The European crisis is no longer a European crisis. It has morphed into something that could easily engulf the global economy. Because of its size, because it involves governments and not just banks, and because it comes at a moment of great weakness, this crisis is more dangerous than the one posed by the collapse of Lehman Brothers, which filed for bankruptcy three years ago this week.
The real problem is Italy, not Greece. Greece is a nano-state, representing 2 percent of the European Union’s gross domestic product. Italy is a G-7 country. Italy’s debt is 1.9 trillion euros, or 120 percent of its economy and greater than the debts of Spain, Portugal, Ireland and Greece combined. Italy’s bonds are trading at 4 percent more than those of Germany, unprecedented in the euro’s history and unsustainable. Italy is too big to fail but might also be too big to bail.
Some have called for the creation of “euro bonds,” which would be a way for Germany to guarantee the debt of Italy, Spain, Greece and other troubled countries. On paper, it is an elegant solution. But it will never happen. Consider: The German people and government are adamantly opposed. Germany’s high court ruled that it is probably unconstitutional. The minute such bonds are floated, Italy, Greece and the others would lose all incentive to make painful reforms; they could borrow all the money they need at German-subsidized rates, so why go through the dreary work of restructuring? The Germans know this — hence their opposition.
Similarly, the idea of coordinating taxation and expenditures from Brussels looks good on paper but will never happen. Governments will never give away core functions such as taxation. There is widespread opposition to ceding these powers to a European bureaucracy, and the courts of many countries would probably rule it a constitutional violation. Even if these obstacles could be overcome, it would take a decade to determine whether a tighter fiscal union was actually happening. Markets need to be reassured now.
Facing a similar crisis in 2008, then-Treasury Secretary Henry Paulson talked about the need for a bazooka, a weapon large enough to scare markets into submission. Europe doesn’t have one. Even Germany — which has a debt-to-GDP ratio of 83 percent — can’t credibly bail out Italy and Spain. Together they need to roll over 600 billion euros of debt before the end of next year. Who has that kind of money?
Today, $10 trillion of foreign exchange reserves are sitting around across the globe. That is the only pile of money large enough from which a bazooka could be fashioned. The International Monetary Fund could go to the leading holders of such reserves — China, Japan, Brazil, Saudi Arabia — and ask for a $750 billion line of credit. The IMF would then extend that credit to Italy and Spain but insist on closely monitoring economic reforms, granting funds only as restructuring occurs. That credit line would more than cover the borrowing costs of both countries for two years. The IMF terms would ensure that Italy and Spain remained under pressure to reform and set up conditions for growth.
What’s in it for the Chinese, who would have to devote at least half the funds and who have already politely demurred when approached by the Italians? China invests its foreign exchange reserves looking for liquidity, security and decent returns. It isn’t trying to save the world. Premier Wen Jiabao made slightly encouraging noises this week, hinting that he would increase bond purchases and asking in return for greater market access to Europe. That’s classic Chinese diplomacy: cautious, incremental and narrowly focused on its interests.
The time has come for China to adopt a broader concept of its interests and become a “responsible stakeholder” in the global system. The European crisis will quickly morph into a global one, possibly a second global recession. And a second recession would be worse because governments no longer have any monetary or fiscal tools. China would lose greatly in such a scenario because its consumers in Europe and America would stop spending.
Of course, China would have to get something in return for its generosity. This could be the spur to giving China a much larger say at the IMF. In fact, it might be necessary to make clear that Christine Lagarde would be the last non-Chinese head of the organization.
In a world awash in debt, power shifts to creditors. After World War I, European nations were battered by debts, and Germany was battered by reparation payments. The only country that could provide credit was the United States. For America, providing desperately needed cash to Europe was its entry into the councils of power, a process that ultimately brought a powerful new player inside the global tent. Today’s crisis is China’s opportunity to become a “responsible stakeholder.”