Europe's Strategy and Europe's Future

Dr. Douglas O. Walker
Robertson School of Government

A week ago, in the wake of its continuing financial crisis and in response to the panicked imploring of Mr. Jean-Claude Trichet, the increasingly anxious President of the European Central Bank, the leaders of the European Union adopted a package of measures intended to stabilize financial markets and support the adjustment of the weaker European economies toward sustainable growth.

European bond markets and the euro have been under intense pressure amid concerns about high fiscal deficits and debt levels not only in Greece but other European countries, most notably Portugal, Spain and Italy. In support of the new European Financial Stabilization Mechanism announced on 9 May, the Federal Reserve agreed to reactivate temporary liquidity swap lines to provide foreign banks with access to dollar funding and the Executive Board of the International Monetary Fund approved a €30 billion three-year loan for Greece. These measures are expected to be supplemented at both the European government and IMF levels in a rescue package worth $1 trillion. For its part, after Mr. Trichet repeatedly said it never, ever would, the ECB has been purchasing Spanish, Portuguese, Greek and Irish bonds to prop up their prices and will no doubt continue to do so.

At the national level, Spain and Portugal announced new austerity measures intended to bring their fiscal deficits in line with the 3 percent of GDP limit mandated by the Maastricht Treaty. These include tax increases, budget cuts, and across-the-board pay cuts for government workers. Other countries with large deficits will no doubt follow these two. Once implemented, these actions will increase already high unemployment and further depress already low levels of economic activity and any impetus these countries might have transmitted to their trading partners, including the U.S. While the euro aid package appears to have calmed global financial markets, conditions remain unsettled and a double-dip recession in Europe could well be on the way.

With these efforts, European leaders have made clear their choice to try and save the euro and their monetary union, even at the cost of a deepening downturn. They fear the repercussions of a Greek default not only on the future of the euro but on the very stability of the other countries of the eurozone. Their decision to support Greece and the other highly indebted countries is an immense gamble, immensely unpopular in much of Europe and it will be immensely costly whether it succeeds or not. These costs will not be limited to Europe and the directly affected countries.

The approach taken to dealing with the problems before Europe, I must say, do not inspire confidence. The immediate response has been to treat the financial crisis of Greece and other heavily indebted countries as one of liquidity, not of solvency. But Greece is clearly insolvent, meaning that it cannot conceivably pay back the debt it has incurred. Greece’s public debt is about 125-150 percent of their GDP. Until recently, when the average rate of interest was 4 to 5 percent, Greece had to pay out some 5 or 6 percent of its GDP in interest payments just to avoid further debt, most of it, let me add to foreigners. But because of Greece's continuing fiscal deficits the debt-to-GDP ratio has been rising rapidly, meaning that even if the interest rate it had to pay were steady, a larger and larger share of the country’s production would have to be transferred abroad to finance its growing external liabilities. Moreover, when questions about the possibility of debt repayment were raised, the interest rate on the debt rose. Recently, the interest rate on Greek debt rose to a point where 10 to 15 percent of its GDP would have to be transferred abroad to meet its obligations, clearly something that is not possible. While the recent stabilization measures and purchases by the ECB of low-grade securities have reduced the interest rate on Greece's debt, it is simply is not possible to continue this kind of support over the longer-term for Greece or for any other country.

Alternatively, if Greece were treated as a case of insolvency rather than liquidity, it would immediately “restructure” the debt, that is, write off a good part of it, my guess 50 percent or more of its value. The losses inherent in defaulting on the debt would have to be shared by the banks and investors in Greece bonds, those foreigners who purchased Greek bonds, Greek taxpayers, government workers, and nationals who would find their taxes raised, jobs cut, and cost of imports much higher. Greece would also have to undertake, as it has promised to do, strong measures to bring its internal and external deficits under control and reduce its domestic price level. By abandoning the euro, it would have gained full control of its monetary policy and be able to design a recovery program tailored to its specific problems and a future path to policy that recognizes that Greece -- like Spain, Portugal and Italy -- does not have a tradition of balanced public budgets and controlling the tension between the desire for more public spending and the willingness to pay for it. I suspect in the end Greece will leave the eurozone. It faces not only the immediate costs of maintaining the euro but a longer-term struggle of keeping its domestic costs in line with the other eurozone countries, something that appears to be beyond its ability.

But the Greek authorities and European leaders have decided for the moment to keep Greece in the eurozone. Rather than dealing with the insolvency of Greece, they (tried to -- to my knowledge the agreement is still somewhat up in the air) put into place a three-year program of financing, as if Greece would be able to carry the burden of the debt after a period of respite.

Why did they do this, knowing full well that Greece will not be able to pay back this debt? First of all, because the leadership of Europe is totally committed to the idea of European integration, regardless of the costs and regardless of the possibilities of success. To this end, they are hoping against hope that somehow Greece will gain the capacity to service its debt. But more importantly and realistically they are bailing out Greece because Greek bonds are held by French and German banks that are themselves on the edge of bankruptcy. If the Greek bonds are written down now, then many European banks become insolvent, with all the implications that has for the wider European economy and the rest of the world, not the least of which is another collapse of world trade. (And, let me add, American banks, many of which are in fact in a state of unacknowledged insolvency today, own securities of the European banks.) It is hoped, with time and a recovery in economic activity, the capital position of the banks will strengthen and they will be better able to absorb losses.

So, the “rescue” program being put in place has as its purpose transferring the losses from the eventual Greek restructuring to the taxpayer, both in Europe and through the IMF, to the rest of the world. Greece, of course, will nonetheless suffer tremendously from the “adjustment” program imposed by the IMF, but in their view it must undergo this adjustment anyway. Moreover, they also recognize that there must be a substantial fiscal tightening across the euro area and beyond, if financial markets are to be convinced that growing sovereign debt levels will not create another worldwide financial crisis.

Needless to say, the entire approach is fraught with great problems. It presumes the governments involved will cobble together an acceptable rescue package and financial markets will agree that the “bailout” will be sufficient in the short-term to stabilize the market and lower interest rates. It assumes governments will implement much tighter fiscal regimes and a wide range of policies intended to rebalance their economies toward fiscal sustainability over the medium-term. It implies these countries will undergo a difficult restructuring of their patterns of production and consumption which over the longer-term results in a sustainable pattern of domestic economic activity and trade. It trusts that the flood of liquidity injected into system will not trigger inflation in Europe and the global economy. It puts in play unprecedented moral hazard because no one -- not the governments spending recklessly and issuing bonds to cover unprecedented deficits nor the banks and investors buying imprudently and speculating wildly on them -- will be allowed to fail and suffer from the bad decisions they made. It does not address the underlying problem of fiscal sustainability that permeates all the countries of Europe, not just those facing debt problems today. It insists without reason that European countries will adhere to the requirements of the Stability and Growth Pact that underlies Europe's Economic and Monetary Union. It means that major reforms in government finances will have to be accompanied by a major revamping of the financial system, with the “Big Banks” being downsized and greatly reduced in influence. And finally, it is all predicated on a rapid return to a pace of economic growth that is nowhere in sight.

The steps taken at the Brussels summit in reaction to the pleadings of Mr. Trichet, like those of Treasury Secretary Henry Paulson when the U.S. financial system came close to collapse in 2008, are understandable as a reaction to an immediate crisis and the need to deal with it. It is an assertion of faith and intentions. In this sense, it is not surprising that an approach taken under the pressure of the moment lacks the depth and comprehensiveness required to deal with long-standing and fundamental problems. As was the case of the American response to its financial crisis, such is the case with the European Financial Stabilization Mechanism the European Union will try and implement in the weeks to come. But no one should think that it is anywhere near adequate to manage, much less overcome the real problems of the long-run solvency of Greece and other European countries. Until a real and determined program of comprehensive reform and restructuring is undertaken, Europe will remain in a constant state of crisis and with little potential for economic growth, political stability, and social advance. The same can be said about the United States.