How do we fix a problem like Europe?

The Eurozone is in crisis – that much is obvious. Talk of bailouts, contagion, and potential collapse have pervaded the news of 2011 and aren’t going away. At the time of writing, the world awaits an announcement on 23rd October, and not just from Dermot. Angela Merkel and Nicholas Sarkozy are expected to decide on a boost to the Eurozone’s rescue fund of around €2tn and a recapitalisation of European banks to the tune of around €1bn. But what is actually going on? Is Greece going to default and why does that matter? And why does everyone hate bankers?

The answer begins in understanding the sovereign debt crisis in Greece, where high government spending and an inability to collect taxes were exposed in the financial crisis of 2008. With debt at 127% of GDP in 2009, the possibility of default emerged and investors started to panic. To accommodate for the high risk involved in lending, interest rates increased. These higher interest rates augmented the Greek problem – herein the drop in investor confidence became a self-fulfilling prophecy as borrowing options to finance the debt dwindled. Today, Greece is faced with a still worsening balance sheet, 16.5% unemployment and a finance minister who has been unable to enter his office for two weeks due to “complete lawlessness” in response to austerity targets the government itself declares unobtainable.

Facing the prospect of insolvency, a country has two main options, one is the monetisation of debt. Here the central bank injects money into the economy by purchasing government bonds. This decreases interest rates and increases inflation as well as depreciating the exchange rate, which increases export competitively to boost the economy, and reduces the debt burden by “inflating the debt away”. This is the strategy being pursued by the UK through quantitative easing (QE), with the second round declared earlier this month.

Unfortunately Greece’s central bank is the European Central Bank (ECB) that has to act on behalf of the entire Eurozone including stronger “core” economies like Germany and France. Here, QE is not necessary and the prospect of high inflation and low interest rates spark anger amongst the people for their negative effect on pensions and savings. Faced with the impossible task of “one size fits all” monetary policy, on 6th October the ECB announced the decision to spend €40bn writing off public sector debt as the crisis intensified. However, the interest rate remained at 1.5% as compared to Britain’s 0.5% rate. Without the ability to pursue aggressive expansionary monetary policy this avenue has not provided a solution for European sovereign debt.
The other option is controlled default, requiring the renegotiation of debt terms. Greece has already received a “haircut” from creditors who voluntarily agreed a 21% reduction and extended the loans for up to thirty years, with further reductions of up to 50% suggested by EU spokesmen. This increasingly appears to be the only option available to Greece, with bailouts simply delaying the inevitable.

The financial shock associated with Greek default would be huge. Banks across the world have exposure to Greek debt and France in particular stands to be hit hard in the face of high coverage. In addition, there is a real risk of contagion to the rest of the weaker European economies. If Greece is allowed to default the precedent is set and this may extend to the likes of Portugal, Ireland and Spain. For the Euro, surviving the Greek mess is one thing but a similar collapse in Spain could be deadly.

Following the €750bn bailout in May, the front page headline of Germany’s biggest national newspaper read “We are once again the schmucks of Europe!”. With public opinion in Germany and France increasingly fraught at the prospect of paying for someone else’s fiscal mistake, the problem is rooted in the fact that Eurozone is not a political union: fiscal policy has differed vastly across nation states since the Euro’s creation and has not been properly controlled.
To save the Euro this time Merkel will be forced to ignore the will of her nation and transfer funds to those economies in need. For the Euro to survive, fiscal policy will have to be controlled even tighter.

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