Europe may no longer be able to save itself. Too many countries have too much debt. Its economic growth — which helps countries service their debts — is too feeble. And nervous financial markets seem increasingly prone to dump the bonds of vulnerable countries. This is the real risk to the global and U.S. economic recoveries, far overshadowing Standard & Poor’s downgrade of U.S. Treasury debt and Monday’s sharp stock market decline.
Europe represents about one-fifth of the world economy and buys about a quarter of American exports. While Europe’s debt crisis was confined to a few small countries, they could be rescued; other European countries supplied loans to substitute for the credit denied by private lending markets. In 2010, Greek, Irish and Portuguese government debt totaled about 640 billion euros (about $910 billion), less than 7 percent of the 9.8 trillion euros of debt of all members of the European Union.
With Spain, Italy and possibly France now under financial assault, the situation changes dramatically. There are more debtor nations and more debt at risk. In 2010, Italy’s debt was 1.8 trillion euros; Spain’s 639 billion euros; and France’s 1.6 trillion euros. But there are fewer countries that can support a rescue; and some of them have heavy debts. Even Germany’s ratio of debt to gross domestic product (GDP), a measure of debt in relation to its economy, was a hefty 83 percent last year, similar to France’s. (The big difference between France and Germany is that Germany’s economy is growing faster.)
Until now, Europe’s leaders have tried to muddle through: Rescue Greece, et al.; hope that modest economic recovery and limited austerity by debtor countries cure the crisis. But this formula is reaching its limits.
Austerity — spending cuts, tax increases — is standard economic medicine for overborrowed countries. It may work for individual countries or even a few countries at a time. But if most of Europe embraces austerity, the logic backfires. Economic growth slows; recession may reemerge. Lower tax revenue makes it harder for countries to service their debts. As this becomes obvious, the financial crisis feeds on itself. Investors sell the bonds of weak countries, sending up their interest rates and making the debt burden heavier.
This is the monster now stalking Europe. Last week, rates on 10-year Italian and Spanish bonds exceeded 6 percent, roughly four percentage points above rates on 10-year German bonds. Meanwhile, the outlook for economic growth is deteriorating without offsetting gains in the rest of the world that might boost Europe’s exports.
So Europe now faces a crisis that is at once financial, economic, diplomatic, political and social. The vaunted “European model” of generous welfare benefits is steadily reneging on its promises. Naturally, this is highly unpopular. Strains among countries are worsening as all seek to shift blame and costs to others.
Can Europe save itself? If not, will anyone? One suggestion is a common bond that would allow weak countries to share Germany’s credit rating; but this would have Germany guarantee other countries’ debts — a role Germans are likely to reject. There seem to be three other possibilities.
First, the European Central Bank — Europe’s Federal Reserve — tries to stabilize financial markets by buying the bonds of besieged debtor nations. It’s already bought Greek, Irish and Portuguese bonds; now it’s buying Italian and Spanish bonds. But where does this stop? The ECB is acting reluctantly, because it fears that excessive bond purchases (“monetizing” government debt) would unleash an inflationary flood of money. This approach is Muddling Through 2.0.
Second, the International Monetary Fund organizes a global rescue package worth trillions of euros. Europe’s debtor nations could borrow at low rates with long maturities. Once debt pressures were relieved, Europe could follow more pro-growth economic policies. But any package would have to be heavily financed by countries with huge foreign exchange reserves, meaning oil producers and — most importantly — China, with reserves of $3.2 trillion.
Third, some European nations could negotiate write-downs on their debts or default on them. Superficially, this seems a solution. But it would create other problems. Defaults would inflict huge losses on banks, insurance companies and pensions. Many European banks might collapse unless rescued. Who would rescue them? Confidence would plunge. A recession would seem unavoidable. Defaulting countries would also have trouble borrowing in the future.
All these possibilities involve momentous political, economic and technical uncertainties. What if the crisis spreads from Italy to Belgium or France? Would China contemplate bailing out Europe? If it did, there would be a stunning transfer of geopolitical power and prestige to China. Can the ECB (or the Fed) buy endless quantities of government bonds without someday fueling inflationary expectations? The questions swirling around Europe are terrible to contemplate. But they will not soon go away.