The Troubled Euro Zone

For most of us, Europe is a nice place to visit but we wouldn’t want to live there.  And we pay little attention to European politics and even less, except when we’re trying to exchange dollars into euros, to European economics.   We may be aware that something has been going on this summer -- rowdy demonstrations in Athens and Madrid, riots in London, gyrations in stock markets that mirror the turmoil on Wall Street -- but it’s all been pretty peripheral. 

As I write this, there are pervasive worries that Greece will default on its debt, that other European economies will tank, that the euro is destined for the scrap heap and the grand scheme for European integration represented by the European Union will falter.

There are three big points that I think are worth commenting on.

1) The problems that have prompted austerity programs in Greece, Ireland, Portugal, Italy and the UK are to some extent very much like the problems afflicting the U.S. economy, since they revolve around short term deficits and long term debt.  And to a significant extent they are quite different because of the size and nature of the U.S. economy.  You can understand some of the underlying dynamics of the problems in Europe by thinking about the U.S. economy.  But you need to avoid the facile comparisons that equate our short and long term issues with the smaller and weaker European economies.

2) The fact that these countries are members of the European Union and the euro zone adds a dramatically different dimension to national economic issues.

3) The so called “Neo-liberal Washington Consensus” continues to dominate international economics.

1)  The roots of the European Crisis 

The collapse of the financial system that began with the bursting of the housing bubble in the United States in 2008 spread rapidly to the rest of the advanced capitalist economies in Western Europe.  The same lousy mortgages that were bundled, “securitized” and sold to U.S. investment banks and insured by folks like AIG were sold to European banks as well, with drastic effects on the ability of businesses and governments to borrow money when those mortgages turned out to be worthless.

Many governments run deficits – spend more money than they raise in taxes in a given year.  Mainstream economists generally agree that some deficit spending is actually a good idea if 1) it is being used for long term investments, like infrastructure, that increase economic growth (which increase tax revenues over time and – at least in theory – pays for itself); 2) it is being used “counter cyclically” – to stimulate demand during a recession or depression (and the other side of the coin is that governments cut spending and/or raise taxes when times are good to prevent inflation.) But if the deficit is for current consumption, that is to pay benefits or wages or for other programs, then it is generally regarded as a bad thing.    

Governments borrow money 1) directly from international banks and 2) on a larger scale by selling bonds that pay interest over a number of years.  The “collateral” for government loans is future tax revenues.  In the imaginary perfect world, a government would use the borrowed money to expand economic activity and its taxes and end up with enough extra money in the long run to pay back the loan or pay off the bonds.  In the short run, the borrowed money would improve the economy enough to let the government pay the annual interest on the loan or bonds, what economists call debt service.  Things go rapidly downhill when the economy does not grow fast enough and the government has to make debt service payments by borrowing more money.  At some point banks and investors stop making loans or buying bonds (or they start charging such high interest that the government can’t afford it.) 

This is very over simplified but, I hope, not such a cartoonish sketch that it is misleading.  Any discussion of deficits and debt is complicated by the recent brouhaha in Congress over the debt ceiling that obliterated the difference between short term and long term effects of spending and borrowing.  In Europe, as in the United States, annual budget deficits and the national debt are are different phenomena.

Greece (along with Portugal, Spain and Ireland) is in deep trouble right now because the government has consistently run deficits to pay for current programs and benefits and the underlying economy is weak.  Greece is a small country with – by European standards – a relatively low standard of living.  That means there is not a huge domestic market and exports become far more important than they are in the U.S.  But Greece does not have a large export market ... it is not a major agricultural producer, it is not a hot bed of high tech industry, it is not a manufacturer of machinery, etc.  Thus the long term prospects for sustained economic growth in Greece at rates that will let the government pay the current bills and keep long term debt at manageable levels are bleak when the global economy itself is faltering.

The Greek situation is quite different from the stronger European economies like Germany and France.  The United Kingdom is different from both the weaker economies like Greece or Portugal and the situation in France and Germany.  The UK does have a pretty strong economy that has been battered by the global financial crisis.  The austerity budget the government adopted last spring that slashed a lot of spending aimed at the poor and working class had, I think, as much to do with the Tory’s ideology as it did with presumptively dispassionate economic analysis.

The United States is distinctly different from both the weaker and the healthier Western European economies.  The U.S. differs from the smaller and weaker economies because our deficit issues are not driven by a fundamentally weak economy but by decisions on financing the Iraq and Afghanistan wars, tax policy, and the impact of the 2008 financial meltdown.  Our big problems are short term, not long term.  And the U.S. differs from Germany and France both  because of the sheer size and diversity of our economy and because of the role of the dollar as the world’s premier reserve currency. 

 But, as the cliche goes, I digress.

2) The Euro zone

From its formal inception in the Treaty of Rome in 1956, the European Union has reflected two very different visions.  One the one hand, the goal has been to create a political, social and economic unit that would transcend and render irrelevant the component nation-states.  The nationalism blamed for the bloodshed of the 19th and 20th centuries would be replaced by a pan-European identity.  On the other hand, the vision has been a much narrower focus on economic cooperation between nations and the goal the elimination of barriers to trade, not some larger transcendent “New Europe.” 

One vision leads to an emphasis on creating new institutions and fostering a common identity ... hence the European Parliament, the Court of Justice of the European Union, the European Council, the European Commission and the European Central Bank.  The other vision leads to an emphasis on the rights of nation-states and the limitations of “European” decisions compared to national decisions. 

Every major development on the path from the common market of 1956 to the Europe of today has generated skepticism from those who see traditional nation-states as the reality of politics.  The vision of a new Europe has been pronounced as dead or near dead time and time again.  So called Euro skepticism is especially pronounced in the United Kingdom.   The acronym PIGS, for Portugal, Ireland, Greece and Spain, complete with the negative connotations, works only in English. 

An important feature of European development, supported by both those who seek a new Europe and those who seek to improve cooperation among existing states, is the common currency, the euro.  The initial major impact of the new money was to make business in Europe far more efficient.  Heineken no longer had to translate its costs and profit margin from Dutch guilders to German marks to French francs to Italian lira, Portugese escudos, etc.  Heineken buys its raw materials in euros, pays its workers in euros and sells the beer in euros. 

The euro zone has not abolished national economies and differences in productivity and costs of doing business, including taxes and some government policies.  The only way a huge economic unit like the euro zone, composed of a number of somewhat distinctive smaller units, can survive is if there is relative uniformity in wages, hours, working conditions and other costs of doing business, including taxes and inflation.  The European Central Bank was created to encourage states to coordinate their economic policies.  When the global financial crisis hit and some vulnerable states were in bad shape, the ECB expanded its responsibilities and launched a series of plans to stabilize government finances and international bond markets.

In effect, the strong European economies tried to share some of their strength with the weaker links.  That exposed Germany and France in particular to pressures on their own economies and what is seen by critics as spending their taxpayers’ money on bailing out other governments. Good old timey nationalism has resurfaced, too, with critics wondering why hardworking, thrifty northern Europeans have to come to the aid of feckless Mediterranean types. 

Decision making in Europe is complicated and even experts in European politics have a hard time explaining exactly how the Commission and the Parliament and the Council interact.  The European Central Bank Board of Governor is composed of members from the central banks of member states and they reflect different perspectives on risk and inflation.  The result, in the eyes of many critics, is that the steps the ECB and the political leadership of the European Union have taken to deal with the problems of the past year and half, have been too little and too late and too confused. 

If Greece is unable to make the interest payments on its outstanding debt, then the bondholders will have to change their balance sheets.  And if international banks suddenly have less capital than they thought (because the Greek bonds are now worth less) then they will have to cut back on loans to businesses and to other governments.  This will further retard already sluggish recoveries.  If a default in Greece or elsewhere results in the collapse of the euro and a return to national currencies, that will not only make the short and long term economic problems in Europe worse, but it will disrupt the global economic system. This will have real, tangible effects on Americans.  For better or for worse, our well being is tied to people and events far beyond our borders.

3) The Neo-Liberal Consensus

The International Monetary Fund, the World Bank and the U.S. Treasury are located within walking distance of each other in Washington, D.C. The number of economists working in those institutions or researching developmental economics in major research universities is quite small and many of them move back and forth between academic life and policy making at the IMF, World Bank or Treasury.    By the mid-1980s the professional economists had come to share a conventional wisdom about what Third World countries should do to spur economic development and came to apply that prescription to more developed countries as well.  The details and specific policy applications of this “Washington Consensus” differ to some extent, but all three global institutions accept the principles that governments in economic trouble should 1) open up their national economies to the globalized capitalist market system; 2) reduce the government’s role in the economy by privatizing the widest possible range of government activities; 3) slash government spending, especially on non-productive immediate consumption including the “safety net” programs.  The fact that the consensus is based on an updated version of the market capitalism first described by Adam Smith makes it “Neo-Liberal.” “Neo” because it is updated and revised, “liberal” in the 19th Century use of the term which is about 180 degrees from 21st Century progressive (since we don’t say “liberal” anymore) thought.

Like all prescriptions, this package is based on both empirical analysis and political values.  I think it is fair to say this approach is skewed in favor of the values and interests of the well off.  If governments have to sell bonds to investors, it is no surprise that the interests and preferences of those investors, be they rich individuals or managers of huge investment portfolios, cast long shadows over policy making.   It is no surprise that the prescriptions for Thailand, Kenya, Greece and the United States all involve immediate hardship for the poor and working class. 

I don’t mean to end this with a sneaky manipulation where you are supposed to think “Oh how fair, to punish the poor for the sins of the rich!”  The conventional wisdom argues that some short term distress may be the only guarantee of long term good times.  The political (moral) question is how much distress is justified.

A hundred years ago this all seemed simpler.  Nicaragua defaulted on its debt and the U.S. Marines went in and collected the taxes for several years until the debt was paid off.   The events of the past three years, initiated by the collapse of the housing market in the United States, have underscored the growing importance of a global economy.  The short term question is whether Greece and the rest of Europe can survive the current crisis.  The long term question is whether countries can act together to increase the benefits of the new economy and shield everyday people from the potential harms.