The European sovereign debt crisis

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.  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.  Economically, it is clear that several EU countries – most notably Greece, Portugal, Spain, Ireland and Italy within the Eurozone but also Hungary, Latvia and even the UK – have been running excessive deficits for some time, and are reaching or have already reached levels of debt to GDP that are above 100% of GDP.  The exact reasons for the deficits and the large debt levels differ between countries:  in Greece’s case it is mainly the result of poor tax collection, in Ireland’s it is a consequence of having to support their banking system, and in most of them there has been a consumption and property boom made possible by the single European market and fuelled by the low interest rates that came with euro membership.  But whatever the causes, in each country government debt has reached excessive levels and markets are expressing doubt that the situation is sustainable.  Indeed, by any normal analysis Greece has already reached the point where debt rescheduling is inevitable, and some of the other states are not far behind.

It is here that the situation in Europe begins to differ from a “normal” sovereign default such as Argentina’s 8 years ago, because a default by Greece or any of the other southern states will be a default in Europe’s single currency.  And if Greece for example were to default, the main losers, after the Greek people themselves, would be the banking systems of France, Germany and Belgium, all of which have lent substantial amounts of money to Greek borrowers[1].  This is a direct consequence of monetary union, as intra-Eurozone loans across national boundaries are far in excess of what any regulator or supervisor would have allowed absent the single currency[2].  The banking exposures are in fact large enough to threaten the banking systems of the creditor states, with the result that the effect of a Greek default would be felt in the finance ministries of the creditors as well as they were forced into rescuing their banks.

The rest of Europe is therefore prepared to go to almost any lengths to avoid declaring Greece formally in default.  This explains both the size of the rescue package, and also the fact that it has been put together as a loan – this is more usually the solution for an illiquid borrower and is almost never the right solution for one which is insolvent.  Indeed, for insolvent borrowers, lending more money merely threatens to increase the size of the eventual rescheduling.

Germany is well aware of this and is therefore determined that alongside the new loans and guarantees for Greece, there are very strict deficit reduction requirements and the strongest possible measures to make sure Greece sticks to the repayment schedules.  These are extremely onerous, to the point that there are legitimate doubts that the Greek government (or indeed any democratic government) has the ability to impose them on their people, and the markets are openly speculating that they will fail[3].

This much is fairly straightforward, and most commentators have drawn the same conclusions, viz firstly that the Greeks will struggle to deliver, and secondly that even if they fail, the attempt to do so will cause a serious recession in the meantime. What is interesting is what comes next, ie if the Greeks look as though they are not keeping to the austerity plan, and this is where politics and indeed history start to dominate the analysis.

Broadly speaking Europe has twice in the 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 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 (to 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[4]. 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.  This cycle was only broken in many countries when the working classes were unable to be squeezed any further and rioted, and the middle classes brought in the military to restore order, and the greatest casualty of the crisis in far too many countries was Democracy itself[5].

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 those highly indebted countries in the Eurozone[6] is much closer to the 1930s than the 1950s[7].  Given the analysis above, and the extreme social consequences of the 1930s, this may seem strange, and the key to understanding what is driving this is in Berlin.

Box – the position of GermanyEver since the modern Germany was created in 1870 from the many German states, it has posed a problem for Europe.  In a nutshell, it is too big to be an equal of other states, such as France and the UK, and too small to dominate, as the US does the North American landmass.  It thus perpetually attracts the jealous attention of other states and perpetually feels threatened.  This, coupled with a geographical position which is totally without natural defences – Germany sits on an indefensible plain with potential enemies on all sides – originally made the German state militarily aggressive, using attack as the best form of defence and always striving to knock out opponents on one flank before facing them on another, in order to avoid their nightmare of a two-front war.When the Federal Republic was formed in 1949, it was without its eastern länder and for the first time the same size as France, Italy and the UK.  This made it less of a target for others’ concern, and when coupled with a leadership which overtly surrendered national interest into a common European interest as an atonement for the blood-guilt of the Nazi regime, Germany was able to reintegrate itself into the European family as a partner not a threat and Europe in turn was able to enjoy a period of peace it had not known since the initial rise of a unified Germany in 1870.  The EU is the pinnacle of this policy and its greatest achievement.The collapse of the Soviet Union and the re-unification of Germany has once again unbalanced Europe, and Germany is now a third larger than the other three big countries.   Secondly, it has now completed a long, painful and costly reconstruction of the eastern länder, and has emerged lean and extremely competitive economically.  And thirdly it has a new generation of leaders, including a Chancellor who is from the old East Germany and who was never part of the (West) German post-war self-denial consensus.  In short, Germany is a normal country again, and is becoming much more willing to fight its national corner.  This need not be a bad thing of course – other nations do so all the time – but in a continent with still-vivid memories of the War and German overlordship, it risks touching on raw nerves and requires a political deftness from Berlin that is not always to the fore.

And nowhere is this becoming more sharply apparent than in matters of finance, where Germany is the continent’s creditor and paymaster, and is beginning to seek to use this position to protect what it sees as its interests.

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.

The challenge for Europe is to make the austerity programmes demanded by the creditors stick.  Here Europe’s political failings loom large:  the political underpinnings of the EU are incomplete and weak, and the Union remains a federation of sovereign states[8] with most relationships between them still very largely at bottom based on international treaties.  This has the result that the “federal” authorities (to use the US parlance) perpetually have to struggle to impose their will on the member states, with the most egregious failure being the Stability and Growth pact, which was widely ignored even before being unceremoniously abandoned in all but name when it suited the larger states to do so.

The solution, for those that believe in the concept of Europe and the EU – and for the moment no serious European politician can afford to be seen not to believe – is “ever closer union”, a phrase which is almost as old as the EU itself but which in the current crisis is being interpreted as “ever closer control of national finances from the centre”. And, with Germany as the main creditor, paymaster and driver of events, this is becoming more and more synonymous, for the debtor countries, with having a German veto over their actions[9].

This is where things currently stand.

If we ask what may happen next, however, it is much less easy to be sure. The crisis is reopening wounds and feelings that Europe had hoped were buried and consigned to history, and at the extreme, threatens to undo the whole of the post-war consensus.  This can make – indeed has made – politicians act in unexpected ways[10] and almost nothing can be ruled out as totally impossible.

The probability is that Europe will recoil from the edge of the abyss, and that sensible voices will prevail, but no-one can say with confidence that this is inevitable or guaranteed.  The nightmare is that the debtor nations do not stick to the austerity plans, that the ECB is forced further and further to compromise its “no bail-out” policy and that eventually, even so, one or more of the debtor nations defaults.  That will cause a major banking crisis, not least at the ECB itself[11], and may push Germany over the edge and encourage them to “wash their hands completely” of the feckless southerners.

Defenders of the euro, when challenged about the potential for EMU break-up, are quick to observe that “there is no way to leave the euro, and no nation would dare try because of the chaos that would ensue”. The first part of this statement is true but irrelevant – no, there is no plan for an exit, but if a state either chooses to leave a monetary union or has to, a way will be found.  And the second part is not even true – yes, if Greece were to leave and reinstate the Drachma, presumably with the intention of devaluing it[12], there would be chaos and the only certain outcome is that the Greek banking system, with its Drachma assets and Euro liabilities, would be insolvent, but the position is very different for a country choosing to leave to re‑introduce a strong currency, and while Germany would face a logistical challenge in re-issuing DM, it would not result in either chaos or the bankruptcy of the German banking system.

At which point, the very heart of the post-war European project, the alliance between Germany and France, will be called into question and the crystal ball goes cloudy …


[1]               In effect Germany et al have been engaged in a huge exercise of vendor finance.  For about 10 years now, German banks have been lending Greek consumers the money to buy German exports.  They now face the fact that those loans may go sour – with the consequence if they do that Germany would lose most of its future exports to Greece (the Greeks won’t be buying many more Mercedes), and much of the value of its past exports.  This “double whammy” is the main reason that German politicians are so desperate to keep the Greeks afloat.

[2]               Indeed it has been received wisdom in the EU that national current accounts and cross-border exposures were rendered irrelevant by EMU, much as (for example) the UK does not compile balance of payments statistics for Wales or Northern Ireland:  if they did, the latter would show a negative balance to the rest of the UK of between 5 and 10% of GDP for every single one of the last 30 years.  The difference is of course that within the UK this is countered with fiscal transfers from London to Belfast, whereas no such balancing transfers have been made in the EU and the counter‑balance has therefore been in the form of private sector bank loans.  The banking regulators overlooked this.

[3]               The austerity package being “recommended” to Greece by its EU partners includes a 4% tightening of fiscal policy in each of the next three years;  but even if the Greeks stick to this their debt to GDP level is expected to reach 145% by 2014!

[4]               None of the European currencies was fully convertible for many years after the 2nd World War.  Indeed the UK did not abolish exchange control and make Sterling fully convertible until 1979 – over 30 years after the war.  And that for the world’s second-most important reserve currency at the time.

[5]               The roll-call of developed European countries that surrendered their democratic governance systems in the 1930s is sombre indeed.  By 1938 Greece, Bulgaria, Romania, Hungary, Yugoslavia, Poland, Latvia, Lithuania, Estonia, Italy, Spain, Portugal, Austria and of course most notably Germany were all either partially or fully under military dictatorship.  The memory of this has dominated post-war European politics and, inter alia, created both the consensus in favour of the post-war inflation and the creation of the EU itself.

[6]               Perhaps we should coin the acronym HIDC – Highly Indebted Developed Countries – to go alongside the existing HIPC, or Highly Indebted Poor Countries …

[7]               But not necessarily for those countries outside the Eurozone.  The UK for one looks as if it has chosen a half‑way house between the 1930s austerity and the 1950s route of devaluation and inflation, and the US may well follow this route too.

[8]               The EU is of course not the first federation to face this issue, and it is hard not to draw parallels with the United States, which faced exactly the same existential question of the sovereignty of the individual member states in 1860.  That was after over 80 years of federation, in a country with a (comparatively) young history prior to the formation of the Union.  The EU is not yet 55 years old and is attempting to bring together countries some of which have centuries of history as independent sovereign entities, so some stresses and strains should not be wholly unexpected.

[9]               An indication of the tone of the debate can be gauged from the – quite widespread – view in Germany that Greece has failed and should be run like a company in administration, ie overtly in the creditors’ interest and with creditor oversight of the Greek finance ministry, statistics office and tax collection system.  (A historical parallel is with the European administration of China’s finances in the 1920s and 1930s).  Even though more sensitive Germans are very careful to talk of “European officials from Brussels” rather than German oversight direct, it is not hard to imagine the folk memories this raises in other European countries, after the experience of Nazi occupations just 70 years ago.

[10]             For example Merkel, among the most communautaire of leaders, unilaterally issuing fiats to the markets without consulting or even pre-warning her closest allies.  A very damaging but also very revealing act.

[11]             The ECB’s decision to buy bonds outright, and therefore accept principal risk, was a major watershed.  It was bitterly – and publicly – opposed by the Bundesbank, which is increasingly clearly at odds with the ECB’s leadership.  It also raises the spectre that the ECB may, if a state defaults, make losses of such magnitude that it needs recapitalisation:  if this were to happen it would need to go cap in hand to the 16 member states of the Eurozone and ask for more capital.  And it is by no means guaranteed that Germany would agree;  indeed many in Germany would say that the ECB had behaved recklessly against German advice, had brought its plight on itself, had forfeited the right to look after the currency of German citizens, and that in response Germany would prefer to wind the ECB up and reissue DM.

[12]             All the evidence of recent sovereign defaults suggests not only that a defaulting country needs to devalue its currency as part of the recovery process, but that the devaluation has to be substantial – of the order of 50-70%, or in other words stabilising the currency at between a half and a third of its previous parity.  This was the case in Mexico in 1994, Indonesia in 1997, Russia in 1998, Argentina in 2002 and Iceland in 2008.  There is little reason to think that a sovereign default by a EU state would be very different.

A version of this essay was first published by State Street Global Advisors as part of their Insight programme