No easy fix for European Union's debt crisis

What is going on? The problem, say close watchers of both the subprime financial crisis in 2008 and the European government debt crisis today, is that many investors think there is a quick and easy fix, if only government officials can come to an agreement and act decisively. In reality, one might not exist. A best case in Europe is a bailout of troubled governments and their banks that keeps the financial system from experiencing a major shock and sending economies worldwide into recession. But a bailout doesn’t mean wiping out the huge debts that have taken years to accumulate – just as bailing out US banks in 2008 didn’t mean wiping out the huge amount of subprime debt that homeowners had borrowed but couldn’t repay.

The problem – too much debt – could take many years to ease. “Everybody has been living beyond their means for nearly the last decade, so it is an adjustment that will be painful and long, and it will test the resilience of societies socially and politically,” said Nicolas Veron, a senior fellow at Bruegel, a research organisation in Brussels. This isn’t to say that the discussions in Europe are moot. If governments can’t agree on how to rescue Greece from its debilitating government debt, some fear the worst case could happen – a collapse of the financial system akin to 2008 that would ricochet around the world, dooming Europe but also the US and emerging countries to a prolonged downturn, or worse.

Just like the US, Europe built up trillions in debts during the past decades. What is different is that while in the US more of the borrowing was done by consumers and businesses, in Europe it was mainly governments that piled on the debt, facilitated by the banks that lent them money by buying up sovereign bonds. Now, just as the US economy is held back by households whose mortgages are still underwater and won’t begin to spend again until they have run down their debts, Europe can’t begin to grow again until its countries learn to live within their means. That means running down their debts during years of austerity and tax increases. In short, it still means years of painful adjustment.

“We have to adjust to lower growth,” said Thomas Mirow, president of the European Bank for Reconstruction and Development, referring to Europe as well as the US. It is of course going to be very painful. But leaders have to speak frankly to their populations.”
The uncertainty about Europe’s future has been driving the gyrations of financial markets since the summer. Earlier this week, stocks rallied on euphoria that a new and more powerful bailout was near, but the rally fizzled last week when cracks began to appear among European nations over the terms of money being given to Greece. On Thursday, markets were mixed after the German Parliament approved the 440-billion-euro ($600 million) bailout fund aimed at keeping the crisis from hurting large European countries.

The trouble is that even this fund, which requires the approval of all 17 nations in the euro currency zone, is already seen as inadequate for the scale of Europe’s woes. Instead, a new idea is to bolster the fund by allowing an institution like the European Central Bank to use it as a guarantee for much greater lending, perhaps up to a couple of trillion euros. This is the cause of the new optimism in markets, but some worry that even that idea may not fully address one of Europe’s most dangerous problems: fully recapitalising its banks. “We’re not seeing any real acknowledgment of the scale of the banking sector problem,” said Simon Tilford, the chief economist at the Center for European Reform in London. And even if the fund were enhanced with a couple of trillion euros of firepower to buy up troubled government debt from the financial system, that would still only shift the debt from European banks to taxpayers and do nothing to pay it off.

“Clearly something is cooking, but the markets will eventually choke on the taste,” said George Magnus, an economist at UBS in London. “It is about getting banks off the hook, but the darker side is it’s not doing anything real.” Certainly, not everybody shares this view. Some economists say they believe that if Europe can only survive this crisis, at least some of its bigger members will be in relatively better shape than, say, the US.

Debt levels are painfully high in countries like Italy, Ireland and Greece, but overall eurozone debt as a percentage of gross domestic product is 85 per cent compared with 93 per cent in the US. When it comes to budget deficits, they are lower in aggregate across the 17 EU countries that use the euro than in the US – on average, 6 per cent of gross domestic product, compared with about 9 per cent in the US. In addition, European consumers did not go through the same borrowing binge, so their retrenchment need not be so severe. “We need to do a lot to get over the crisis but once we are over it, it will be the US facing years of fiscal retrenchment, not Europe,” said Holger Schmieding, an economist at Berenberg Bank in London.

Indeed, a quick resolution of the crisis could increase confidence in these battered economies, and lead to a return to positive growth. But the danger is that the strict austerity measures being adopted will only worsen economic downturns that some think could drag on for a decade in Greece, Portugal and Spain. The threat is that, in turn, slow growth may make it harder for governments to pay down their debts. Germany managed to pull itself around after labouring for years as the “sick man of Europe,” with high unemployment and sluggish growth. In the early 2000s, while the so-called Club Med countries of Southern Europe spent beyond their means, the German government initiated a series of structural reforms, deregulation and wage adjustments that helped it become the economic powerhouse that it is today.

But it is unclear where growth is going to come from in other European nations. None of the Continent’s weaker countries have a similar solution. Portugal and Spain, for instance, have pledged vigorous programs of spending cuts and tax increases. Yet it is unclear how this will stimulate growth unless they, too, can make over their economies to compete with the quality of German products or the cheaper labor costs of other markets like China.

The 440-billion-euro bailout now being voted on, and even the ideas to maximize its power, amount to “Band-Aid city,” said Carmen Reinhart, senior fellow at the Peterson Institute for International Economics and co-author of “This Time Is Different,” a history of debt crises. “For a few weeks it buys tranquillity,” she said, “but it does not get at two critical issues: it does not reduce the massive debt overhang and it does not restore growth.”

Until real measures are taken to restore growth, the divide in Europe between wealthy northern countries and weaker southern ones will continue to plague the region, say many analysts, putting continued pressure on Germany to support its weaker neighbors.

That comes at a time when Germany’s own economy is showing signs of slowing as other Europeans become less able to afford German goods. In the long term, some political leaders and economists are pushing for a more integrated economic, fiscal and political union in Europe – what they see as the only real solution.

“I don’t think little steps are credible here,” said Kenneth Rogoff, a Harvard economist and the co-author with Reinhart of “This Time is Different.” “There needs to be a United States of Europe at the end of this, and it may well not include everyone in the eurozone.” He added, “That’s always been part of the plan. They were thinking they had 20 years to get there, and instead they have 20 weeks.”