A Primer on the Eurozone Crisis and How It Could Affect Us

The economic viability of the Eurozone continues to slowly leech away.   The latest iteration of the crisis originated again in Athens.  Last week, voters there chose parties on the left and right that agreed on one thing:  No more austerity, including measures already agreed to in exchange for another bailout this summer from the European Union (EU) and the International Monetary Fund (IMF).  The popular revolt against austerity could not have been a surprise.  Greece has seen its GDP shrink 20 percent, its unemployment rate reach 22 percent, its state pensions and government salaries slashed by 30 percent, and the real hourly wages of Greek workers decline 15 percent.  Yet more austerity, designed to assure global investors that Greece will not default on its debts, could mean another 15 percent decline in wages and another 10 to 15 percent drop in GDP.  The Eurozone plan, in short, asks the Greek people to accept an extended depression and sharply lower incomes in order to reassure European bankers.  

To be sure, most governments have to reassure global investors that their bonds are sound and their private sectors produce healthy returns.   What is unique here is that until the financial crisis blew Greece’s cover, it had deliberately misled the EU and global markets about its deficits and debt.  Using a scheme concocted by its Goldman Sachs advisors, the Greek government moved a significant part of its deficits and outstanding debt off its balance sheets.  And Goldman’s scheme was so complex and exotic that nobody grasped the deception.  Without hard guarantees from the Eurozone, foreign investors are unlikely to trust Greece for a long time. 

This Eurozone crisis has other singular features.  Most important, the basic arrangements of the Eurozone hobble Greece’s efforts to recover.  In good times, the euro gave Greece greater access to capital markets than it could ever manage on its own.  But in the bad times that have followed, Greece has found itself carrying crippling debt and unable to devalue its way to competitiveness.  So, Greece is forced to depend on EU bailouts and the willingness of the European Central Bank (ECB) to accept Greek bonds as collateral for new loans to European banks.  The price for these concessions has been drastic austerity.  Imposing more austerity on an economy already in a deep downturn was a formula for economic depression and political upheaval – and Greece now has both. 

What does this mean for the U.S. economy?  The crisis could reach a climax in matter of weeks, dealing another nasty shock to the recovery.  Both sides, however, have good reasons to delay the day of reckoning at least one more time.  That means that it is just as likely that the next president will have to deal with this shock.  So, if not next month then early next year, it seems likely that the Greek government will formally reject more austerity.  With their credibility on the line, the EU and IMF will almost certainly suspend future bailout payments, and the ECB will dial down its indirect supports for Greek bonds.  Without those measures, Greece will default on its sovereign debt in a matter of days. 

Even if the result is inevitable, a delay of several months will let everyone prepare for a Greek default and exit from the Eurozone.  The Eurozone has no rules or provision for kicking out a member.  But without the Eurozone’s continued support, Greece will have to quit:  Only by leaving can Greece reissue the drachma and let it devalue sharply.  Everything Greek will be available at fire sale prices, which will attract foreign investors and make Greek exports price competitive.  Greece and its people will be left a lot poorer, but that’s also now inevitable. 

For everyone else, the main danger is contagion.  Once the Eurozone lets Greece go, global investors may decide it is time to get out of all risky, European sovereign debt.  That would include the huge markets for Italian and Spanish sovereign debt – and if that happens, the crisis would quickly go global.  Every bank in Spain and Italy carries large portfolios of its own governments’ bonds.  That’s why many big depositors at those banks are already shifting their funds to German banks.  Already weakened, the Italian and Spanish banks would be bankrupted by a sharp drop in the value of their government bond holdings.  The Eurozone’s emergency bailout facility can spend up to € 500 billion buying up falling government bonds and providing capital to faltering banks.  But if Italy or Spain teeters on default, that won’t be nearly enough to rescue them. 

That would bring the world, including the United States, back to 2008.  French and German banks also have huge holdings in Spanish and Italian government debt.  Our banks do not.  But once again, nobody knows how many credit default swaps our institutions have issued for European sovereign debt and the Eurozone banks that hold them.  If U.S. financial institutions issued those swaps in large numbers, or simply have large transactions going with European banks caught up in the contagion, the meltdown could lead to a new American financial crisis.  After this week’s revelations about the reckless bets taken out and lost by J.P. Morgan Chase, there should be little doubt that our financial system would be very exposed to a full-blown Eurozone crisis. 

The Eurozone could have resolved all of this some 18 months ago, and at relatively modest cost.  That would have required that German Chancellor Angela Merkel accept the basic rule of every monetary union, that the full faith and credit of the whole stands behind the full faith and credit of its parts.  And the instrument for doing so would have been the ECB.  But that posed short-term term political costs for Merkel. 

Last week, the President of the Federal Reserve Bank of Kansas City, Esther George, noted in the Globalist that, “the current [Eurozone]crisis is following much the same pattern of previous financial crisis – an inability or unwillingness to see the warning signs and take preventive action, followed by massive damage …”  So, we have been have been here before, substituting the ideological blinders of Henry Paulson and his colleagues in Bush administration for those of Merkel and her confederates.  We all know how that worked out last time.