The Eurozone Crisis Then and Now

The expansion of the European financial crisis and its deepening into a political crisis has followed a clear causal chain produced by a series of missed opportunities.

The problem began in early 2009, as a knock-on effect from the 2008 global financial crisis, which had already claimed Iceland as a victim. Iceland was not an institutional issue for the EU, but in 2009 Eastern members of the EU not using the euro began to have balance-of-payments problems. They suffered effective devaluations of their national currencies and sought help from Brussels to resolve their mounting budget deficits. In response, the EU doubled the funds in an existing facility to address balance-of-payments problems.

The larger West European powers that dominate the EU were more concerned with creating a common front against Washington in preparation for upcoming G-20 summits, so they papered over the already emerging signs of similar problems with their own government budget deficits. They did this knowing that their own experts predicted continued economic contraction into the foreseeable future, and hence lower tax revenues. The European Commission (EC) then feigned shock when Greece’s budgetary problems – a consequence of the increased burden of the country’s euro-denominated debt compounded by what the EC had previously warned to be creative accounting in Athens – were publicized after the October 2009 elections that brought a change of government.

At first Brussels refused to bail out Athens. But the crisis in Greece could not be separated from the crisis in the rest of the “PIIGS” countries (Portugal, Ireland, Italy, Greece, Spain) in the eurozone’s periphery. These economies cannot easily sustain fiscal deficits, generate an external surplus, or restart private sector borrowing on their own. European central bankers refused through much of 2010 to acknowledge the Greek budget crisis, which meanwhile went from bad to worse.

While the Eurocrats and their political leaders procrastinated, Ireland became the second country in the eurozone to seek a rescue. The insolvency of the Irish banking system put the lie to the “stress tests” performed on European banks in the summer of 2010. An atmosphere of contagion began to infect the other PIIGS countries. The EU’s central bankers were among the last to accept that the euro itself was in danger, even though (as was soon to be common knowledge) the €440 billion at the disposal of the European Financial Stabilization Facility (EFSF) – a temporary stopgap set up in May 2010 – could be exhausted by the needs of Greece, Ireland and Portugal. If the EFSF were cashed out, there would be nothing left for Spain, where banks already heavily committed to Portugal would be at serious risk.

A ‘perfect storm’ brews anew

In autumn 2010 it was undeniable that an unrelated but precipitous fall in share prices on the Shanghai stock market, together with the failure of the November 2010 Seoul summit of the G-20, threatened confidence in the recovery from the 2007-08 crisis and reawakened fears of global financial instability. Because Chinese economic decision makers will continue to put Chinese domestic priorities ahead of any international considerations, even at the risk of a global slowdown that would diminish foreign demand for Chinese goods, this “perfect storm” is brewing again.

Earlier this month, three things happened at once: Europe’s sovereign debt crisis turned into a banking crisis, Standard and Poor’s downgraded US debt and statistics came out of Washington showing continued weakness in the economy. This month, US consumer confidence also fell off a cliff; and the economy continues to suffer from a papered-over mortgage crisis, the effective devaluation of the dollar that drives commodity prices upward, and stagnant unemployment even despite some recent job-creation that has proven insufficient to absorb new workers in the labor market.

The volatility of global stock markets suggests the very real possibility in the US of a ‘double-dip’ recession that many thought had been avoided with the apparent economic recovery earlier this year. In retrospect, with the exception of stock prices, it looks more and more like the recession never left its ‘first dip’.

As a result of these coincidences, asset prices on both sides of the Atlantic have begun to move together, increasing volatility in much the same way as a bridge will oscillate violently in the wind if aerodynamic forces couple with the bridge’s natural vibrating frequency (and can result in a spectacular collapse). This volatility will likely continue, at least in Europe, until the political leaders of the EU member states make a choice. They must either allow the eurozone to shrink, by finding a way for Greece to exit, which would likely be followed (at minimum) by Portugal and Ireland; or move toward a fiscal union in order to preserve the euro’s integrity; or find a way to do both together.

The recent meeting between Sarkozy and Merkel did not even approach these issues. The week before the two leaders met, Berlin released disappointing statistics on German economic performance, confirming that European stagnation is unlikely to change. German exports, which buy domestic social peace, cannot save Europe. In the face of these economic and financial prospects, Sarkozy and Merkel opted for cosmetic political and bureaucratic measures. Since then, European stock prices have notably declined, hinting at the despair of professionals in the financial markets.

The issuing of Eurobonds – rejected a priori by Sarkozy and Merkel – or a massive increase in the funds available to the EFSF could have been a step towards halting the snowball effect, though with no guarantee of avoiding the avalanche. Yet if the financial markets’ run on French and Italian banks has exposed the half-hearted EFSF as a source of contagion rather than a solution, the Sarkozy-Merkel meeting amounts to playing ostrich.

In retrospect, the last few years have been anything but a haphazard zigzag – except of missed opportunities. The expansion of the European financial crisis and its deepening into a political crisis has followed a clear causal chain. A balance of payments problem (in the Eastern EU) became a government deficit problem (there and in Greece), then a debt restructuring problem (in Greece and other PIIGS). This debt restructuring problem then became a sovereign default problem (in Greece and the PIIGS), quite obviously a problem for the European banking system as a whole.

This complex of problems is now threatening to become a liquidity crisis for the whole eurozone currency system. Whereas in Europe itself, mechanisms of political control have so far reined in social protests, outside Europe the situation is no more sanguine. In the Middle East and North Africa, where food prices were a key trigger of the recent unrest and are projected only to rise (as throughout the world), these protests have spilled over into regime change.

This post originally appeared at ISN and is reproduced here with permission.