March 24, 2023

Economix Blog: The Euro Zone Crisis: A Primer

View From Europe

Dispatches on the economic landscape.

A euro sign sculpture in front of the European Central Bank's headquarters in Frankfurt, Germany. Hannelore Foerster/BloombergThe European Central Bank‘s headquarters in Frankfurt.

FRANKFURT — With the daily drumbeat of alarming news from the euro zone, it’s often hard to hear above the din. Here’s a quick chance to catch up before the shouting starts again.

What’s all this talk about ‘‘contagion’’? Why is the global economy threatened by a small country like Greece, or a few troubled Spanish banks?

If Greece leaves the euro, anyone who is owed money by the Greek government or private individuals there can probably forget about being paid in full. In fact, that has already happened to a lot of Greece’s creditors in the debt restructuring completed in March.

The next time, if it comes, a lot of the people getting hurt would be European taxpayers, because most of the government debt is owned by the European Central Bank or the European Union. The investment bank UBS estimates the total cost at 225 billion euros, or $286.5 billion.

Commercial banks that have extended loans to Greek clients would also suffer. And some could fail, destabilizing the European financial system, which is already vulnerable enough. Likewise, the failure of several banks in Spain or elsewhere could stick those banks’ creditors with losses, perhaps causing more failures, as the problems cascaded through the system.

But the biggest effect might be psychological. Investors would begin to worry that the whole common currency union would fall apart. Europe could become toxic to international lenders and investors. Governments and businesses in the region could be cut off from credit, with disastrous effects on the whole economy.

What about the social and geopolitical effects if Greece leaves the euro?

The social effect of the crisis is already visible in jobless numbers, which are at depression levels in Spain and Greece, and at a record high of 10.9 percent for the euro zone as a whole.

There are also political consequences. In countries like Greece, the Netherlands or even France, the economic pain is nourishing the growth of parties on the far right and far left, as voters lose faith in mainstream political leaders.

At the geopolitical level, Europe has lost prestige because of the perception that its leaders have mishandled the crisis.

All these trends would intensify if Greece left the euro zone, raising questions whether the continent could continue the historic economic and political integration that followed World War II. The whole concept of Europe as a single entity might be in doubt.

Now Spain seems to be a big worry. Is Spain just another Greece — but one with an economy and population more than four times as large?

Spain is in better shape than Greece by many measures. But, yes, it’s a much bigger country. So its problems could cause much more trouble.

Spanish government debt is equal to about 69 percent of gross domestic product. That is far more manageable than in Greece, where the ratio is 165 percent.

The gaping issue with Spain, though, is not public debt but private i.o.u.’s. A real estate boom and bust has left Spanish banks burdened with 663 billion euros in property loans. A bank bailout would cost an estimated 200 billion euros, which the government in Madrid could not finance without European help.

Like Greece, Spain has an economy that is not competitive. It is burdened by industry restrictions and labor laws that tend to retard growth. It faces a long restructuring process of its social services and its business markets that will test the fortitude of its people. The real estate collapse has led to thousands of jobless construction workers who must be retrained before the economy can recover. At nearly a quarter of the work force, unemployment in Spain is even worse than in Greece. Among young Spaniards, it tops 50 percent.

Economists estimate the cost of a Greek exit from the euro zone at as much as ¤500 billion. The cost of a Spanish collapse would be in the trillions.

What are the main ways that Europe has tried to solve the debt crisis, and why aren’t those remedies working?

European leaders have created a 780 billion euro bailout fund with a lending capacity of 500 billion euros. That would not be adequate to deal with a collapse in investor confidence in Spain or Italy.

Leaders from the United States and elsewhere have called on Europe to commit a wall of money so large that it would erase all doubts about leaders’ commitment to the euro. Such a wall would probably have to be worth 2 trillion euros or more.

German leaders like Wolfgang Schäuble, the finance minister, have resisted committing more sums, however, because they fear southern European countries would feel less pressure to fix the underlying weaknesses in their economies.

European leaders have also agreed on a so-called fiscal pact to prevent countries from running up unsustainable debts, and have tried to strengthen European institutions. For example, the European Banking Authority has been given more power to supervise banks throughout the euro zone. So far, though, those measures have not been convincing enough to restore investor confidence.

We keep hearing about ‘‘growth versus austerity.’’ Are the two mutually exclusive?

Economists practically get into fist fights on this issue. In Germany, the prevailing view is that growth is the natural outcome of budgetary prudence by the government. Austerity, the argument goes, will restore confidence of both consumers and investors and lead to growth.

On the other side, economists of a Keynesian bent say that countries should increase government spending to stimulate growth. But this may not be an option for Greece, Portugal and some other countries, because no one is willing to give them any more money.

There is a growing acknowledgment, even in Germany, that austerity may have been overdone. When a country’s economy shrinks, so does tax revenue, and the debt becomes that much more overwhelming. Greece’s economy is one-quarter smaller today than it was in 2008, while the debt has continued to increase.

One problem is that countries like Italy and Greece already have what are generally considered to be bloated government agencies that burden business with paperwork and regulations and impede job creation. So stimulus would help only if the government spent the money wisely. Policy makers are now arguing about ways to offer Greece some relief from austerity without reinforcing bad habits.

Who’s actually in charge of the currency union? Is it Angela Merkel, the chancellor of Germany? Or is Mario Draghi, the president of the European Central Bank, the de facto leader?

The euro zone has no strong political leader; the United States of Europe does not yet exist. As leader of the largest and strongest big economy in Europe, Ms. Merkel has been in a position to push policies on countries that are dependent on aid, creating much resentment on the streets of Athens.

Mr. Draghi is arguably more powerful, because the European Central Bank controls the currency printing presses and does not need legislative or popular approval to act.

But the E.C.B. controls only monetary policy. It sets official interest rates and provides loans to banks to make sure they have money they need to operate. The E.C.B. cannot rescue banks that have too many bad loans and are insolvent. Nor, by law, can it rescue governments by buying all their bonds. (It has bought some government bonds, but not on the same scale as the Federal Reserve has done in the United States.)

Because the euro zone has no real central government, policy making has consisted of continuous brinkmanship between those that have money — Germany and the E.C.B. — and those that don’t. The haves demand policy overhauls in return for aid, while the have-nots, especially in Greece, try to get more aid by raising the threat of euro Armageddon. The spectacle has been deeply unsettling for financial markets.

We hear about a ‘‘bank run’’ in Greece, and the specter of one in Spain. If every country in the euro zone uses the same currency, why aren’t one country’s banks as safe as any other’s?

Talk of bank runs is probably overblown, at least so far. But it’s true that Europe lacks the equivalent of the Federal Deposit Insurance Corporation in the United States. Individual countries have their own versions of the F.D.I.C., but depositors in Greece or Spain are understandably nervous about whether their governments would have the funds to stand behind troubled banks. Spain has already largely depleted its deposit insurance fund.

In addition, in some countries banks have sums at risk that far exceed total economic output. This was the case in Ireland, an otherwise sound country that sank into crisis when it bailed out its banks after the Irish real estate bubble burst. There is not yet a central European banking authority with the power to unwind failed banks in an orderly way.

If German taxpayers and politicians are fed up with bailing out countries like Greece, wouldn’t Germany be better off if Greece (or Spain, or Portugal or Ireland) dropped out of the euro?

Some economists, like Hans-Werner Sinn at the Ifo Institute in Munich, make this very argument with regard to Greece. If Greece had its own currency, they say, its government could devalue money and thus effectively bring wages down to a level where the country could compete in international export markets.

If Greece keeps the euro, wages would need to fall 40 percent before the country could be on competitive export terms with Germany, according to some estimates.

But many others argue that a Greek exit would be disastrous. It would be very difficult for Greece to execute a switch to a new drachma without prompting panic on the streets, as citizens tried to withdraw euros from their bank accounts while they still could.

And with the new currency probably plunging in value, questions would arise about the solvency of any foreign banks or companies with major exposure to Greece.

Courts around the world would be clogged with lawsuits as Greek companies and lenders fought about whether contracts should be paid in euros or the new currency. As has happened with Nicaragua and other defaulters, courts in the United States might seize Greek assets to enforce claims, paralyzing the Greek financial system.

The consequences of a Greek exit might not be as bad as the doomsayers say. But the effects could also be worse than proponents claim. United States policy makers thought that the collapse of the investment firm Lehman Brothers in 2008 would be manageable. Instead there was a global financial crisis.

Ms. Merkel and other European leaders are fundamentally averse to risk. Despite threats to cut Greece loose, they will probably try to keep it in the euro zone — if they can.

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Setbacks in Portugal and Ireland Renew Worry on Debt Crisis

Officials in Lisbon said Thursday that the country’s budget deficit last year was 8.6 percent of its gross domestic product, well above the goal of 7.3 percent. Although officials said the revision would not affect the government’s goal of reaching a deficit of 4.6 percent of domestic product in 2011, the news was a reminder that, even after the problems from Greece’s fraudulent deficit statistics, some numbers from the euro zone remain unreliable.

Also Thursday, Ireland’s central bank announced that four of the country’s most prominent financial institutions would need an additional 24 billion euros to cover sour real estate loans, a move that pushes the country’s banking system closer to being nationalized.

The new figure, which includes 10 billion euros that the International Monetary Fund has already committed, was included in the results of a rigorous stress test of the nation’s banks. While largely expected, the announcement brings the total banking bill for the Irish government to 70 billion euros.

The cost of insuring the debt of Portugal and Ireland, as well as that of Spain and Greece, rose on Thursday, as did the yields on all their 10-year benchmark bonds. Late Wednesday, a plan to merge four troubled savings banks in Spain collapsed, and that news appeared to add to investor fears on Thursday.

It seems just a matter of time before Portugal, like Greece and Ireland, is forced to seek assistance from Europe and the I.M.F.; it lacks a government plan, and its 10-year debt has a yield of 8.5 percent, above the level that Greece and Ireland had when they were bailed out.

But with Europe having increased its rescue fund to 440 billion euros, it is now in a position to cover Portugal’s financing requirement.

And for that reason, Portugal’s slow-motion collapse has not set off a broader market panic, especially since neighboring Spain appears to be able to address its problems without outside financial help.

Still, any sign that Spain may be wobbling again is likely to renew concern that Europe has yet to definitively address its problems.

“The problems in the periphery are getting worse, not better,” said Jonathan Tepper, an analyst at Variant Perception, a research firm based in London. “Ireland and Greece are undergoing major contractions with no end in sight. It is a matter of time before Portugal is bailed out and Spain is very much like Ireland with extremely large exposure by the banks to property developers and to overvalued land.”

In Ireland, the announcement by the central bank about the needs of the country’s top financial institutions vividly illustrates the extent of the country’s financial troubles.

“This has been one of the costliest banking crises in history,” said Patrick Honohan, the governor of the Central Bank of Ireland, which oversaw the stress tests. “There was a need for the banks to have ample capital to meet the markets’ gloomy prognostications.”

In a step that could ease some of the pressure on Ireland, the European Central Bank said Thursday that banks could use government bonds as collateral for borrowing from the central bank, regardless of how the bonds are rated. Because of that, banks would have more flexibility to borrow from the European bank at its benchmark rate.

Also on Thursday, a fallen Irish bank not included in the stress test, Anglo Irish, disclosed a loss of $25 billion, the largest loss in the country’s corporate history. Anglo Irish, which is expected to receive 34 billion euros in funds from the state, was not included in the test because it is being gradually wound down.

The 24 billion euros needed to shore up the four Irish banks includes 18.8 billion euros for Allied Irish Bank, 5.2 billion for the Bank of Ireland, 4.2 billion for two smaller institutions and an additional 5.3 billion to serve as an extra layer of equity.

Officials said the process of reducing the Irish financing gap, or the difference between bank deposits and loans, will take years and will require the write-off and disposal of 72 billion euros in problem loans by 2013.

The gap, otherwise known as the loan-to-deposit ratio, now stands at 171 percent against a government goal of 122 percent and it is currently being financed by the European Central Bank and the Irish Central Bank at a cost of about 150 billion euros, an amount that is about equal to the country’s gross domestic product.

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