Why Does Europe Matter?

They blame the United States for fomenting a culture of debt – borrowing to build and maintain consumer lifestyles, national debt to support governmental waste and highly leveraged corporate debt to create mega-wealthy elites… often at the expense of the economic system and everybody else. Their institutions and populations just followed us in the hope of achieving our golden dream. They’re angry at us, so why do we care if they sink into the abyss, largely of their own making, despite their attempts to shift blame. Why does Europe matter, and what can they do about their massive issues anyway?

First, major American-based transnational financial institutions are heavily exposed in the sovereign debt crisis that toppled both the Greek and Italian incumbent governments and resulted in massive new austerity problems. Hence, bad news in any of these markets, and down goes the stock market. Second, our balance of payments suffers when the U.S. dollar rises against the euro: our exports cost more for Europeans (and they are already struggling with the extra costs of salvaging their EU market, so they have even less disposable income) so they buy less of the stuff we make, and our imports of European goods are cheaper for us so we buy more. Third, many of our mega-corporate players (from General Motors to Disney to Microsoft) have extensive European operations, and a decline in those markets goes straight to their bottom line… and the overall value of American corporations. Fourth, financial markets abhor instability and uncertainty; they tend to pull back, slow investments and gird for the worst… the opposite of building and growing for the future, an infection that most certainly has impacted US-based employers. Lenders further tighten their willingness to lend… to anybody, particularly when that much bad debt has sucked up the global borrowing base so completely.

Greece (pictured above) is just a side show compared to what could happen if Italy failed. Italy has five and a half times the population of Greece and is the eighth largest economy in the world (third largest in Europe). Greece’s collapse, while very negative, could be absorbed by the European Union; Italy’s collapse could bring the entire EU 17-nation euro currency market system down, and there is insufficient EU funding to backstop the resulting devastation.

As a result of the crisis, both Greece and Italy seem to be replacing their leaders with technocrats with a background in sophisticated regulatory or economic expertise: “Greece named Lucas Papademos, a former vice president of the European Central Bank, interim prime minister of a unity government charged with preventing the country from default. In Italy, momentum was building behind Mario Monti, a former European commissioner, to replace the once-invincible Prime Minister Silvio Berlusconi as early as [November 13^th].” New York Times, November 10^th.

When one of the failing European nations began to teeter, the financial markets have reacted by pushing the interest rates to that country significantly higher to make up for the risk. The higher interest charged on the failing nation’s sovereign debt only pushes the debtor nation deeper into the hole, accelerating the decline. Long before France’s Sarkozy and Germany’s Merkel convinced lenders to accept a cut of 50% of their Greek debt valuations, Greece’s effective interest rate soared passed 15%, literally swamping the country with exceptionally higher costs, negating most of the value of the austerity programs that had been imposed.

Recent announcements of an increase in Italy’s borrowing rates to 7%+ (from 4%) also effectively negated almost 4% in proposed austerity cuts in that country. The rising rates create a vicious spiral, often forcing extreme measures. It was at about this 7% level that Greece, Ireland and Portugal felt enough pain to begin requesting rescue packages from the European Union. Fortunately for Italy, the potential of new blood at the top with regulatory experience pushed lenders to back off that 7% number… for now.

But what exactly are the European Union’s options (primarily through the European Central Bank – ECB)? First, there is the jawboning to push heavy austerity programs onto the profligate nations, getting them to stop increasing the debt load and severely cut their social benefits, governmental employment rolls and begin increasing taxation and other governmental sources of revenue. When the jawboning alone does not work, the pledge of more tangible financial support is almost always accompanied by a requirement to accept such austerity measures.

The EU currency nations have established a bailout fund, administered by the ECB, but it is still in the process of raising money from reluctant member nations, to lend to failing member nations at reasonable interest rates (effectively buying up their sovereign debt). At present, the fund just isn’t prepared to face the kind of demand it may have to deal with in the immediate future: “[This] new eurozone bailout fund, the EFSF, isn't ready yet and may not have enough lending power. Eurozone governments have balked at adding more money, so they are looking at ways to increase the existing €440 billion ($600 billion) in financing to over €1 trillion by allowing it to partially insure against losses on government bonds… Such an insurance scheme has yet to be finalized, however, and might not cover Italy's massive financing needs — €300 billion next year alone.” New York Times.

Europe could float eurobonds from the aggregation of its euro currency-member nations – effectively allowing member states with bad credit ratings to access funds based on the blended credit rating of the totality of these European nations – drastically reducing the interest rates failing nations would have to pay. This structure would, however, effectively make the high-value states – like France and Germany – the de facto guarantors of the payback from these weaker countries, a politically difficult concept to sell to voters in the richer countries. “Germany, which is already funding the bulk of the existing bailouts, has made it clear that eurobonds are not an option.” NY Times. At least not yet. If the threat of dramatic collapse escalates, the richer nations may have to revisit this option and swallow a very bitter pill.

The sentiment currently is that the ECB and top EU policy-makers will go only so far to create temporary measures to support failing member-states, but that ultimately, it is every country for itself. While this sounds convincing, the fact remains that a failure of larger nations like Italy and Spain could topple the entire euro-based market, requiring richer states to take vastly great action that they seem currently willing to accept. While China has been asked to step in and support the euro, so far the PRC response has been underwhelming.

The “print money” option – which allows the EU to increase the money supply in order to fund their purchased of badly-rated sovereign debt of their nations in trouble – hits at a European gut-wrenching fear of hyper-inflation, the kind of hyper-inflation that destroyed Germany after WWI and brought Hitler to power. “The ECB in theory has unlimited power to help Italy, because as a central bank it can simply create new money to buy bonds. The problem is that can create inflation, which the ECB is tasked with keeping low as its primary job. It would also be difficult politically, because the bank would appear to be helping governments that did not properly reform their economies.

“Both the U.S. Federal Reserve and Bank of England have created new money to help their economies, but the ECB has avoided doing so by withdrawing an equal amount of money from the financial system… The Federal Reserve, however, has a broader mandate — to control inflation, promote financial stability and boost growth and jobs. The ECB, under the EU treaty that created the euro, must focus on inflation.” NY Times. Will the big EU states just sit there and admonish their prodigal sons and deploy only minimal efforts, risking that in the end their system collapses, the euro disappears (with an amazing amount of loss and displacement in the process) and the member states revert to their previous currency? Or will they issue enough in the way of guarantees and positive financial announcements to stop financial institutions from applying these batteringly-high interest rates on weaker states that may well take the richer EU nations down as well? We know that the US is not exactly inclined to lend a helping hand, given its own crisis of debt.

I’m Peter Dekom… and the problem with a global economy is… that it is… er… global.