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Can Europe Save Itself - and Avoid Pulling Down the U.S. Recovery?
At last weekend’s IMF / World Bank annual meetings in Washington, the question on everyone’s minds was, what’s happened to Europe’s instinct for economic survival? While our Congress squabbles over bookkeeping for disaster assistance, the talk in the corridors of the IMF was that Europe is two to three weeks away from financial meltdown. It would start in the sinking market for Greek government debt, followed by turmoil in much-bigger markets for the public debt of Italy and Spain, as well as Portugal and Ireland. And if Europe’s leaders can’t head that off, it will likely take down most of Europe’s large banks. Angela Merkel, Nicholas Sarkozy and their counterparts across Europe get this. What they don’t want to face is that the only solutions ultimately lead to a radical rewriting of postwar social contracts across the Eurozone.
The financial carnage wouldn’t stop at the continent’s shores. British banks have large holdings of Spanish, Italian and Irish government bonds, so they would be very vulnerable. Our own banks sold most of their portfolios of European government bonds over the last year. But U.S. officials worry privately that U.S. banks are holding unknown billions of dollars of credit-default swaps against both those bonds and the European banks that hold them. That puts them in a position that recalls AIG in late August 2008, as insurance providers for a catastrophe that now lies somewhere between the possible and the likely. Finally, a meltdown of European finance would mean horrendous recessions across Europe and an end to our own recovery.
The sober minded men and women at the IMF aren’t given to nightmare scenarios. They believe in data, and it’s the analysis of those data that now points to impending crisis. Over the last six months, for example, the shares of the largest banks of Greece, Italy, Spain and France have sunk 30 percent to 50 percent. Even scarier, the costs to insure against the failure of those banks reached the same levels last week as they did here for Lehman Brothers a few weeks before its collapse. And the costs to insure against the complete default of Greek, Italian and Spanish government debt – financial Armageddon -- have risen 60 percent to 80 percent.
For months, financial analysts and global investors have tracked the perfect storm now taking shape across the Eurozone. But unlike the weather, European leaders know how to head off much of it and to contain most of the rest. Yet, like Henry Paulson’s Treasury throughout much of 2008, Germany’s Merkel and France’s Sarkozy have spent the six months trying to ignore the undeniable. The bottom line this time: Monetary unions across states or countries, like the Eurozone, work only when the full faith and credit of the whole stands behind the full faith and credit of each part.
The classic example of a successful monetary union was the United States in the late 1700’s. Under the Articles of Confederation, the southern states paid off their revolutionary debts, and their credit was sound – think of them as Germany, the Netherlands, and Northern Europe today. But profligate Massachusetts, Connecticut and most of the rest of the north let their debts, both old and new, just pile up – they were the Greece, Italy, Spain, Ireland and Portugal of their day. Resolving these debts hung up approval of the new U.S. Constitution, so the framers created a Bank of the United States which assumed the debts of the northern states. In return, by the way, the credit-worthy southern states got to take the national capital away from New York and relocate it in a swampy track on the border of Virginia.
A similar task now faces Merkel, Sarkozy and the Dutch and Finnish members of the Eurozone –- in effect, pledge their own good credit to guarantee the same for the Eurozone’s profligate southern countries. So far, they’ve thrown a lot of money at Greece, hoping it would satisfy global investors. We now know that hasn’t worked, and that much harder adjustments lay ahead.
In fact, Europe’s crisis is even more serious than our own in 2008. To begin, Europe’s banks hold the failing sovereign debts of the southern Eurozone countries as well as toxic assets left over from 2008. Moreover, no one doubted the U.S. Government’s capacity to step in and bail out our banks and provide massive stimulus for an economy spiraling downward. This time, it’s sovereign debt itself that’s under attack, so that option isn’t available for Greece, Spain, Italy, Portugal, or even France. Washington also could head off bank runs when Lehman, AIG and Merrill Lynch collapsed, by guaranteeing everyone’s money market balances. None of the Eurozone countries in such deep trouble today would have the credibility to take such a step. So, if everything begins to unravel, there’s very little they can do to save their banking systems. And such a banking crisis will hit Germany as well, since its private banks also hold many tens of billions of Euros in Greek, Spanish and Italian debt.
There are still a few precious weeks left to head off this Euro-catastrophe. The Eurozone’s rescue fund so far has focused on delaying Greece’s default. In the next two weeks, it will have to, at once, inject capital into unknown numbers of large banks and buy massive amounts of Greek, Spanish, Italian and Portuguese debt on the open market. The politics of pulling that off are daunting, because it will require the unanimous support of 17 Eurozone governments. So far, only six have agreed, and they’re mainly the ones that would be rescued. Of the others, Finland, for one, has put up impossible demands that will have to be dialed back. And while Merkel now says she’s prepared to do what she said a month ago she’d never do, it’s unclear if her own party will go along in a vote scheduled for later this week.
One reason for their opposition is that most of the bill will fall to Germany and the five other Eurozone countries that still have sound credit. There are ways to stretch the bail-out capital, however. The European Central Bank could underwrite it – it still says no to that -- or the rescue mechanism could guarantee losses of up to 20 percent on sovereign bonds. But such moves are immensely complicated matters to work out in just a few weeks, especially when everything requires the unanimous consent of the Eurozone governments. When Henry Paulson had to come up with a bailout plan quickly as Wall Street melted down, he managed to pull together three pages of general principles saying the Treasury could whatever it wanted. That won’t wash this time.
The second reason will be even harder to handle. If the Eurozone can find its way to guaranteeing the sovereign debts of all of its members, their future debts will have to be centrally and uniformly constrained. In short, the solution to the crisis could spell the end of each government’s autonomous right to conduct its own spending and tax policies, since that’s what generates sovereign debt. That would require fundamental revisions of the long-time social contracts these governments have with their peoples, including provision for the world’s most extensive public pensions and health care coverage. That’s the real reason Merkel, Sarkozy and the rest have spent so long denying the emerging crisis. The next two to three weeks will tell whether they have the courage and vision to finally address it.