The Slime of Indecision

Emmanuel Pierrot / Agence VU

There is no logical reason why a minnow-size sovereign debt crisis made in Athens should have ballooned into an existential threat not only to Europe’s ill-designed experiment with a common currency and to the cohesion of the wider European Union, but also to the prosperity of the world.

For all the billion-going-into-trillion estimates of the cost of getting out of this mess, the still wealthy continent’s problem is not in truth a debt crisis. Taken overall, the euro zone’s debt profile is neither disturbingly high nor heavily dependent on outsiders to finance, and its current account is close to balance. This is a currency crisis, and the absence of European leadership has magnified it into a burgeoning political as well as an economic disaster.

You could even argue that when the storm first broke, the Europeans had a stroke of luck. The euro’s structural faults were bound to be exposed at some point—most prominently, the persistent trade and credit imbalances within the euro zone attributable to the unworkability of a one-size-fits-all interest rate for 17 markedly disparate economies, all issuing sovereign bonds but no longer printing their own currencies, with no effective ways to secure fiscal discipline and no lender of last resort. And the meltdown could easily have started in a country larger and more costly to bail out than Greece.

In the summer of 2010, the task for euro-zone politicians was relatively simple: admit the evident truth that Greece was bankrupt, organize a rapid and deep restructuring of its unpayable debt, and use the breathing space to recapitalize European banks and build better defenses against contagion before the markets lost confidence in Europe’s more serious players. The downside risks at that early point were minor. In the worst scenario, there would have been turbulence if Greece had done a backward somersault out of the euro zone, but the sky would not have fallen in.

The politicians blew it. On the pretense that Greece was just a bit short of money and could put its house in order with a robust dose of austerity, Europe advanced some cash, sent in the accountants, and crossed its collective fingers.

Why? Principally because German Chancellor Angela Merkel was not prepared—and still is not prepared—to admit to irate German voters that the “no bailouts” guarantee that had persuaded them to give up the Deutsche mark for the euro was not worth the paper it was written on. Secondly, because euro membership was legally irrevocable and even to hint that it might not be so was unconscionable heresy. And finally, because Germany and France were anxious to “protect” their banks, which were loaded with Greece’s worthless bonds.

That was then, 19 months ago at the time of writing. This is now. Ireland and Portugal have joined Greece in the emergency ward, and others, such as Cyprus, belong there, too; Italy and Spain can finance their debt only at prohibitive and unsustainable cost; markets are demanding stiffer premiums on Belgian, French, and even Austrian and Dutch bonds, and by December some investors had begun to steer clear even of the doughty German Bund.

Europe’s banks are choked with dicey government debt that they were encouraged to buy on the basis that the euro was forever and those bonds were therefore zero risk, all equally safe. Under political pressure to roll over their virtually untradable Greek bonds at 50 percent of face value, or 25 percent if the Greeks had their way in the negotiations, their understandable reaction was to shed Italian holdings as fast as they could—by nearly half in the case of BNP Paribas, and 88 percent at Deutsche Bank—thus exacerbating fears that the euro was not just in crisis but close to meltdown. In response, U.S. money markets stopped lending dollars to European banks, forcing the Federal Reserve and other central banks from Japan to the U.K. to intervene to avert a commercial banking collapse. That decisive concerted action to treat the symptoms, while essential to protect the global banking system, merely confirmed the life-threatening seriousness of the euro disease—and the growing doubt that the euro zone’s politicians, and its institutions, are capable of the decisions required to calm the markets.

The political mantra all along has been that the euro must at all costs be glued together. But no one can locate the gluepot. For Berlin and Brussels, the solution is “more Europe.” Germany demands treaty changes that are not only hotly controversial but would, even if agreed tomorrow, take more than a year to implement—time Europe no longer has. New rules to enforce economic convergence might, moreover, help to avert trouble in the future but will not put right what is wrong right now. Besides, it is not clear that the public would stand for “more Europe.” Irate voters have chucked out the Irish, Portuguese, and Spanish governments, and bureaucrats have displaced the feckless politicians of Italy and Greece. The Irish are already complaining that their votes are of no account, since decisions are all made in Brussels and Berlin.

Having surrendered control over national interest rates, the exchange rate, and the printing press, the euro zone’s invalids are hurtling downhill without brakes. A treaty change that imposed fiscal union would deprive them of the fiscal-policy steering wheel as well: pretty scary. Merkel declares that she would “give up a piece of national sovereignty” to save the euro, but in Athens, Rome, Lisbon, and Dublin, where the EU fiscal police are already ensconced, people ask just whose sovereignty she has in mind. The more the fiscal austerity on which Germany constantly harps crushes incomes and destroys jobs, the greater the risk that saving the euro will come at the price of Europe’s political disintegration.

Europe is paying through the nose to save the Euro, and still the panic deepens. Something has to give.

All credit then to Valérie Pécresse, the French budget minister, for admitting that the emperor is naked, and that “the soundness of the euro zone” is the real issue. Concerted action is imperative. But in Germany there is no willingness to build a wall against financial panic that would inevitably be largely made of German bricks.

So Europe’s leaders slither on in the slime of indecision. Summits have come and gone, and each unconvincing quick fix spreads the cancer of uncertainty.

Time frames are contracting, fast. Last year’s first European rescue plan for Greece brought a respite of a few months; this summer’s, a few weeks; by this winter, not even a landslide victory for the center-right in Spain lifted the mood. The damage caused by the weak political response is mounting, not only for euro nations but for non-Euro neighbors Britain and Turkey, and there is no political solution in sight. Merkel repeats at every turn that “if the euro fails, Europe fails.” But Europe is paying through the nose to save the euro, and still the panic deepens. Something has to give.

Europe collectively has the financial strength to calm the markets, even at this stage. It has enough left over to combine much-needed structural reforms with enough fiscal stimulus to help reforms translate, eventually, into a resumption of growth in its troubled periphery. Why, then, the policy blockage?

Because of the tricky Franco-German partnership underpinning the euro’s creation. The single currency was conceived by France in the early 1990s as a way of subduing reunified Germany—and accepted by Helmut Kohl, for the same reason—as a gateway to full political union. It was a consciously political decision to make “Europe” run before it could walk. Ignoring the history of currency unions, the euro was introduced before, not after, its members’ economies had converged, trusting in the “logic of union” to bring convergence about. The independent European Central Bank, charged above all with ensuring price stability, set the common interest rate, yet had no powers to control national fiscal policies or stop states from borrowing too much at the new and seductively cheap rate. To deter free riding, Germany insisted on the Stability and Growth Pact (“and Growth,” significantly, was a French add-on) that capped public debt and deficit levels. Whatever moral force the pact might have had evaporated when Germany and France became the first countries to break the rules. Euro states could no longer print money to pay off their debts, and yet, on German insistence, the ECB was also treaty-barred from acting as lender of last resort.

The buck stopped nowhere. Failure was never considered, and therefore never provided for.

Merkel, not entirely tactfully, describes the crisis as the biggest threat to Europe since World War II. Far from invoking the Marshall Plan, however, she insists that, just as Germans made painful sacrifices after reunification, so others must tighten their belts now.

She has a point; Germans naturally resent underwriting Greece’s bloated public-sector bills when the state has failed to collect €60 billion worth of taxes. They also resent subsidizing the shamelessly inflated pay and perks of Italian politicians. There is no doubt that market pressures have been far more effective prods to serious reform than political exhortation. But Germans should ponder another historical analogy. After the Great Crash of 1929, Germany’s “starvation chancellor” Heinrich Brüning cut spending so savagely that a third of the workforce lost their jobs, paving the way for Hitler, and unemployment in Greece and Spain is about as bad now as Germany’s was then. Sure, the underperforming euro members need massive, courageous structural reforms. But they also need to convince investors, right now, that they can produce enough wealth to service their debts.

Politically, too, austerity requires a minimum of assent, not easily secured for fiscal diktats from Berlin via Brussels.

Moreover, it is not only profligacy that has landed Mediterranean Europe in the mire. The overwhelming economic weight of Germany in the euro zone ensured that throughout the currency’s first decade, ECB interest rates were aimed at restarting the mighty German engine. But that kept rates unjustifiably low in real terms for the Greek, Irish, and Spanish economies—an open invitation to the Greeks to live on credit, and to Irish and Spanish speculators to build the castles in the air that now stand empty and unsellable. To boost Germany’s recovery, the ECB further allowed the euro zone’s M3 money supply to balloon at more than double the 4.5 percent official growth target, flooding Europe with easy money.

The euro was built to a largely German design, and Germany has profited hugely from a common currency, without which the Deutsche mark would have spun skyward. The euro zone, Germany’s “home” market, is entering a recession that will be deepened by fiscal austerity coupled with a sharp deleveraging in its financial sector. The euro zone could die of depression. Finally, Germans are being fooled by Merkel’s no-bailout stance, because in practice the Bundesbank, which already holds €465 billion worth of Greek, Irish, and Portuguese bonds, is on the hook for more than €180 billion held by the ECB. Besides, it has a €211 billion share of the underwhelming European Financial Stability Facility (market moniker: Expected to Fail, Sure to Fail), a much-trumpeted nonsolution that has scant prospect of leveraging up its base capital of €440 billion to the trillion mark—and would even then be too small to handle major economies like Italy and Spain. Merkel has so far done enough to alarm many German voters but not enough to restore confidence in the euro—surely the worst of worlds.

She would dispute that. For her and her finance minister, Wolfgang Schäuble, the lesson of this crisis is that discipline has not been tough enough. They demand strong central government of the euro, with fiscal oversight, automatic penalties against budgetary delinquents, and power to take ailing countries into receivership. More dangerous even than a crippling recession, in German eyes, would be a pooling of Europe’s liabilities in a “transfer union” by issuing Eurobonds (cunningly renamed “stability bonds” by the European Commission) that let the spendthrift off the hook. To free the European Central Bank to bail governments out, contrary to Article 123 of the EU Treaty, is even more unthinkable. Germans gave up the Deutsche mark on the solemn pledge that this could never happen. It would be the end of sound money.

Merkel will not, however, be able to hold the line for much longer. If France loses its AAA rating, its banking system is hugely vulnerable, and without France, Germany would be exposed to the full force of the financial storm. She has allies in Finland and the Netherlands, but much of the rest of Europe, not to mention America, has had enough of Germany’s national obsession with the hyperinflation of 1923 when deflation and a prolonged depression were imminent dangers. That puts the ECB in center frame.

The ECB has unlimited powers to print money, and the pressure on it to do so is becoming irresistible. It could use those powers, under the treaty, for the purpose of restoring stability to the markets and “economic cohesion” to the euro zone. Coupled with lower interest rates, the ECB has the capacity to address both the market-funding crisis and the risks of prolonged recession.

The economics may look neat but the politics will be dreadfully stormy. Mario Draghi, the ECB’s new president, will be reluctant. He complains that the ECB has spent months buying time for politicians and they haven’t used it. But only the ECB’s full firepower will gain enough time for fundamentally solvent Italy and Spain to correct course and for the enactment of new fiscal rules to underpin the euro. Germany may hold out against such a solution to the end, in which case the ECB’s governing council would have to outvote its two German representatives—not a step to be taken lightly, even in Paris. The euro would fall on world markets—to the benefit of Europe’s economies but the chagrin of sound-money Northern Europeans. The currency zone may not survive the impact of a Franco-German collision, at least in its present form. The whole structure has been based on the fiction that their interests basically coincide, and this crisis has shown this is not so. But the European ideal will be crushed along with its economies unless the panic is stilled. Merkel’s proclaimed willingness to “do whatever it takes to save the euro” faces an extremely painful test.

This essay was published in Newsweek International's Special Edition, 'Issues 2012,' on sale from December 2011-February 2012.