Euro Crisis Redux

When global leaders met in Davos, Switzerland this past January for the annual World Economic Forum, it was not just an opportunity to chatter about the state of the global economy, but also a moment for a collective sigh of relief. The fiscal cliff in the United States had just been avoided, Barack Obama was even able to raise some revenue by letting some of the Bush-era tax rates expire, and the currency crisis in Europe appeared to be on the mend. What a difference a month makes. As another battle over deficits and spending looms in Washington and threatens to pull the U.S. economy back into recession, a far greater worry is the ever-present crack-up of the euro, which would be an economic tsunami to the spring shower of sequestration.

It all starts with Italy and the possible return of Silvio Berlusconi. Many thought the media mogul’s long strange trip as Italian prime minister had finally come to end in November 2011 when he resigned after pressure mounted to fix the ballooning Italian debt. A respected economist-cum-politician technocrat, Mario Monti, stepped into the breach and began implementing reforms, while the European Central Bank (ECB) lent a hand by buying Italian bonds and pushing down interest rates so that borrowing costs remained low. But the public’s taste for higher taxes and negative growth has proven limited, and Monti was forced to call for new elections after support for his austerity policies dried up, creating an opening for the politician most associated with Italy’s decline over the last decade to reinsert his unctuous visage into national politics.

Although last weekend’s election produced a stalemate, the mere prospect of Berlusconi’s presence anywhere near the halls of government was enough to spook the markets and send Italian interest rates soaring. After all, this is the man who reportedly told a prominent Italian newspaper that the German chancellor, Angela Merkel, was an “unfuckable fat-ass." Not particularly wise, considering Germany’s economic girth alone makes it the only country able to bail out Italy if things took a turn for the worse. This is also the man who, as prime minister, was reportedly so overwhelmed by the technicalities of the crisis in the summer of 2011 that he regularly feigned falling asleep in roundtable meetings with other European politician so that his advisors could hash out the details beside him.  

It is hardly surprising then, that investors were unnerved by Berlusconi’s popularity in national polls leading up to last weekend’s election, where his party garnered 29.1 percent of the vote, just below that of the rival coalition of leftwing democrats who scraped by with 29.5 percent. An insurgency was led by the comedian-turned-social-critic, Pepe Grillo, whose protest movement, Five Stars, garnered an impressive 25 percent. As one Italian newspaper put it: “The winner is ungovernability”. None of this bodes well for the Italian economy, which was already struggling with negative growth and had only recently showed signs of resurgence.

The flight of capital out of Italy is a cause for major concern, for the country remains the lynchpin and a litmus test regarding the strength of the European currency union. Economists often point to the confidence game that undergirds financial markets and the risk that ‘contagion’ poses for the euro. Individual European governments continue to issue their own bonds to pay for things, but being locked into a common currency means that devaluation is not an option. Greece, for example, would have had far fewer problems, had it been able to devalue its currency, which would have lessened its debt in real terms and made its economy more competitive. But since the goal was to keep the euro together no matter what, Greece was granted bail out after bail out, so that markets wouldn’t turn against other weak countries in southern Europe like Spain or Italy.  

The ECB’s bond-buying scheme, akin in many ways to the Fed’s quantitative easing, helped calm markets significantly last year in Spain and Italy but it also required the tacit endorsement of Germany, whose economic strength, in turn, guarantees the future solvency of the ECB. In return, Germany wanted “fiscal discipline,” which translated into austerity—higher taxes, less government outlays, and, therefore, anemic growth in countries that really needed fiscal expansion instead. That gambit only worked in Italy for a year—higher taxes are a tough sell when the economy isn’t growing, with the political fall-out being Berlusconi’s resurgence in Italy. Political turmoil is running high in Spain as well. Youth unemployment in both countries has plateaued at an eye-popping 50% in many regions. Ungovernable indeed. 

Hence, the drama of the eurocrisis has returned. If Italy is judged not to be safe for international investors, then neither would Portugal or Spain. And with lackluster performance taking hold in France as well, perhaps not even la grand Nation. This would be a truly terrifying prospect for European policy makers. If Italy goes, then so does the neighborhood, igniting a chain reaction that could snowball into a general unraveling of the euro, as investors flee one country after another. Would Germany be willing and able to stem the tide by bailing out Spain, Italy, and France?

Nothing good would come out of the euro collapsing. Martin Wolf of the Financial Times likens it to trying to unscramble eggs after an omelet has been partially cooked. When times were good the currency union not only led to low interest rates for historically weaker countries in southern Europe, but also an expansion of banking activity across the Eurozone. German banks have Spanish, Italian, and French assets on their books, just as Italian banks own shares in things such as German companies and German real estate, not to mention the complex problems that arise from private citizens who can transfer their savings to any bank of their choosing across the Eurozone. A re-introduction of national currencies would wreak havoc on the European banking system (and it is a system, unlike the fiscal structure of Europe, which is still fragmented along national lines). This would no doubt cause a financial crisis far greater and deeper than that triggered in 2008, as the entire world banking system would seize up amidst the panic of unprecedented uncertainty, hinder the proper provision of credit, and lead to the mother of all bank runs.

While governing in the United States remains dysfunctional, there is at least the comfort that only one government can screw up, and even then, within fairly well-defined parameters. It is clear how much money is at stake with the sequester, as it is relatively easy to anticipate the costs of another debt limit debacle in a few months’ time. In the Eurozone, however, there are 17 governments to watch and anticipate, each with its own interests, tradition, and set of attitudes toward the project of a united Europe. If the euro is to survive, there will inevitably need to be more consolidation at the European level, some form of ‘fiscal union’ that will require member states to give up more sovereignty. Yet the current crisis has only deepened nationalism and created resentment—in both the southern countries dependent upon help, as well as in the northern countries committed to giving.

The stakes couldn’t be higher or more complicated. The European Union remains the largest economic block in the world economy and the most important trading partner with the United States. The Obama administration and the European Union are eager to liberalize trade in the hopes of getting their economies as well as the global economy back on track. Only time will tell. But forget about the doomsayers on the sequester. The real catastrophe could come from Europe.

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