The Eurozone: A Crisis of Policy, Not Debt

Three months ago, I wrote here about the risks that the European authorities were posing to the US economy and asked what the US government was going to do about it. It was clear at that time that "the Troika" – the European Commission, European Central Bank (ECB) and the International Monetary Fund (IMF) – was once again playing a dangerous game of brinksmanship at that time with the government of Greece. They were trying to force the Greek parliament to adopt measures that would further shrink the Greek economy and therefore make both their economic situation and their debt problem worse, while inflicting more pain on the Greek electorate. The threat from the Troika was putting the whole European financial system at risk, since it raised the prospect of a chaotic, unilateral Greek default.

My hope was that someone in the US Congress would step up to the plate and try to hold the US Treasury Department accountable. Treasury is still overwhelmingly the biggest power within the IMF – in fact, it has dominated the fund for the past six decades. Since the IMF is one of the three key decision-makers in Europe, the US government could at least use this avenue of influence to prevent them from making things worse there. And since that crisis in June, the Troika has also played a similar game of chicken with Italy – a country with more than five times the sovereign debt of Greece.

Last week, President Obama woke up to the fact that the Troika could pull the US economy down along with Europe and sent Tim Geithner to crash the eurozone ministers' meeting. His job was to tell them to get their act together before their mess spreads across the Atlantic and costs Obama his re-election. On Monday, Obama took the even more unusual step of making his criticisms public, saying that the crisis in Europe was "scaring the world" and that the European authorities had not acted quickly enough.

Yet, there is no sign that the administration is even using its influence within the IMF to avoid disaster. One of the main triggers to the most recent financial turmoil was another fight between the IMF and Greece over a measly €8bn loan disbursement. The fund – presumably with US approval – has been threatening to hold up this money unless the Greek government implemented further budget tightening. In the face of massive protests and Greek public opposition to further punishment, this intransigence by the IMF once again threatened to push Greece to a chaotic default. That, in turn, could bring major European banks to insolvency and risk a full-blown financial crisis. And all because the Greek government couldn't meet its budget targets for an €8bn loan disbursement.

If that sounds incredibly irresponsible or even stupid, it gets worse. The reason that Greece cannot meet its budget targets is that the policies imposed by the Troika have succeeded in shrinking the Greek economy and therefore its tax base. The IMF has repeatedly had to adjust downward its forecast for the Greek economy; it is now projecting a decline in GDP of 5% this year, as compared to one of 3% just six months ago. When the first "bailout" package for Greece was negotiated in May of 2010, the country's debt was about 115% of GDP; it is now projected to hit 189% of GDP next year. Clearly, the Troika's policies have had the opposite effect of their stated intention.

Now, the IMF has revised its projections for Italy downward as well, most likely because of the $65bn budget tightening that the Italian government has agreed to in the last month. This can set in motion a process similar to what has happened to Greece, where the economy slows and budget targets get more difficult to meet, and then interest rates on Italian bondsrise, increasing the government's budget deficit. Bondholders and speculators then sell or short the country's bonds, driving interest rates up further and reducing the value of the bonds held by European banks. A London bond trader described the process from his own point of view on 4 August:

"The SMP [the ECB's Securities Market Program] is back but it's not in the right places – what's going to stop us attacking Spain and Italy over the summer months, [be]cause I can't think of anything. There is no buying of Italy and Spain going on and there won't be, so why can't we push these markets to 7% yields. I think we can quite easily."

Of course, this kind of unrestricted speculation is also part of the problem. But in the first sentence, the trader was describing what had opened up his opportunity at that moment: the ECB was threatening not to buy Italian bonds, in order to pressure the Italian parliament into more budget tightening.

The European authorities have the ability and the potential firepower to do whatever is necessary to resolve the crisis: restructure the Greek debt; end speculation against Italian and Spanish bonds by buying enough of them to push interest rates down, and committing to keep these rates down; and guaranteeing liquidity for the banking system. The US government has repeatedly shown its willingness to provide dollars as necessary to prevent any foreign exchange crisis.

But most importantly, the European authorities have to reverse course and ditch the contractionary fiscal policies that are at the heart of the problem.

There are a number of technical fixes under discussion, including allowing the European Financial Stability Fund to leverage its resources by loaning to another entity that could issue bonds. But the main point is that the ability to provide the necessary resources is there. The Fed has created more than $2tn since our recession began, without any detectable impact on inflation here; the European central bank can do the same. There is no risk of inflation getting out of control: in fact, the IMF projects that inflation in the eurozone will fall from 2.5% this year to 1.5% next year. If Angela Merkel is listening to her FDP coalition partners' bizarre rants about the threat of inflation, she needs to be thinking about another coalition.

The "European debt crisis" is misnamed; it is not so much a crisis of debt as a crisis of policy failure. There are always alternatives to a decade without growth, trillions of dollars of lost output and millions of unemployed that the European authorities are offering to the people of Spain, Portugal, Ireland, Greece and now Italy. All that is lacking is the political will and competence to change course.  

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