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The Euro In Crisis, Part I: All the Kings, Their Horses, and Their Horses’ Horses

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The Eurozone is in crisis. Since the onset of the sovereign debt debacle in 2008, economic conditions in nearly all of its member states have grown worse as pro-austerity economic policies have all but silenced prospects for renewed growth. Of the seventeen nations that use the Euro, the economies of five are in danger of defaulting on their debts and two have already had their financial sectors bailed out at least once already. Seven have seen their sovereign credit ratings lowered to near non-investment grade and eleven have unemployment rates at or near 10 percent.

As the economic landscape grows more perilous, so does the political one. Governments in Ireland, Greece and the Netherlands have capitulated at least once since 2008 over debt concerns, not to mention the tens of thousands in Spain demonstrating against more bailouts of its troubled financial sector. And at the heart of it lies the European Central Bank, chief regulatory and policy authority for the Euro, whose indecision over entering the fray has cost the Eurozone billions. If anything, the crisis has exposed the weakness of the ECB’s, necessitating an overhaul to the structure of Europe’s national banks. It is more than clear that the severity of current economic conditions throughout the Eurozone lies in the failure of European monetary authorities to counteract rising unemployment, rising national borrowing costs and near-zero economic growth. To kickstart a recovery, European leaders must enact policies that are directed towards reforming the role and purpose of its central banks (both the ECB and NCBs) to allow new capital to be invested into the non-financial sectors of Europe’s economies.

 The health of any given economy can be measured by looking at its unemployment rates, debt-to-GDP ratio, and its credit rating. The following chart shows an overview of these metrics for each member state in the Eurozone and the average for the union as a whole.  

Note that the Moody's ratings were excluded from this chart in order to improve the clarity of the data presented here.

Looking at the data, unemployment rates are a clear point of concern. In general, high unemployment has a negative impact on economic productivity and leads to increases in deficit spending. High numbers of unemployed persons come from national governments and private firms reducing their expenditure on labor in order to pay out less in wages.

As the unemployed pool increases, the number of benefit assistance recipients increases, inciting accelerated government spending since workers laid off from both government and private industry are often eligible. The capital the government puts towards assistance programs only serves to keep consumer spending on staple products consistent; it slows a general economic recovery by diverting new capital away from further investment in projects that could create new jobs or growth. In the private sector, increased layoffs hamper economic productivity, because fewer workers are available to complete the same amount of work. As workflow inefficiency grows, profitability decreases. In the Eurozone, Estonia, Greece, Ireland, Portugual, Slovakia and Spain have acute unemployment problems, especially Greece and Spain whose rates are above 20 percent. Cyprus, Slovenia, Italy and France are also on the radar with rates between 8.5 and 10 percent.  Keep in mind that names like Italy, Spain, and France are big players in the Eurozone, representing 35 percent of the Euro’s economic strength and as conditions worsen, an increase in unemployment in these three nations poses a great threat to the viability of the Euro. 

 The second area of concern is the debt-to-GDP ratio, which is a measure comparing a nation’s debt to the value of the goods and services produced by its economy. High debt-to-GDP ratios indicate that a government is or has taken on debt whose value outweighs the profits its economy can produce, and is often used to determine a nation’s credit worthiness. To demonstrate how a high debt load impacts the economy, consider the following scenario:

 As governments spend money to spur recoveries, bailout troubled financial institutions, and safeguard the unemployed, they rely on available lines of outside credit as a way to supplement their income from tax collection. Normally this process occurs through the sale of government issued bonds, which are a type of debt instrument that promises return on investment at a given interest rate once the bond reaches the end of its maturation period. During time of higher economic activity, this method of financing is useful, as governments can borrow from outside sources to invest in projects to boost economy prosperity. The increased level of business tends to result in higher tax revenue, which can then be used to repay bond purchasers, resulting in a nation being regarded highly amongst its creditors. However, if a nation has problems meeting its existing obligations after a bond sale it seeks out more loans (either from its existing pool of creditors or new ones) to pay down the old debt or to inject more capital into its economy. As the national debt load increases, its creditors will sometimes raise the interest rates on the loans they provide in order to achieve optimal returns on investment. When economies continue to worsen, government revenues tend to decrease, because the taxable pool of commercial and consumer assets contracts, leading the government to borrow more to compensate for lower incomes. Provided the cycle continues, the interest rates on the newer loans it receives increases in relation to its debts, and if the interest increases then the overall debt owed increases beyond the principal amounts borrowed. 

 The cycle deepens further as government responds to increased debt obligations by employing its central bank to raise the interest rates on loans disbursed to its own businesses, and increasing sales and income tax rates to bolster sliding tax revenue. These actions tend to impact economic activity negatively  (provided that the tax rates aren’t already very low and that businesses dependent on government sponsored credit aren’t well capitalized in their own right) since many private firms use government funding to finance their own operations. Commercial and investment banks are good examples; the working capital they use as collateral for loans they receive from other institutions tends to be guaranteed (in various degrees) by their government’s central bank. Individual firms reliant on cheap credit begin to assume more debt as reduced economic activity lowers their revenue and prompts more borrowing to pay down old debts or to take on higher risk ventures (in the hope of acquiring arbitrage returns), but they eventually are less able to pay their debts. At this point both private firms and the national government can’t effectively meet their obligations to their creditors, and investors increasingly retreat from bonds issued by that nation’s central or private banks. 

In a country with a monetary policy structure like the United States, the ability of the government to capitalize its private sector against diminishing credit and increased interest rates is easier, because the Federal Reserve System has the ability to independently raise inflation and maintain low interest rates for its own banks. These tools allow the US to reassure its creditors that the United States federal government will repay them since the Federal Reserve can increase the money supply to whatever it deems necessary, giving the US government flexibility to meet the obligations owed to holder of its treasury bonds. In the Eurozone, the above scenario (called a credit contraction cycle) is lethal for European economies because the central banks of member states cannot independently raise inflation nor can they set their own interest rates, but they can sell their own bonds to foreign central, commercial, or investment banks. In short, the National Central Banks in the Eurozone can dig themselves into a hole, but don’t legally have the tools to climb their way out.European Central Bank HQ, BrusselsThe European Central Bank is the chief financial authority of the Euro, but unlike the Federal Reserve, it is only charged with ensuring interest rate stability and that annual inflation never increases above 2 percent which is a weak position when its various central banks are struggling. /> Overall, the credit situation in the Euro is precarious. With the downgrade of Cyprus bonds to BB+ from Fitch Ratings, that makes three nations (including Greece and Portugal) whose bonds hold a “junk” rating from at least one of the three major rating agencies.

Estonia, Malta, Slovakia, Slovenia, Ireland, Italy and Spain’s credit worthiness have fallen significantly since 2008, with the majority of these nation’s bonds just above the “speculative grade” mark. It’s also important to look at the amount of debt these nations are carrying since the majority has dangerously high levels of debt in relation to their respective gross domestic products.European System of Central Banks Greece, Italy, Ireland, and Portugal all have outstanding debts that far exceed their GDP, and together make up 24 percent of the Eurozone, meaning that if a severe credit contraction forces these troubled nations to default on their debts, there will be increased pressure on the remaining 13 nations that may make the Euro unsustainable.We also have to keep an eye on France, Germany, Belgium, Austria and the Netherlands whose economies are not as threatened as the fore mentioned four, but have debts that far exceed the 60 percent ceiling prescribed by European financial guidelines. In particular France and Germany are nearing 90 percent debt-to-GDP and most of the confidence that’s left in the Eurozone resides in the economic reliability of the French and German economies so increased problems here could be the nail in the coffin for the currency union as a whole.This chart displays the economic weight of each of the member states in the Eurozone. Green indicates a value over 5% while Yellow indicates a value between 1.75 and 5% width=

Outside of unemployment and mounting debts, the Euro has one additional, but critical weakness, The European Central Bank and the system of National Central Banks. Of any party, the ECB is the most responsible for the acuteness of the financial concerns throughout Europe as it failed to take preemptive measures to rescue ailing banking sectors, and instead, pursued policies that exacerbated existing levels of unemployment, sovereign debt, while facilitating the overleveraging of both central and private banks without any reasonable plans for creating new growth. From the outset of the fiscal concerns over sovereign debt, the European Central Bank did little to manage the financial difficulties of less agile economies (particularly those of Greece and Ireland) that surfaced during the 2008 liquidity crisis in the United States. The collapse of Lehman Brothers investment bank highlights the exposure European banks had to weaknesses in the US financial sector, especially in the asset-backed securities markets. It also demonstrated the reaction of global markets to undercapitalized financial firms as several US banks experienced increased borrowing costs due to lowered credit ratings and a tacit retreat from treasury bonds and stock indices. The smaller, less diverse economies in the Eurozone proved to have extensive exposure to a contraction in credit from foreign lenders who shored up loans and increased interest rates on existing obligations. Much of their growth from the previous 10-15 years had been financed with low interest loans and the safety of the single currency union that had been presumed as a safe haven for investment. 

Both Greece and Ireland presented with sudden economic difficulties when the credit-sourced real estate bubble ruptured across the globe. The Irish economy was the first in the Eurozone to officially be pronounced as in recession (later in depression) as the economy contracted nearly 14 percent by the end of 2008. The problems in Greece were complicated as the Greeks had secretly violated the EU’s borrowing regulations and had an unknown level of GDP shrinkage due to its national statistics bureau failing to keep accurate records of vital macroeconomic data. The European Central Bank allowed the governments and central banks of both nations to attempt to assuage investors’ concerns on their own, without adequate support or legitimate tools to effectively resolve their problems. Governments and central banks could offer “guarantees” of the solvency of their bonds (similar to the currency guarantee of the US Dollar by the Federal Reserve) but neither had the legal power to augment the supply of Euros and inject new capital into their troubled banking sectors. The ECB didn’t act to rescue troubled banks in Ireland until 2010, by which point the Irish and Greek economies were mired in recession, the costs of bailouts were far higher than they should have been and too late to be effective at easing their fiscal concerns or curbing market speculation. 

Secondly, the ECB cosigned and pursued policy that led to dramatic increases in unemployment, sovereign debt, and negatively impacted the credit worthiness of several of its essential component nations. After its failure to act in time to aid Ireland and Greece in 2008, the ECB made another critical error by enforcing overly stringent budget reduction measures in exchange for its issuance of low-interest emergency capital. Unlike the Federal Reserve System, the European Central bank isn’t a legal lender of last resort who implicitly guarantees the Eurozone’s central banks against bankruptcy. Instead the ECB is only legally bound to monitor and control the Euro’s inflation, meaning individual national central banks (who could accumulate their own debts) don’t operate with guaranteed debt from their central bank. The austerity measures required sudden, deep reductions in government expenditures, particularly in the area of social safety net programs and government payrolls. In smaller economies, where economic activity had been fueled by a steady influx of low interest credit, the spending reductions exacerbated existing contractions in economic growth. Unemployment worsened as governments laid off thousands, whose numbers were boosted by layoffs from private sector firms whose dependency on government backed credit left them too poorly capitalized to accommodate existing labor budgets.

At the same time austerity measures were diminishing economic productivity, the ECB refused to step up liquidity injections into central banks across Europe, and further increased the debt loans carried by nations that had pre-existing debt concerns. Because it refused to provide central banks with adequate rescue capital, NCBs were forced to continue to issue bonds at an accelerated pace, increasing their debt and making them subject to increased market speculation, as well as higher interest rates on their debts. The ECB sat idly by until late 2011, when it attempted to bail out and restructure Greece’s indebted banking sector, but by that point speculation fears had moved to Cyprus, Italy, France, Portugal, Spain and the Netherlands. The credit ratings of nearly half the Eurozone were downgraded to near “speculative grade” between 2008 and 2011, and when rescue funds were dispensed, the loans weren’t enough to spark economic activity, because debt loads were too high and economies too weak to make use of the additional capital. 

There are also major structural problems in the European Central Bank and the National Central Banks. The ECB is the chief monetary authority in the sense that it is the only Central Bank in the Eurozone that can independently increase or contract the money supply, issue policy directives to other member banks, and modulate interest rates on loans it issues to member central banks. NCBs are charged only with carrying out policy directives from the ECB, regulating their regional financial firms and borrowing money for their respective nations.

However, there are two key weaknesses in this framework, the first of which is the ability of NCBs to issue their own bonds. Whenever a central bank sells bonds, the purchasers expect repayment plus interest at a rate that is primarily determined by the credit worthiness of the issuing bank. Central banks in the Eurozone can do this, but unlike banks in the United States, who lend and borrow with a Federal guarantee, European banks are not backed by the ECB in this way. In periods of economic distress, European NCBs become heavily dependent on garnering new lines of credit from outside investors and debts increase as new credit is used to finance old debts, leading to a severe credit contraction cycle. The second weakness is the styling of the ECB as a monitor of the Euro’s inflation and not as a lender of last resort. Since the NCBs can sell their own bonds on the open market, their ability to repay the debts owed is based (almost entirely) on maintaining a high level of economic productivity. As an “inflation hound,” the ECB is essentially a nonfactor; it’s disinclined to raise inflation by injecting new capital into struggling economies. Its inaction prompts further borrowing and debt accumulation from NCBs attempting to keep their economies intact, which worsens the threat of credit contraction. So under the status quo, the ECB is poorly positioned to manage a crisis on this scale, even though it is the only body with enough legal authority to counteract the negative impact of excessive sovereign debt. 

Continued in Part II

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About Alexander J Smith III