The Crisis in Europe C.P. Chandrasekhar

On Thursday, July 21, European leaders were to once again meet at a summit called to resolve the Greek debt crisis with a new Euro 115 billion bail-out plan. This meeting had an element of urgency about it, since failure to arrive at an agreement could result in a crisis that goes beyond Greece and engulf Europe as a whole. This is not just because a collapse of talks with respect to Greece can lead to contagion that precipitates new crises in other weak links in the European chain such as Portugal and Ireland. It is also because there are clear signs that the disorder afflicting Greece is now having repercussions in Italy and Spain, the third and fourth largest economies in the eurozone, and in large economies outside the zone such as the United Kingdom.

Just before the July summit, the yields on government bonds issued by Italy and Spain rose sharply to their highest levels since the launch of the Euro and the share values of banks headquartered in these countries fell significantly. These were clear signals that fears of the crisis spreading beyond Greece had gripped financial circles. Yet, it is not just the spread that defines the magnitude of the problem. Rather, it is the fact, revealed far more clearly than during the 2008 financial crisis, that the crisis goes deeper than recognised at first sight.

One feature of the Greek debt crisis is that the accumulation of public debt that defines it was not largely the result of a banking bail-out. Debt was not incurred to rescue banks on the brink of failure, because they had lent to households and created and invested in toxic financial assets. Rather public debt ballooned because it was used to finance expenditures needed to keep the Greek economy going.

When the Euro was launched and the eurozone with a single market and currency was formed and then expanded, a feature that was inadequately thought through was that the group consisted of members at differing levels of development and with different degrees of competitiveness. The more advanced countries were likely to cater to the larger European market and be quite successful in this effort. They had the advantage of higher productivity. They were not overly disadvantaged by much higher labour costs, since they had access to the unemployed and underemployed labour force of the union as a whole. And their competitiveness could not be bruised by the devaluation of the currencies of the less developed European nations since they had adopted the Euro as their own.

If the less developed nations could not find themselves a niche in which they could compete, the only way they could keep income and employment growing is through large public expenditures and a complementary expansion of the non-tradables sector, especially services. There remained the question of how these public expenditures were to be financed. Moreover, governments also needed to finance the welfare expenditures that were in any case historically significant in European countries, and were rising because of the aspirations generated by the possibility of a common European standard.

In the circumstances, in what was clearly a partly visible and partly concealed violation of the Maastricht criteria, the Greek government had resorted to excess borrowing to promote growth and finance minimal welfare expenditures by European standards. Embedded in the Maastricht criteria was the notion that governments would not resort to excessive deficit-financed spending to create jobs, expand output and sustain welfare. In return for that discipline, the governments in the less-developed European countries were promised compensation through transfers in the form of structural funds for development, and their populations the right to migrate to other countries in Europe for a better life.

The problem was that being independent and democratic nations, governments in each country needed to keep an eye on the electorate and adopt programmes and policies that could win them elections. Given the circumstances created by their entry into the eurozone, this might have required enhanced deficit spending and debt.

The resulting ”error” was not purely that of governments. Banks within Greece and elsewhere in Europe were obviously willing to lend to the Greek government, presumably on the grounds that this was sovereign debt of a ”developed” country, on which default was unlikely, and returns reasonable. Many factors contributed to the perception that lending to European governments involved low risk. The risk of income or capital loss due to default was seemingly low, since the debt involved was public debt with a sovereign guarantee. Even any residual risk of sovereign default was seen as negligible, since such default by any one country threatens the euro’s stability. The risk of loss due to a collapse of the exchange rate also appeared minimal because of the many governments and central banks interested in a stable or strong euro.

In the event, banks, seeing an opportunity for lending at low risk for reasonable return, ”over-lent” to governments like Greece, not merely ignoring evidence that the Maastricht criteria were being flouted, but that the level of debt was rising rapidly. This is not to say that all affected countries in Europe had followed the same route to a potential public debt crisis. There were others, like Ireland for example, where the problem was in the first instance not excessive public borrowing but excess private debt encouraged by a credit-happy banking system. When the danger of simultaneous default by a large number of private borrowers and consequent bank failure was revealed, the government had to step in to bail out the banks by taking over their non-performing credit assets. This resulted in the large scale substitution of private with public debt that could be easily ensured because of the perception of low risk. In due course, this led up to debt levels that provided the basis for a potential default on sovereign debt.

But the Greek case is particularly telling. Inasmuch as the current crisis has its roots in the processes described above, it is a crisis that challenges the very possibility of coordination of the kind required for the sustenance of the eurozone in a world of mobile finance.

The fact that the whole of Europe is under siege is coming through in news from the banking sector. Greek banks are the most exposed to Greek debt and therefore the most fragile. They are substantially dependent on funding from the European Central Bank (ECB) to keep their operations going. Such funding is provided against collateral, which consists largely of government bonds. If the government defaults on its debt, the value of those bonds would turn suspect, and the flow of funds from the ECB to the Greek banking system would under normal circumstances freeze. Thus the bail-out for Greece is almost directly a bail-out of the Greek banking system as well.

But the problem does not stop with the Greek banks. As noted earlier, bank share values in countries such as Italy, Spain and even England are falling sharply. This is despite the fact that in the ”stress tests” conducted recently by the European Banking Authority, only a few banks were found to be in difficulty and most passed the text. This was because, while focusing on the adequacy of capital with these banks to deal with non-performing assets, the danger of large scale sovereign default was not factored in. But those looking at the exposure of these banks to default-prone sovereign assets find it to be high. In the event the market has discounted the EBA’s test and dumped banking shares.

Thus, if the Greek crisis is not resolved quickly it is bound to spread elsewhere, beyond Ireland and Portugal, touching some of the largest eurozone economies and even the United Kingdom. Yet there is little confidence that a satisfactory solution will emerge soon. The immediate reason is the stance adopted by Finance. When a little more than a year ago an agreement on the first Greek bailout was arrived at, the banks that had ”over-lent” but had been saved from potential failure by the prevention of default did not contribute to the solution. The IMF put in its bit. So did squabbling European governments and tax payers. And they did so in return for a massive austerity package that spelt loss of jobs and benefits for large sections of the Greek population. But the banks went scot free and even chose to hike the interest rates they charged for any new credit they provided.

As a result of all this, more than a year later, the Greek crisis remains unresolved. Recession induced austerity is limiting the revenue generation needed to repay debt. And the debt gets larger because of higher interest rates. In search of another dose of support, the Greek government has adopted a new set of austerity measures. But a solution remained elusive even as leaders prepared for their mid-July summit. The basic problem is that the banks and financial institutions are unwilling to pay a price to resolve a problem that they created through the speculative lending that helped inflate sovereign debt in Europe. They have their way because they exercise immense economic and political power, aided by the ECB that has disagreed with any plan that smacks of a write-off of a part of debt owed to the banks, or even a restructuring that replaces old with new debt with extended maturities and lower interest rates.

The rating agencies discredited during the crisis have also contributed to the mess and served the interests of the banks that create the credit assets they rate for a fee. As if to re-establish their credibility, these agencies are routinely downgrading debt across Europe and elsewhere, pushing up interest rates in the bargain. They have also threatened to declare full or ”selective” default on Greek public debt if banks are required to accept even a small ”hair-cut” or a restructuring that reduces the value of their credit assets. If default is declared banks would have to provide for the losses involved and could find themselves cash-strapped and even insolvent. Fear of the ripple effects that this may have restrains governments and central banks.

This has angered the German and Dutch governments who are upset that they are called upon to contribute to the resolution of the region’s problem, while the banks that were an important part of the problem take home the benefits of resolution. These and other European governments are also faced with the strengthening of a new parochialism in Europe, with the citizens of the more developed nations resenting being asked to save the ”profligate” citizens of countries burdened with debt.

All these elements together delay the agreement needed to save the Euro on the one hand and prevent another crisis of the kind experienced in 2008. Finance capital was responsible then and is responsible now. Unless the interests of finance are subordinated to the interests of the real economy and that of ordinary citizens, the future does look bleak.

(This article was originally published in The Frontline, Volume 28 – Issue 16:: Jul. 30-Aug. 12, 2011.)