European debt crisis is about much more than debt

December 9, 2011

On my blog, I tried for a while to get the term “Euromess” to catch on. Fail. The world seems to have settled on “the European debt crisis” as the accepted term for the run on sovereign bonds that’s bedeviling the euro area. So I gave in and started calling it “the European debt crisis,” too. Now I’m regretting it.

I’ve spent the last week in Germany talking to policymakers, business leaders and bankers. One thing has become clear: This isn’t a debt crisis. This is a crisis first of growth, then of institutions, and only then of debt.

It’s easy enough to prove that this is about more than debt. Let’s start with a puzzle.

Q: What do these six numbers stand for — 81, 100, 67, 121, 81, 84 — and what don’t they have in common?

A: According to the International Monetary Fund, those are the respective percentages of gross debt to gross domestic product for the U.K., the U.S., Spain, Italy, France and Canada. But the U.K., the U.S. and Canada can each borrow for 10 years at a rate slightly above 2 percent. Spain, which has the lowest debt-to-GDP ratio of the bunch, is paying more than double that. And note that the U.S. and the U.K., in addition to having larger debt-to-GDP ratios than Spain, also have the largest total debts of any nation on the list.

This is about much more than debt, and the Germans and the European Central Bank know it. They could stop the run on the European periphery. But they don’t want to. They see it as an opportunity. The run is exposing underlying deficiencies in the euro area and putting the periphery economies under enormous pressure, and that’s giving Germany and the European Central Bank the leverage they need to make changes to the currency union itself.

The institutional concerns were put quite starkly in a recent report from UBS. “The euro should not exist,” the report stated. “More specifically, the euro as it is currently constituted — with its current structure and current membership — should not exist.”

That’s basically the German take, too. You hear it everywhere you go. “You can’t have a currency union without a fiscal union.” Some say they need a political union, too.

But the truth is, Europe can have all that and still fail because the crisis has another powerful driver: slow growth. The Organisation for Economic Co-operation and Development projects that, continent-wide, Europe will grow 0.6 percent in 2012 and 1.7 percent in 2013. Remove the strong performers like Germany and the Netherlands and it’s quickly apparent that the growth prospects for the others are grim.

From about 1997 to 2005, Italy and Spain were actually cutting their debt-to-GDP levels. But then the housing bubble popped, and so too did their growth. The result was a drop in public revenue, a rise in spending and ballooning deficits. The austerity packages both countries are now implementing will cut growth prospects further.

And that’s where things really get tricky. Europe’s institutional crisis is tough but ultimately solvable. It’s not clear the same can be said for the European growth crisis.

The Germans have a prescription: Be more German! After all, Germany was “the sick man of Europe” as recently as a decade ago. Tough reforms and a laser focus on exports brought the economy back. But one of the reasons it’s hard for the European periphery to be more German is, well, Germany.

Germans admit this. They’ve been the big winner in the euro. Their exports are cheaper than they have any right to be, because their currency is cheaper than it has any right to be. And that’s because weak economies like Greece, Italy, Portugal and Spain are using it.

The big losers of the euro are, at this point, those same weak economies. Normally, countries in their situation would devalue their currency and try to grow through exports. But they can’t. And to make matters worse, they share a currency with Germany. Just as they drag the euro down, Germany pulls it up. So while Germany’s exports are cheaper than they should be, those of southern Europe are more expensive. The euro is making those countries less competitive and less able to grow.

But they can’t just leave the union. If a weak economy tried to exit the euro area, the run on its financial institutions would be instant and unstoppable. The economic chaos would make the current tribulations look like a walk in the park. So to their dismay, now that those nations are in, they can’t get out.

A deal is on the table: If the weak nations join the fiscal union, Germany and the European Central Bank will mount a rescue and the debilitating run on government bonds will be over. But the weak nations worry that without better growth prospects, joining the fiscal union means giving up sovereignty over their budgets and accepting economy-crushing austerity.

In other words, if the prospects for growth were good, the institutional changes would be an easy sell and the debt problems would mostly take care of themselves. However, if the growth isn’t there, then ultimately the institutional reforms won’t be sustainable, because the nations on the periphery won’t be able to reduce debt burdens without destroying their economies.

That’s why the situation is rightly understood as the European growth, institutions and debt crisis — in that order. Somehow, I doubt that name will catch on, either.

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