailouts and appears to be edging toward stability.
One dividend of the present crisis is that it seems to have forced Europeans to confront the stark reality that a Europe without its Union is a continent without a dream, a fate without hope. Going back to national currency and trade wars, enmity and turmoil is hardly a future to propose to the generations of Europe to come, no matter how difficult the current national financial muddle might be.