Monday, May 23, 2011

Europe's Impossible Trinity – Or Why European Leaders are Not as Dumb as you Think

Judging from the majority of the financial press, European leaders are compounding error with error in dealing with the continent's debt crisis; timidity, lack of vision, incoherence – these are the words to describe those currently at Europe’s helm. But that accusation ignores the totality of problems that Europe must resolve. Europe faces three crises, not one: a debt crisis, a political-economy crisis, and a political crisis. And it is almost impossible to deal with all three at the same time.

The debt crisis is the most obvious: several countries – chiefly the PIIGS – are saddled with high public debt levels and thus find it harder and harder to finance their deficits. As a result, yields on their bonds continue to rise, fueling a vicious cycle where borrowing costs increase as markets question the PIIGS’ solvency, which in turn makes them even less solvent. And given the linkages in the continent’s economies, markets fear that a default in one country will inflict wider losses, pushing other countries closer to default.

To resolve this cycle, the EU and the IMF have provided short-term funding to give countries time to tidy up their finances and convince markets to lend them money again at low rates. So far, these measures have failed to bring down bond yields in Greece or Ireland (too soon to tell on Portugal). So the current measures have not resolved the debt crisis, just postponed it, which is one reason most analysts are critical of how Europe has handled the crisis.

The second crisis is how to address the underlying structures that created the debt crisis to begin with. To ensure that the bailout packages are not merely channeling good money after bad, the EU and the IMF are imposing strict conditionality on the loans. Here, the PIGS are distinct from Ireland, whose otherwise sound economy has been derailed by bankers gone wild. The political problem chiefly is a Southern European problem, where high debt reflects (among others) state meddling, tax evasion, rigid labor markets, and regulations that restrict competition.

There are inherent tensions in dealing with these two crises. The proper response to a debt crisis is to either counter with overwhelming firepower or cut one’s losses and default. The tension is that neither overwhelming firepower nor default help foster long-term reform – that depends on winning bailout money gradually through tough actions. Spending money to cover the near-term financing needs of the PIIGS will only succeed if there is a serious effort towards reform, and the momentum towards reform will be sustained only if there is continuous external pressure rather than a blanket guarantee that funds will be available.

Then comes crisis number three which is to ensure political buy-in from people in the funder countries. Northern Europeans are not keen to write checks to subsidize vacations in the Greek isles or to allow for early retirement; they want to make sure that the countries that receive the money make honest efforts to change. The grumbling can be heard most loudly in Germany and Finland, but it exists elsewhere as well. It also coincides with a broader sense of xenophobia and a decreased sense of cosmopolitanism. The real restriction on providing overwhelming firepower is that the people who provide the firepower may be voted out of office. Even worse, they may provide increased space for extremist groups to become more powerful.

In that context, the current muddling through does not look that bad. Option #1, which is to provide overwhelming firepower, has obvious political limitations both in terms of triggering reform in the target countries and in gaining approval in the funder states. Option #2, which is to restructure debt in the PIIGS, has some electoral appeal in the funder countries, but it may not quell the debt crisis since the contagion risks and uncertainty will drag on, nor will it make domestic political reform in the PIGS easier to accomplish. Option #3, which is to provide begrudgingly conditional support, may sustain the uncertainty in the markets but it provides continuous pressure for the target countries to reform and it limits the chances of a political backlash in the north. Among the three, Option #3 does not look that bad.


  1. A fine post, Nikos.

    I fear that muddling through the morass will only work for so long - eventually sentiment will turn and force Europe's hand, making option 3 not viable.

  2. What do you mean by overwhelming firepower and who, in theory, has enough gunpowder?

  3. @asp. By overwhelming firepower I mean that the richer European states step in and say we will lend x amount to the countries in debt - enough to insulate them from the pressures of the market and enough to give them to get their finances in order. If you only lend but not sufficiently, you may merely push back the problem rather than resolve any solvency questions. It also means, however, that you basically turn all the debts from private to public, which is why it's politically tricky.


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