Three European crises feeding each other

The European “crisis” is back

By Robert J. Samuelson

Actually, it never went away — and won’t for many years. The problems are so deep and pervasive that there is no easy or obvious solution. Government debt and deficits in many countries are not sustainable, but the usual remedies of cutting spending and raising taxes — a.k.a. “austerity” — may make matters worse by deepening already severe recessions. Europe is caught in a trap that promises more political and social unrest.

The wonder is that, for a few months, there was a sense of complacency. Interest rates on vulnerable debtor countries Spain and Italy declined. Fears about European banks eased. Some commentators said “the worst is over.”

Well, probably not. Interest rates are headed up again, while European stocks have taken a pounding.

The momentary optimism reflected an unprecedented move by the European Central Bank (ECB) — Europe’s Federal Reserve — to make low-interest loans of 1 percent available to strapped banks for three years. In late December, more than 500 banks borrowed 489 billion euros (about $635 billion); and in February, 800 banks borrowed 530 billion euros ($690 billion).

The ECB “dumped tons of cash onto the banks,” says economist Jay Shambaugh of Georgetown University. As he notes, this had two beneficial effects. First, it relieved fears that some banks wouldn’t be able to repay maturing loans. Second, it helped reduce interest rates on government bonds because banks used the new cash to buy bonds. (Bond rates move in the opposite direction of prices; if bond prices rise — because investor demand increases — then interest rates fall.) For the banks, this seemed to present a huge profit opportunity: borrow at 1 percent; buy bonds yielding 5 percent or more.

But all this, though reassuring, barely affected debtor countries’ underlying problems.

Spain is the latest focus of concern. On March 2, Prime Minister Mariano Rajoy announced that the country would miss its 2012 budget deficit target of 4.4 percent of the economy (gross domestic product) and wanted to raise that to 5.8 percent of GDP. After complaints from other European leaders, the target was set at 5.3 percent of GDP. But this required more austerity in an economy in deep recession.

“Spain is a classic expression of the problem,” says Shambaugh. “You look at its almost 24 percent unemployment, and it’s hard to see austerity as the path out.”

In a recent paper, Shambaugh argued that Europe’s problems are so intractable because they reflect three parallel crises that feed on each other. First, there’s a banking crisis. Banks have too little capital (a buffer against losses) and have a hard time raising funds. Next is the sovereign debt crisis. The high debts of many countries raise fears that, like Greece, they may default. And, finally, there’s an economic growth crisis. Low growth or slumps afflict most of the 17 countries using the euro.

Each crisis aggravates the others. Because banks hold huge portfolios of government bonds, fears about the bonds’ values weaken the banks and threaten their failure. Weak banks in turn don’t provide ample business and consumer loans to increase economic growth. And feeble or nonexistent growth shrinks tax revenues and makes it harder for governments to service their debts.

Just how Europe escapes this trap is unclear. In his paper, Shambaugh proposes a few policies that he thinks might help. For example, stronger countries such as Germany and the Netherlands might cut their value-added tax (VAT) to spur consumption — and imports from weak debtor countries. Slightly higher inflation in the stronger countries would improve debtors’ competitive position.

Europe’s best hope may be that faster economic recovery in the rest of the world triggers an export boom. But this is a hope, not a policy. The policy has been to muddle through.

“Whenever pushed to the brink, policymakers have always done something to pull them back from the brink,” says Shambaugh. “They’ve done things that no one thought possible five years ago” — including the ECB’s recent, cheap three-year loans. The improvisations have been impressive, but how long can they continue?