Have you ever switched channels on TV and started watching a movie ten minutes before it ends? It’s confusing and irritating. Just when you've figured out what's happening, in walks some totally new character and you realise that actually, the plot of the movie was more complex than you thought.
For those who’ve just started following it, the European crisis is a lot like this. However, unlike TV, you can’t change channels. Like it or not, the economic future of the world will be deeply impacted by what will happen in Europe over the next few years.
So here's it is—a complete yet easy-to-understand synopsis of what happened before you switched to this channel. The story starts in 1999, when a number of European countries converted to a new joint currency, the Euro. These countries included most, but not all, countries of Europe, the most notable exceptions being Britain and Sweden, which kept using their own currencies.
As with all currencies, there was a central bank to manage the Euro—a new institution called the European Central Bank. The ECB's headquarters are in Frankfurt, Germany. The ECB's job is to manage the value of the Euro, by ensuring that inflation stayed under 2 per cent. The ECB did this by setting interest rates like any other central bank. When inflation looked like getting too high, they set the interest rates high, and vice versa.
Crux of the problem
So the supply of fresh Euros and the setting of the base interest rate in the economy (the monetary policy, in other words), is not in the hand of the 17 national governments of Europe. These countries don’t actually have a monetary policy. They have, instead, committed to following a common monetary policy set by the ECB. This arrangement—a unique new experiment in human history—lies at the heart of the curious animal that modern Europe is. Do read this paragraph again. If you wish to understand the European disease, rather than just observe the symptoms, then this is the key.
However, each of the national governments does raise its own independent debt. When they need to borrow money, they issue their own debt by selling bonds on the markets and investors—banks, foreign governments, their domestic savers, whoever—buy those bonds.
It’s a basic rule of lending that the more creditworthy a borrower, the lower the rate at which lenders are willing to lend to it. Historically, Germany has been the strongest economy in the Europe and lenders have been willing to lend to it at lower rates than any other country. Rates on German bonds have always been in the range of 1 to 2.5 or at most 3 per cent.
However, besides lending cheaply to Germany, banks were also lending cheaply to all other countries in the Eurozone. Even if you were a formerly risky Portugal, Italy, Greece, or Spain (PIGS), your bonds got bought at rates that weren’t that much higher than Germany’s. The bond market seems to have operated with a tacit understanding that the bonds were denominated in Euros and the Eurozone as a whole would pay up in case any of the economies got into trouble. Countries that were borrowing at 6 per cent or more in 1999 soon found out that they could borrow at 2 to 3 per cent. Naturally, they had a party. Now, a decade later it turns out that they have no way to pay the bills.
Things would have turned out fine if the weaker economies of Europe had used the cheap money over a decade to build up the infrastructure to drive economic growth, but they didn’t. Greek politicians, for example, did little else except lower taxes and increase welfare spending, both measures designed to win elections and nothing else.
Bond market wakes up
The bond market has now realised that these countries have no way of paying back the money. As a result, it has become a lot more expensive for them to roll over earlier debt. Italy’s fresh debt is going at close to 7 per cent, a level which is considered ruinous. Greece can’t get any fresh debt but the markets indicate a rate of close to 30 per cent per annum, which is squarely in credit card territory, and justifiably so.
However, in recent weeks, things have gone beyond this. Even perfectly robust economies in Europe have seen the markets jack up their interest rates. For example, Austria’s yield was 2.82 per cent on September 1, but had risen to 3.64 per cent by November 16. France’s yield has gone up from 2.65 per cent to 3.67 per cent over the same period. On November 23, a bond auction by Germany stayed half unsold. At this point, this is beginning to look like a run on Europe. The problem is that a general run on Europe could become a very different kind of crisis than the original one of the Greeks not being able to pay their debts.
What are the options?
Let’s step back and examine the various options that a country can use for solving a problem of excessive debt. Here they are:
* Inflation. It can just print money. This brings down the value of money and thus implicitly reduces the real size of the debt. However, it’s useful only for debt denominated in its own currency. In any case, this route is closed to the PIGS because they don’t have control of their own money supply.
* Growth. Earn more so that the debt can be repaid. An important input to earning more is to devalue their own currency so that their exports become cheaper and the economy becomes more competitive globally. Manmohan Singh did this in 1991. The PIGS can’t do this because they don’t have a currency of their own.
* Austerity. Reduce expenditure. This is what is actually being tried in Europe. The problem is that austerity generally leads to lower growth.
* Default. Simply not repay.
* Haircut. A haircut is simply a controlled, partial default. Lenders agree to reduce the debt so that they can at least get something back. In the case of Greece, lenders have ‘voluntarily’ agreed to a 50 per cent haircut.
What will happen next?
So what’s going to happen? What is this solution that everyone is waiting for? The conventional idea, the one that the financial sector is looking for, is for the ECB to back the debt of all European governments. According to this view, the ECB should act as the lender of last resort for European governments (and not just the banks, as it does now). It should publicly declare that it will buy as many sovereign bonds as necessary to prevent their yields from rising too high. This would calm the financial markets and they would start lending again. In the long run, this would inevitably be followed by joint ‘Eurobonds’ issued by all Eurozone governments. It would also mean inviolable limits on fiscal deficits imposed on individual governments by the Eurozone’s central authority. In effect, it would mean close fiscal, and by implication, political union of Europe. The problem in this is that Germany won’t have it. Any such plan would work because of Germany’s implicit guarantee. In effect, it puts Germany’s national solvency on line for the whole of Europe.
At this point, what seems more likely is that the Euro is heading for a collapse. All it would take is a default by a government, or a major bank, or even retail depositors starting a run that banks cannot honour. Unless Germany and the ECB act, this could now be imminent. However, if one looks at the behaviour of markets, they seem to be pricing in credit problems, but nothing like a full disaster that could follow. Perhaps they are right, and perhaps things will turn around. But the odds are getting shorter by the day.