The European sovereign debt crisis has become the dominant issue not just in European markets, but in global finance. The world is watching in fascination and with considerable concern as European governments struggle to bring stability back to their national finances, and the European Union works to stave off sovereign defaults. Much hangs on their efforts, including possibly the fate of the euro itself.
The challenge in analysing Europe’s crisis and predicting its future path is not so much in understanding the economic issues, which in themselves are fairly straightforward, as in interpreting them against the wider political backdrop. For although the crisis started in the financial sphere, with over-extended banks running into difficulties in the financial turmoil of 2007-09, it soon became a fiscal issue, as states moved to support their banking systems, and it is now threatening to become a political crisis, as the EU grapples with the challenge of preventing national finances being overwhelmed.
Sovereign debt crises are not new, and there is much economic analysis of how nations can extract themselves from them, and historical experience of the results of their efforts. Indeed, Europe itself has twice in the relatively recent past faced debt crises of this magnitude, after both world wars. Nor was it only the vanquished who faced huge debts and (in Germany’s case in the 1920s) official reparations – even the victors faced debt to GDP levels well above 200%. But the response to the two crises, after the First World War and after the Second, could not have been more different.
In the 1920s and 1930s, Europe joined with most of the rest of the world in believing in fixed exchange rates (ie the gold standard) and a general orthodoxy that government budgets should be broadly balanced. In this environment the natural course for a nation facing fiscal stresses – viz devaluation – is officially resisted, and the only other course of action is fiscal retrenchment, austerity and a deflationary depression. The idea was that debts would be paid off “the hard way”, ie in real terms, and this was largely achieved, albeit at the cost of much social unrest and hardship.
In the 1950s and 1960s, on the other hand, Europe had become overtly Keynesian, and the policy recipe contained devaluations, demand management through fiscal actions, and unconvertible currencies protected by exchange controls. Not very surprisingly the result was a multi-decade inflation that remains unmatched in peace-time history, and the many national debts were in effect paid off “the easy way” by being inflated away, with much less social unrest and hardship – except to creditors.
It is important to realise that the choice that European policy-makers made to allow inflation as the way of eliminating their debts post WW2 was a conscious policy decision. The experiences of the 1930s were still extremely fresh in policy-makers’ minds, and no-one wanted to recreate the vicious cycle which so many countries had experienced then of (i) Bank failures, leading to (ii) Government bailouts, leading to (iii) Fiscal strains, requiring (iv) Austerity measures, producing (v) Deep recessions, leading to back to (i) Further bank failures.
Turning now to the present crisis, it is clear that in almost every way – viz the fixed currency backdrop, the preference for balanced fiscal budgets and the proposed austerity regimes – the outlook for the highly indebted countries in the Eurozone is much closer to the 1930s than the 1950s. Given the analysis above, and the extreme social consequences of the 1930s, this may seem strange, and one key to understanding what is driving this lies perhaps in Berlin.
In the previous two debt work-outs in Europe, the winners and losers were very clear. In the 1930s, with austerity and deflation, there was a transfer of real wealth from debtors to creditors. In the 1950s, the general inflation transferred real wealth from creditors to debtors. Today Germany, the largest and most powerful country in Europe, is also the largest creditor, and naturally seeks to protect and preserve the real value of its assets. When this is coupled with the legendary German aversion to inflation as a result of their experiences in the early 1920s, the stance from Berlin that “the debts must be paid and the debtors must pay” is both understandable and inevitable. This is driving the current belief at the EU level that belt-tightening and a drive for greater competitiveness is both necessary and sufficient for the weaker states to restore their finances
The challenge for Europe is to make the austerity programmes demanded by the creditors realistic and politically achievable. The same economic realities that Europe faced 80 years ago in the 1930s are still valid – sharp fiscal tightening risks undermining the economic activity that forms the tax base, and threatens to make resolution of the debt not less but more difficult. But there is in addition a new twist, which is that the austerity measures are being demanded by the EU. And at this point the political construction of the EU becomes relevant.
The EU is fundamentally an institution based on agreements between states. All of the legal underpinning of the EU is based on inter-governmental treaties rather than primary legislation, and the Union is not and has never been based primarily on the consent of its peoples. This has resulted in a democratic deficit in the workings of the various EU-wide institutions. (The EU parliament was an attempt to remedy this, but has not been able to exercise real power, largely because the various nation state parliaments and their leaders have not allowed it to).
As long as EU-wide bodies and institutions did not exercise real or significant power, this was a flaw, but one that the Union could survive. Increasingly though, the real power in the EU is being centralised, especially (though not only) in the financial sphere, and most specifically for the Eurozone countries. Financial regulation and supervision, monetary policy and increasingly these days fiscal policy too – all are decided, formulated or directed by the EU’s central institutions. This has resulted in a two tier union: at the EU-wide level, we have power and policy formulation but no politics, while at the Nation State level we have politics but no power or policy formulation. The lack of electoral oversight and democratic legitimacy of the policy‑formulation level is becoming more acute.
This matters when the EU has to take difficult or unpopular decisions. These can appear in any sphere of our common life: immigration, food security, climate change, energy policy and longevity are all subjects which arouse strong feelings and where difficult decisions need to be faced. However no field of human activity has more power to move people to anger than the financial sphere – citizens may profess to be interested in many issues, but history shows time and again that it is financial matters, and especially taxation, that causes them to man the barricades.
Matters financial, and especially matters of taxation, are at the heart of the democratic contract between rulers and the ruled, between governments and their electorates, and are the flashpoint that time and again in history has led to major social unrest. Taxation without Representation has been a fuse that has ignited many a conflagration.
This is the challenge that Europe’s leaders face. The euro was introduced with minimal consultation with the peoples of Europe, and partly because of that, many would now say, it was created with flaws and weaknesses – weaknesses that have helped lead Europe to its current problems. Given the scale of the crisis, it is absolutely vital in a democratic society that there should be the widest possible involvement of the people in working out the solution, and plotting the course back to financial stability.
This is more than a “call for dialogue”. It is a call for our political leaders to wake up and realise how estranged the people are from “Europe” and how much this puts the EU at risk. Successive generations of leadership have fallen short in explaining the EU project to the people of Europe. They have failed to consult the people, persuade the people or get our consent for what they are doing in our name. And when it all goes wrong, there is simply no sense in the general population of ownership of the issue. As a result, “Europe”, by which the ordinary person always means the unelected bureaucrats who run the EU, is always blamed. This is extremely unhealthy.
It is not enough for the EU leadership to declare that there is no alternative to the austerity measures being implemented in the indebted states. They should enter into a proper debate with the people of Europe and explain why this is so, and be prepared to argue for their proposed course of action. Only then will the taxpayers of Europe – in both the creditor and debtor states – support their leaders. Only then will Europe resolve its crisis.
A version of this essay was first published by State Street Global Advisors as part of their Insight programme