Business Breakdown: Where Did the European Financial Crisis Come From? Business Breakdown: Where Did the European Financial Crisis Come From?
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Business Breakdown: Where Did the European Financial Crisis Come From?

by Tim Fernholz

September 28, 2011

Europeans are in a panic over public borrowing and a burgeoning financial crisis. U.S. Treasury Secretary Tim Geithner traveled to Poland to ask continental financiers to get their acts together, and International Monetary Fund officials are having heartburn in Washington. Today, Greece votes on the first part of a controversial austerity plan. What's going on across the Atlantic?

The financial crisis isn’t over. Trouble sprung up quickly in Europe after the global crash in 2008. In 2009, a new government in Greece discovered that it couldn’t pay off the debt it had incurred. That would be disastrous for those who made the loans to Greece—largely European banks, which own $71 billion in Greek debt and also have many commercial loans in the country. If those banks had to write off those assets, it would spur a financial crisis with cascading repercussions across the globe, increasing pressure on other European countries and financial institutions at a time of already fragile growth.  The U.S. wouldn’t be exempt: Our financial institutions own plenty of European debt, and the Euro zone is our largest trading partner. Many economists believe the initial stages of the Greek crisis helped slow economic recovery in the United States.

Thus began the last two-plus years of back-and-forth in Europe, as Greece came close to default and was halfheartedly bailed out in 2010 by other members of the Euro Zone. The group is led by Germany, a country that makes fiscal rectitude a watchword, and the European Central Bank, as fiscally conservative an institution as there is. Both are reluctant to offer much help the more profligate European countries unless they adopt austerity policies by raising taxes and cutting spending, which in turn hurts growth and has brought on popular demonstrations in Greece against the government and European institutions.

But it’s not just about free-spending countries. While Greece and Italy carried irresponsibly high debt loads in the early days of the crisis, other countries facing financial trouble, like Spain, Ireland and Portugal, had balanced budgets. The events of the last couple of years have exposed systemic issues within the European Union that many critics had long anticipated: It’s very hard to run a monetary union, with a central bank and single currency, for 17 states with different economies and fiscal policies. In good times, things swim along, and money flows from the stronger countries to high-earning investments in weak ones. But when the economic fortunes of countries in the Euro zone diverge, the European Central Bank has to decide which group of states to support. Typically, a country with massive debt would try to devalue its currency and inflate away some of the burden, but Greece can’t do that unless the ECB lets it, and the inflation-wary bank isn’t budging.

This is, then, a problem with the system, the same kind of problem the United States faced just after the constitution was drafted, when individual states couldn’t pay off Revolutionary War debt. Our solution, proposed by Alexander Hamilton, was to adopt all of the states’ debts into a single national debt, which was more easily paid off by the larger entity. The move resulted in richer states paying off some of the poorer states’ debts, which is exactly why Europeans are reluctant to follow this path, or any mechanism that uses the same method: They don’t want to cover the costs of their neighbors.

They’re—we’re—all in this together. It’s not clear that Germany and other creditor states have the luxury of staying out of this, as Deustschland’s slowing economy suggests. That’s certainly the message that Geithner and other representatives of world powers are seeking to convey in Europe. Some commentators say the European Union can’t survive this crisis and that some kind of splits will be necessary, but others think more aggressive actions to support the troubled countries will see the EU through the storm.

What’s on the agenda now? Greece’s government is set to adopt new austerity packages, which will hopefully win the approval of the rest of the European Union—but those packages will also have deleterious affects on the country’s economy. Most important now is 17 EU member states approving, in the next several weeks, an expanded rescue fund with more tools to make emergency loans to sovereigns and banks who can't maintain their obligations; observers are already worried that too many conditions pushed by Germany or Slovakia could derail the effort. Greece and other states whose debt burdens are too high to feasibly return will push for “bail-ins” as well as bailouts—essentially, for their creditors to accept losses and restructure their loans in an effort to avoid total default. Beyond quenching the immediate fires, Europeans must look ahead toward more economic integration and coordinated fiscal policy—steps that involve becoming more like a United States of Europe and less like a European Union, a controversial issue indeed.

European leaders are debating exactly how much they want to help the troubled members of their community, but if they wait too long to act, they may lose their Union—and their economies. That’s the breakdown. 

Photo via (cc) Flickr User Images_of_Money

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Business Breakdown: Where Did the European Financial Crisis Come From?