“If the euro fails, Europe fails,” according to German chancellor Angela Merkel. And if Europe fails, we all fail.
November 18, 2011
Fourteen summits in 21 months; the collapse of six eurozone governments; four bailout packages; and still we have an economic crisis on the verge of engulfing the world’s largest economies—this is the picture of political failure. We have repeatedly seen European leaders unveil painfully constructed but ultimately grossly insufficient bailout plans that collapse into irrelevance and confusion within days. As the schism between economic exigencies and the political reality that is Europe (and more important Germany) becomes increasingly unbridgeable, we are left to wonder what a failed Europe will look like; what kind of Europe will emerge from this crisis, and what it will all mean for the United States.
Q1: With the sudden collapse of the Greek and Italian governments, the European crisis has entered an acute phase. What were the last three weeks of political, economic, and market turmoil in Europe really all about?
A1: It is hard to believe that it was only three weeks ago that European leaders reached a hard-fought agreement to prevent the eurozone contagion from spreading to Europe’s largest economies. This bold agreement included a so-called voluntary 50 percent loss on Greek debt by European banks, opaque plans to leverage the firepower of the EFSF, and forced recapitalization of European banks (click here for a more detailed explanation of the October Summit).
Exactly five days later and on the eve of the French-hosted G-20 Summit, this bold plan was overwhelmed by a surprise announcement by then Greek prime minister George Papandreou. Papandreou called for a referendum on the second Greek bailout and accompanying austerity measures. The stakes were extremely high. This referendum would be a decision by the Greek people on whether Greece wished to remain in the eurozone or not.
Europe’s immediate displeasure was vocalized by German chancellor Angela Merkel and French president Sarkozy. And a cardinal rule of European solidarity was broken; French and German leaders publicly suggested that Greece could leave the euro if it so desired. Greece would not receive any further bailout aid until it could demonstrate a politically unified commitment to upholding the austerity requirements of its next bailout package. Global markets and global leaders went into a full frenzy.
The proposed and eventually dropped Greek referendum caused a market reaction perfectly opposite to what European leaders had hoped to accomplish with their 4:00 a.m. deal on October 27. The contagion had fully engulfed Italy, driving up borrowing costs to unsustainable levels. This in turn resulted in a change of government in both Italy and Greece. After intense political wrangling, unity governments under the leadership of respected European technocrats emerged in both Athens and Rome.
Q2: What happens next?
A2: The new Greek prime minister Lucas Papademos must ensure smooth passage of the second Greek bailout in parliament and pave the way for early elections in February 2012. Although Greek opposition parties overwhelmingly voted to support Papademos, it is unclear whether this support will extend to a new round of austerity measures, especially because these politicians will have to defend their decisions in the upcoming elections.
Even if there is opposition support for the next round of severe cuts, it is unclear whether the Papademos government will be able to implement any of these austerity measures. If recent history is our guide, over the past 18 months Greece has not fulfilled its promises on privatizing assets or increasing tax collection despite repeated parliamentarian approval. According to the New York Times, Greece has a backlog of more than 165,000 tax cases totaling approximately €30 billion in projected revenue. A European Commission report suggests only about €6 billion to €8 billion of projected revenue is still collectible by the Greek government.
Although European leaders and the markets are temporarily relieved that a unity government has been formed in Athens, the daunting challenge of implementation amidst heightened societal tensions is the reality the Papademos government faces. Reflecting this uncertainty, the IMF has recently stated that it will need additional political guarantees: “It’s important that the unity government now shares its commitment to the implementation of the economic program.”
Q3: What is important to watch as the European crisis continues to deepen and widen?
A3: While there is no one particular issue to watch; there are several important trends to monitor in the coming days and weeks:
- Italy. Although Italy’s fundamental economic policies are in far better shape than those of Greece or any other periphery nation, Italy still bears an enormous debt load, the third-largest in the world. Italy cannot sustain borrowing costs of 7 percent or greater for extended periods of time as it will not have the ability to access the private market to purchase new debt. When Greece, Portugal, and Ireland’s borrowing costs hit 7 percent, bailouts followed soon thereafter. In the upcoming months and years, Italy will need to go the market repeatedly to roll over maturing bonds, each time publicly testing market demand and risk-appetite. The year 2012 will be particularly tough as debt worth 350 billion euros is up for rollover. Almost all of this debt will be rolled over at much higher interest rates than previously assumed. Without continued intervention by the European Central Bank on the secondary market, Italian bond yields could quickly escalate to an unsustainable level, jeopardizing Italy’s ability to appear as a credible creditor.
Look also for future IMF statements regarding Italy. Under strong pressure from the United States and Europe, Italy agreed to allow the IMF to oversee the implementation of its $75 billion austerity measures every three months. This concession came after two previous sets of austerity measures were pushed through parliament this summer with little practical effect as they were deemed insufficient in helping to pay down the country’s public debt of €1.9 trillion, or 120 percent of GDP.
- Spain. Several weeks ago, Spain, Europe’s fifth-largest economy, looked as if it might squeak by without needing additional European support. Unfortunately, in the past week Spain has suddenly risen to near the top of the crisis list behind Italy. Spanish ten-year bonds sold on November 17 experienced yields of nearly 7 percent with anemic demand. Moreover, Spanish unemployment is at a European high of 21.2 percent (with 48 percent youth employment), and it has recently reduced its economic growth figures for 2012 to 0.9 percent. On this happy economic news, Spain heads to the polls this Sunday to elect a new prime minister, which, according to all polls, will result in a win for center-right People’s Party leader Mariano Rajoy. Spanish banks will be under increasing pressure by a Rajoy government to expand credit to stimulate growth. At the same time, these same banks must raise capital and address losses in unsellable real estate assets in excess of €30 billion. Watch for increased distress in an already distressed Spanish savings and regional banks, and should Portugal’s rescue become more tenuous, more downward pressure on Spanish banks will occur as Spanish banks hold €78 billion of Portuguese debt.
- France. Perhaps the most worrisome trend has been the spread of the contagion to French banks, which are heavily exposed both to Italian and other European peripheral debt. BNP Paribas alone is exposed to €21.8 billion worth of Italian debt. Furthermore, the banks have a €8.8 billion capital shortfall spread over four banks (BNP Paribas, Société Générale, Crédit Agricole, and Group BCPE), which compose a whopping 80 percent of France’s banking sector. To demonstrate to the markets that he will take the necessary steps to maintain France’s AAA rating, President Sarkozy unveiled a €65 billion savings plan (consisting of a mixture of tax increases and reductions in government spending) on Monday, November 7. The plan would include the €15.2 billion in spending reductions already announced in August of this year. While these announcements may improve market sentiment, they will certainly not improve the public mood six months before national elections.
- Austria, Finland, and the Netherlands. For the first time this week, bond yields for three AAA-credit rated countries rose. Dutch and Finnish spreads rose to their highest since 2009, while Austrian 10 year bonds hit euro-era highs. Could the contagion be spreading even further? It is unclear. This appears to be some initial market testing of how far the contagion has spread. But it does underscore that, should the eurozone members decide to substantially increase the firepower of the European Financial Stability Facility directly (and not simply through leveraging gimmicks), all six of the AAA-credit rated countries would likely see borrowing costs rise as their national debt increases.
Q4: What is the timeline for this crisis?
A4: It is important to remember that there are two completely different timelines: market time and Merkel time. Market time has significantly accelerated the time horizon of this crisis, particularly since the July 21 European summit. The market as well as other large economies demands to see financially sufficient and decisive decisions coming from Europe to resolve the crisis once and for all. Unfortunately, it is a fundamental misreading of how European institutions, parliaments, and decisionmaking works, and it is on a direct collision course with German chancellor Merkel’s notion of the crisis’s timeline: “step-by-step”; no emergency or dramatic decisions; all austerity, all the time; and policymaking devoted to long-term strategies of achieving European fiscal and monetary integration. And we wonder why the European crisis feels like it is on running on two separate speeds?
Q5: What does this all mean for the United States? Can or will the United States help rescue Europe?
A5: How this continually unfolding crisis will impact the United States is also uncertain, but it will take a significant toll. A real economic shock in Europe would certainly upend the fragile U.S. economic recovery. The European Union is the second-largest trading partner of the United States (after Canada), and our trade relationship accounts for $240 billion in U.S. exports, excluding sales by European affiliates of U.S. companies, totaling $200 billion. How exposed the United States is, both directly and indirectly (through derivatives and guarantees), to the 17 eurozone economies countries is less clear. According to Dr. Uri Dadush, director of the Carnegie Endowment for International Peace International Economics Program, U.S. banks have $850 billion in direct exposure and $1.8 trillion in indirect exposure. These daunting numbers do not include American exposure to banks in the United Kingdom, nor do they include the nine other European Union countries not in the eurozone that would be deeply impacted by the crisis. It is estimated that the outstanding debt of economically troubled European nations stands at $4.6 trillion. It is important to note that this figure is four times greater than the debt caused by U.S. subprime mortgages.
However, on the bright side, U.S. money market funds have fled troubled European nations, and U.S. banks are actively shedding their European debt holdings, which, while further exacerbating the credit and liquidity crunch in Europe, may help protect U.S. institutions. U.S. banks are far better capitalized today than they were in 2008, which has shored up their ability to minimize their exposure to European debt and will help insulate them from the crisis should it occur.
In the twentieth century, the United States has repeatedly come to Europe’s rescue—albeit reluctantly and late to need—at extraordinary cost. In the twenty-first century, will the United States come to Europe’s aid again or is it willing to let its “cornerstone of U.S. engagement with the world” potentially slide into fragmentation with unknown economic and political costs? This time the United States is politically and economically unwilling or incapable of rescuing Europe, either multilaterally via the IMF (Secretary Geithner recently noted that the IMF’s assistance to Europe will be “supplementary and limited”) or unilaterally (there is zero political appetite in Washington to bail out Europe). The only question we must ask is: at what great future cost?
Heather A. Conley is a senior fellow and director of the Europe Program at the Center for Strategic and International Studies (CSIS) in Washington, D.C. Uttara Dukkipati is a research assistant with the CSIS Europe Program.
Critical Questions is produced by the Center for Strategic and International Studies (CSIS), a private, tax-exempt institution focusing on international public policy issues. Its research is nonpartisan and nonproprietary. CSIS does not take specific policy positions. Accordingly, all views, positions, and conclusions expressed in this publication should be understood to be solely those of the author(s).
© 2011 by the Center for Strategic and International Studies. All rights reserved.