Pressure on Italian bond yields is putting the future of the Eurozone in doubt. But with varying diagnoses, and equally varying prescriptions, it is to worth to step back and ask, what kind of a crisis is Europe facing? I see four (overlapping) views with varying validity that translate into drastically different solutions.
View #1: This is a crisis generated by markets. The international investment community, otherwise known as the "electronic herd" in Thomas Friedman's words, is plunging the Eurozone into a self-defeating cycle: by demanding higher yields to lend money to Europe's sovereigns, it undermines their capacity to repay their debts, fueling a never-ending cycle where higher yields produce even higher yields until a country seeks either a bailout or is forced to default. Embedded in this worldview are two more propositions: the first is that there is an enormous bet on who will default and when, creating speculative pressure on governments; and the second is that markets are impatient and are forcing policy that tries to tame the stock market rather than deal with underlying problems. In that worldview, a solution will hinge on a strategy that contains this yield-rising spiral and will restrain the use of credit default swaps and other speculative bets on the collapse of individual countries.
View #2: This is a crisis generated by timid European leadership. From the start of this sovereign debt crisis, around March 2010 when Greece started coming under pressure in the bond market, European leaders have taken plenty of little decisions but no big one. In that worldview, the sin is the refusal by Europe (read Angela Merkel) to step in and provide sufficient firepower to quell this crisis before it gets out of hand. Broadly speaking, the demand for leadership takes two forms: one option is to issue Eurobonds that will commit the richer European countries to assume the debt of the more indebted ones and hence bring down yields because markets will focus on German's ability to pay rather than Greece's or Spain's or Italy's. The second option is to let the European Central Bank print money to buy the debt of the sovereigns under pressure. And alternative option, which is less attractive but which certainly has supporters, is to create a proper framework for debt restructuring, similar to the haircut that the Greek government is negotiating.
View #3: This is a crisis generated by bad economic policy. This view is the Keynesian critique of the crisis and it has no advocate more erudite and more eloquent than Paul Krugman. Simply put this critique says we're worried about the wrong thing. The problem in the Western world is a lack of private demand as economies deleverage from their credit binge - in that world, the obsession with deficits and with debt is misplaced. We should instead be worried about growth - and to generate growth, governments should be running deficits. Otherwise, countries will be caught in an austerity-generated low growth trap from which they will take very long to escape. In that worldview, this is a battle for economic theory and reality - and if the right people could accept the logic of Keynesian economics, perhaps some of our obsession with deficits and debt would dissipate.
View #4: This is a crisis of credibility towards reform. This is my view. Before getting to this worldview in itself, it is worth thinking about the other three worldviews from the context of the fourth one.
First, markets are surely being counter-productive and perhaps self-defeating. I am no romantic when it comes to markets – I know too many financiers to be a romantic – but I also know that markets feed on fundamentals. Market can amplify, distort, exaggerate but they rarely create realities. To say that the markets “created” the Greek debt crisis is silly. Blame markets for not waking up sooner but otherwise, this is akin to shooting the messenger.
Second, it is true that Europe’s leaders have no grand plan to quell the crisis – but it is not clear to me that there is indeed a grand plan (see also here and here). Europe faces a multi-faceted crisis and the challenge is how to solve this crisis without creating the foundations for the next one. If Germany or the ECB were to alleviate the borrowing pressure from the periphery, then what would happen to reform in these countries? The answer is that it could come to a halt. With no reform, these problems will resurface again – ironically those who accuse Germany of merely pushing the resolution to the future are urging it to do the same by postponing the hard political choices that Greece, Italy, Portugal and Spain need to make.
Third, the Keynesian critique makes sense but with a caveat – macro-economic solutions work better when you have solid microeconomic foundations. When a country is indeed faced with an aggregate demand problem (like the United States) deficit spending that will create growth makes sense even if it adds to the debt. But in a country with several micro-economic deficiencies – rigid labor markets, protected industries, lagging productivity, etc. – the challenge is not to create demand but to make markets work better. And in several countries – certainly in Greece – government spending is a big part of the problem, and markets are right to look at reining in spending as the barometer for the country’s commitment to reform. In other words, the Keynesian critique works but is of limited use for many countries.
So the problem is that markets are looking around Europe and they see a bunch of politicians who cannot force change in their countries. They doubted Papandreou – and they should have. They doubted Berlusconi – and they should have. Now Papandreou said recently that, “it is unacceptable that [markets] are the ones driving the countries, day after day, hour by hour, not giving their governments the time that democratic institutions need.”
That’s rubbish – markets are indeed pressuring but they are demanding a commitment to change – if they expected an overnight resolution, they would indeed be unreasonable. But what they crave for it some directional commitment by governments to tackle unions, to collect taxes, to cut down their public sectors. They want commitment and they want seriousness. And as long as they cannot see it, they will not be convinced. In that sense, the European crisis is indeed a leadership crisis – but not a crisis of leadership in Berlin, Brussels and Paris but a crisis of leadership in Athens, in Rome and in Madrid. And that’s where the solutions need to start.