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The Euro Debt Crisis - Explained

2011-11-10 12 min read Essays marco

euro_1It’s one of those moments in my life when people around me ask the same question over and over again. This time, it’s, “What’s wrong with the euro?” Since there are only so many hours I can spend explaining my version of the story, here is an article about it, and I hope this will answer some questions.

What Was Before the Euro?

I grew up in Europe, a child of a mixed marriage between an Italian and a German. They were not just citizens of their respective countries: my father and mother came from families that were deeply embedded in their cultures. When my parents fell in love, there was strong resistance to the marriage outside the culture. I can imagine the surprise that everyone felt when the marriage actually worked perfectly well for over twenty-five years, until my mother passed away.

One consequence of this mixed heritage is that I got to travel from one country to the other at least four times a year. We’d usually drive through Switzerland, which was the worse travel route, but it was prettier and my father loved the (car-sickness-inducing) hairpin turns going up and down the Alps. In the course of the years, we saw infrastructure improve: from the two-lane country roads that wound up and down the faces of mountains, we got to four lane roads that still looked like spaghetti on a hillside, to the amazing Gotthard tunnel that plunges right through the very mountain for the longest and most boringly dangerous route I could imagine.

The improvement in infrastructure were paralleled by an ever tighter integration of the economies in the region. At first, we’d just buy seasonal products from outside the country – you’d buy Spanish strawberries in April, because they’d be ripe a month later in Tuscany. But later we bought more and more from our neighbors, and we cared less and less about where something had been made. I recall when foreign-made cars showed up for the first time on Italian streets – the shock! – but ten years later, domestic manufacturers had lost the majority share of new registrations.

Which gets us to the early 90s. The economies of Europe were tightly integrated, but their political institutions were not. The problem showed up in many different circumstances, but was felt most hard in the currency exchange rates. Whenever a European currency would go up, goods imported from that country would cost more. That made it really hard for anyone to plan and create supply routes, and industry was unlikely to change supply chains to limit themselves to their own country.

A common currency had to be made. That way, all the exchange rate stuff would just go away. Problem solved.

At first, the common currency became simply an accounting unit. All European currencies were pegged against this unit, and the central banks of the European Monetary Union had to help keep the pegs intact. That didn’t last long, once it became clear that some currencies would just be speculated into oblivion by investors that knew about the weaknesses of certain countries. So the currency was made real, and the national currencies abolished.

The Euro was introduced in 2002, and by all accounts the new currency is a huge success. In America, you’d think that’s not the case, given how the media report about it. But if you go back in time, people thought the euro would soon implode, national currencies would be established again, and even if not, people said that the euro would be slumping towards a secondary status, forever lower than the dollar.

None of those predictions were true. The euro, soon to slump, found its pace and started growing stronger and stronger. While it is down from its height of $1.5, it’s still in the $1.3 territory – a 30% plus over the dollar. More importantly, the euro has gained international strength against the dollar as a reserve currency, which is something not even the strongest pre-euro currencies ever managed to do.

What’s With the Debt?

The next question is, why do some European countries have such huge debt mountains to live with? Why are they such random countries such as Spain, Italy, Greece, and Belgium?

If you look at those countries, you’ll notice one thing they have in common: they are all countries with a deep fracture within their political systems. Spain and Belgium have a notable nationalistic problem, in that both countries are composed of different national cultures. Belgium is almost evenly split between Dutch-speakers and French-speakers, whereas Spain has a number of national minorities within its borders.

Italy and Greece, on the other hand, always had a very strong Communist party whose participation in government was impossible due to the participation in NATO. When I was young, the Communists were at about 30% of votes consistently, yet they were never allowed into any government.

European countries, with the exception of the UK, use parliamentary systems with many different parties. A government is formed by a coalition of those parties. Once sufficient parties agree on terms of coalition, a government is formed. Where there are significant parts of parliament that cannot agree on terms of coalition, or where some parties are not allowed to enter into coalitions, many small parties and their respective constituencies have to be bought into the fold. It’s a little like the owner of a small parcel of land that can extort whatever concessions to allow a large construction project to begin.

In the usual manner of societies that need to bribe their way out of a problem, the nations with the most fractured political system put off payment for later. Debt in European countries was a result of political necessity. Debt in those European countries worst affected (the same ones that are in the cross hair of the news right now) was known to be a big problem.

The Cardinal Mistake

Is Europe a multi-national entity, or is Europe a nation? When I moved to America, I was surprised that the correct grammatical use of “United States” is in the singular. The United States has done something, not have done it. That’s the opposite of the correct use in most other countries, and even of the apparent use in English. But I learned that this was a conscious decision, brought about by the most painful conflict in American history. The United States is one nation, grammar be damned.

Europe is still finding out what it wants to be when it grows up. It is torn between two forces: on one side, there is the desire to distance oneself from other people’s problems; on the other, there is the realization that this is not possible or desirable anymore. Sure, the Greeks should never have made all that debt, and they “deserve” to suffer their fate. But it’s also true that your stock market, your economy is going to tank if Greece defaults. It’s not just their problem anymore.

The cardinal problem of the euro is that it’s a hybrid beast. It’s a currency, it has its own central bank, and it has a coordinated banking and budgeting policy. At the same time, debt is almost entirely carried by the nations, and they alone have the power to tax their citizens.

The result? The problems of the nations have been carried over into the eurozone. When Greece joined the euro, it had an unsustainable debt problem that the European Union didn’t address, because it had no way of dealing with it. So the issue was just patched over, hoping that fiscal discipline alone would make things better.

Enter the World Financial Crisis

Why was it that, of all places on the planet, the Mortgage Crisis affected banks in tiny Iceland first? Isn’t that weird?

Well, not to Europeans. Speaking with them, they are mad at America for what they call its fiscal recklessness during the Bush years.

I am not here to judge the merits of this case, but a consequence of the American Mortgage Crisis was a World Financial Crisis. It’s become harder and harder to find sources of money, and those that have the worst credit ratings have the worst time getting new money.

Which is where the debt crisis comes into being. Countries with over 100% of GDP in debt (like Greece, Italy, and Belgium) absolutely need fresh money. The interest payment on their debt alone requires staggering amounts of money, as someone that maxed out all their credit cards would know.

As soon as lending gets tight, there is a downward spiral. Countries with lots of debt are less likely to repay it, which means they have to live with higher interest rates because of the risk. Higher interest rates, on the other hand, require more interest, which makes it even less likely that those countries can pay back their loans.

At some point, speculators come in. When they realize that a particular country is not going to be able to repay its loans, they start speculating against it, which makes it even harder for the country to get new loans. On the other hand, so much of its budget is tied up in interest payments that it is vital for it to be able to “refinance” its loans. A country that pays 25% of its budget to interest and cannot get new loans is looking at a 25% budget cut across the board. No economy can sustain that.

Why is the Euro Stable?

To all my friends that complain about the euro and that see its demise, I show this chart:


This chart is the Euro-to-Dollar ratio since the euro was born, in 1999. You can see that the euro reached its lowest point in 2002, but that from there on it went on a long march upwards until 2008, when it settled at a high level, going up and down a little.

The Euro debt crisis started where the last big spike upward begins in the chart, in early 2011. For the first few months, this crisis was balanced by the debt ceiling debate in America, that sent the dollar fast down. But even since that has been resolved, the euro is still relatively stable at over $1.3. The euro is not in freefall, as you’d think listening to the media.

Now, why is that? To a certain extent, it’s that the country that is worst off, Greece, is too small to really matter to the euro. If Greece defaults on its debt, it’s going to send shock waves through the financial markets, but only in the sense that any country defaulting would. Remember when Argentina defaulted on its debt? Huge turmoil on the financial markets, but soon after things were back to normal.

So, what’s the big problem? There is one part that says that while Greece could fail without a lot of issues, Italy could not, since it’s the third-biggest country in the euro zone. But even if Italy defaulted on its loans, it wouldn’t be such a horrible thing – a lot of Italy’s debt is tied up in the internal market (Italians love to buy Italian bonds, for fiscal reasons). If Italy decided not to honor its internal debt, the rest of the world would be none the wiser.

The big issue is the same as the one precipitating the mortgage crisis: if Greece defaults on its debt, the former holders of the debt have to write it off, which means their pro-forma capital goes down. Since banks are allowed to loan only a certain percentage of the capital they own, less capital means less money loaned, which means they have to call in a few loans until they are below the lending threshold.

If Greece default on its debt, the first an immediate consequence is that nobody is going to get fresh loans. Not because of a market panic, but because of capitalization rules. If a banks loses enough money on Greek debt, it not only cannot lend more money, it must get some of the money it lent back. This is a one-two-punch that no economy likes, especially if it’s in a fragile state as most world economies are.

So, you see, the big problem is global, not European. The euro is relatively fine, because it is clear that it’s not the euro that is going to suffer from a Greek or Italian default, but the whole world.

How Should the Euro Be Different?

Europeans as a whole dislike European institutions. That’s mostly because they are hybrid monsters, beholden to both a vision of a unified continent and to the interest of each constituent nation. Positions in them are assigned by national quota, according to schemes worked out at the onset, in a rotating fashion amongst nations large and small.

Imagine that the President of the United States had to come from each one of the 50 states, one at a time, for a period of 6 months. In January, California’s assembly decides who’s President, then in June it’s Colorado’s time, and next January it’s going to be Delaware.

Imagine that each of the members of Cabinet had to come from a specific state. California chooses the Secretary of State, Colorado the Secretary of Defense, Delaware the Secretary of Agriculture.

Does that makes sense to you? Of course it doesn’t. It doesn’t make sense to Europeans, either. But that’s the hybrid model that allows national politicos to extend their power outside of their own borders at the expense of the common good.

When the euro was born, it suffered from the same problem. Since the single nations hold virtually all the debt, the common policy of interest rates clashes with the reality of sovereign debt. Imagine if the United States Treasury didn’t have its own bonds, but all bonds were held by the single states of the Union. While it is unimaginable that the United States as a whole wouldn’t be able to pay its debt, a single state might as well. If all the dollar debt was in single states, then the dollar as a whole would suffer greatly from the inability of a single state to pay its interest.

Similarly, the hybrid model for the European Union needs to be discarded. Europe needs to choose its path: a ruinous path to irrelevance as an agglomeration of 25 nation-states, or a modern supranational state with efficient political institutions and the ability to tax its citizens and freely dispose of its means.

That’s what America has done, and it’s what has made America the greatest nation on earth. The European crisis is deep, because it place the continent on a fork in the road – a similar fork to the one that made the United States one country.

You see, it’s really not about debt at all.