The law of unintended consequences is the only real law of history

Niall Ferguson on How Europe Could Cost Obama the Election

Spain has accepted a big bank bailout, but the Eurostorm isn't ending anytime soon—and it may come to American shores just in time for the election.

by Niall Ferguson  

Could Europe cost Barack Obama the presidency? At first sight, that seems like a crazy question. Isn’t November’s election supposed to be decided in key swing states like Florida and Ohio, not foreign countries like Greece and Spain? And don’t left-leaning Europeans love Obama and loathe Republicans?

Sure. But the possibility is now very real that a double-dip recession in Europe could kill off hopes of a sustained recovery in the United States. As the president showed in his anxious press conference last Friday, he well understands the danger emanating from across the pond. Slower growth and higher unemployment can only hurt his chances in an already very tight race with Mitt Romney.

Most Americans are bored or baffled by Europe. Try explaining the latest news about Greek politics or Spanish banks, and their eyelids begin to droop. So, at the end of a four-week road trip round Europe, let me try putting this in familiar American terms.

Imagine that the United States had never ratified the Constitution and was still working with the 1781 Articles of Confederation. Imagine a tiny federal government with almost no revenue. Only the states get to tax and borrow. Now imagine that Nevada has a debt in excess of 150 percent of the state’s gross domestic product. Imagine, too, the beginning of a massive bank run in California. And imagine that unemployment in these states is above 20 percent, with youth unemployment twice as high. Picture riots in Las Vegas and a general strike in Los Angeles.

Now imagine that the only way to deal with these problems is for Nevada and California to go cap in hand to Virginia or Texas—where unemployment today really is half what it is in Nevada. Imagine negotiations between the governors of all 50 states about the terms and conditions of the bailout. Imagine the International Monetary Fund arriving in Sacramento to negotiate an austerity program.

This is pretty much where Europe finds itself today. Whereas the United States, with its federal system, has—almost without discussion—shared the burden of the financial crisis between the states of the Union, Europe has almost none of the institutions that would make that possible.

The revenues of the European central institutions are trivially small: less than 1 percent of EU GDP. There is no central European Treasury. There is no federal European debt. All the Europeans have is a European Central Bank. And today they are discovering the hard way what some of us pointed out more than 13 years ago, when the single European currency came into existence: that’s not enough.

Indeed, having a monetary union without any of the other institutions of a federal state is proving to be a disastrously unstable combination. The paradox is that monetary union is causing Europe to disintegrate—the opposite of what was intended. According to the IMF, GDP will contract this year by 4.7 percent in Greece, 3.3 percent in Portugal, 1.9 percent in Italy, and 1.8 percent in Spain. The unemployment rate in Spain is 24 percent, in Greece 22 percent, and in Portugal 14 percent. Public debt exceeds 100 percent of GDP in Greece, Ireland, Italy, and Portugal. These countries’ long-term interest rates are four or more times higher than Germany’s.

Perhaps the most shocking symptom of the crisis on the so-called periphery is youth unemployment. In Greece and Spain, more than half of all young people are out of work. That’s right: one in two young Greeks and Spaniards are unemployed, eking out an existence on doles, cash-only gray-market jobs, and rent-free accommodations with mama and papa.

In the north European “core” of the euro zone, however, the picture is completely different. Unemployment in Germany is 5.4 percent. In the Netherlands and Austria it is even lower. These economies are growing. Their governments have no difficulty borrowing. The phrase “two-speed Europe” hardly does justice to the bifurcation. There are in fact now two Europes: a Teutonic core and a Latin periphery.

Privately, senior politicians and businessmen now admit that Europe would be in a much better position today if the monetary union had never happened. If there had been no euro, there would have been no borrowing bonanza on the periphery and no property bubble in Spain. And if they still had the drachma, the lira, the peseta, and the escudo, the weaker European economies could simply devalue their way out of recession, as they used to, rather than try to cram down wages, slash spending, and hike taxes.

The trouble is that the costs of a monetary breakup would in all likelihood be even greater than the costs of a transition to American-style federalism. On June 17 many Greek voters will cast ballots for parties that reject the austerity conditions imposed on their country under the terms of two bailouts. True, a clear majority of Greeks say they don’t want to leave the euro zone. But it’s hard to see how a Greek government could ditch austerity without being forced back to the drachma.

Even the possibility of a “Grexit” has made people in the other Mediterranean countries nervous. The most telling sign of contagion is the deepening crisis in the Spanish banking system as depositors withdraw their money. After all, if the Greeks return to the drachma, that would mean converting all Greek bank accounts back to the old currency. And if that could happen in Greece, why not in Spain too?

Europe’s monetary union has entered a doom loop. Recessions in peripheral Europe are driving down tax revenues and increasing welfare spending. Despite German-imposed austerity programs, deficits keep overshooting the targets. But these governments can no longer borrow at affordable rates. Meanwhile, their banks are hemorrhaging deposits. Up until now, broke banks could prop up broke governments by borrowing from the European Central Bank and using the cash to buy their governments’ bonds. But that game is over. For there is nothing the ECB can do to stop panicky Spaniards swapping “Spanish euros” for “German euros”—in other words, putting their savings into German banks for fear that Spanish accounts will one day be converted back into pesetas.

This is a potentially explosive process. Already the centrifugal forces at work have generated a vast imbalance within the TARGET2 system, which processes payments between the euro-zone member states’ central banks. In effect, the peripheral central banks owe the German Bundesbank €650 billion. This is a figure that grows larger with every passing week.

What makes all of this so terrifying is that it vividly recalls the events of the summer of 1931. It’s often forgotten that the Great Depression, like a soccer match, was a game of two halves. If the first half was dominated by the U.S. stock-market crash, the second was kicked off by a European banking crisis. It began in May 1931, when the biggest bank in Austria, the Creditanstalt, was revealed to be insolvent. The lethal blow was the collapse two months later of the Danat Bank, one of the biggest in Germany.

As economic confidence slumped, unemployment soared to unprecedented heights. At the peak in July 1932, 49 percent of German trade-union members were out of work. We all know what the political consequences were. All over Europe, the extremists of the right and the left—fascists and communists—surged in popularity. Hitler came to power in 1933. Six years later Europe was at war.

Nobody expects all of that history to repeat itself. Europe’s population is older today and much less militaristic. Nevertheless there are disquieting signs of a populist backlash in many countries—and not just in Latin Europe. In the Netherlands and Finland, right-wing parties win votes by denouncing both Europe and immigration. In the upcoming French and Greek parliamentary elections, the far right will also do well, as will the hard left. And maverick politicians and movements are springing up in the most unlikely places: the comedian Beppe Grillo in Italy, the Pirate Party in Germany.

Today’s populism won’t lead to war. But it is making the task of governing Europe progressively harder every time an election is held. In Europe there is now no such thing as a two-term leader. In the age of austerity, the incumbent always loses.

So, after more than two years of procrastination—known universally as “kicking the can down the road”—Europe has reached the moment of truth.

It’s binary. Either German Chancellor Angela Merkel has to bow to the logic of her predecessor but one, Helmut Kohl, who always saw monetary union as a route to federalism, or it’s over—and the process of European disintegration is about to spiral out of control. Put another way: if Europe’s leaders try kicking the can one more time, it will turn out to be packed with explosives.

For the Germans, it’s an agonizing dilemma. The federal route means breaking the news to German voters that they are going to be handing over very large sums of money to Southern Europeans for the foreseeable future—maybe as much as 8 percent of GDP. That’s much more than German reunification cost in the 1990s. But the breakup scenario could also cost Germans hundreds of billions, because the financial shock waves would be immense. Not only would the Germans risk hefty losses on those TARGET2 balances, but the collapse of the peripheral economies would hardly leave German business unscathed, since 42 percent of German exports go to the rest of the euro zone—eight times the amount that goes to China.

So what is to be done? If Alexander Hamilton were alive today, he’d advise the creation of a federal system much more like the U.S. Constitution than the unworkable Articles of Confederation. That would mean three things: a European banking union complete with Europe-wide deposit insurance, the recapitalization of ailing banks with funds from the new European Stability Mechanism, and some kind of scheme to convert part of national debts into euro bonds backed by the full faith and credit of the EU.

So far the Germans have been willing to entertain the first option while strongly resisting the second and third. To justify the risk of guaranteeing Spanish bank deposits, the Germans want even more central control over the fiscal policies of member states than they were already given under last year’s fiscal compact. The trouble is that such arrangements strike Italians and Spaniards as—to quote one key decision maker in Rome—“quasi colonial.”

Germany’s qualms about bailing out Latin Europe are understandable. Why should the Southerners get serious about reforming themselves if the Germans keep ponying up? But Europe is on the brink of disintegration, and euro bonds must be an essential part of any meaningful solution, just as U.S. Treasuries were crucial for America in the 1780s. Sometimes the best really is the enemy of the good. Structural reforms in Latin Europe are highly desirable, but they would take years to implement. Europe doesn’t have years. It may have only days.

My best guess is that all this brinksmanship will ultimately end with the Hamiltonian solution: fiscal federalism and, ultimately, a United States of Euro Zone. An important step was taken in this direction over the weekend, with the announcement that 100 billion euros will be made available to bail out Spain’s ailing banks. This was a major victory for the talented Spanish Economy Minister Luis de Guindos, who cleverly asked for more than twice what the International Monetary Fund deemed necessary, and got away with far fewer conditions than were imposed on neighboring Portugal when it sought a bailout. The mood in Madrid this weekend was one of relief, even confidence. But there are all kinds of hazards along the way, not least the impending Greek and French elections. Meanwhile, the world waits—and braces—for a European Lehman Brothers moment.

Even in a best-case scenario, this crisis has already delivered a massive economic shock to Latin Europe. The consequences are already detectable in the rest of the world in sagging stock markets, purchasing managers’ indices, and job-creation numbers. Europe’s agony threatens to inflict a double-dip recession on the United States as well as slow down growth significantly in big emerging markets like China. Remember, exports to the EU account for 22 percent of total U.S. exports. For some big American companies like McDonald’s, Europe accounts for as much as 40 percent of total sales.

The most recent U.S. jobs numbers were lousy: employers added only 69,000 jobs in May, and the unemployment rate actually rose. Manufacturing activity has also slowed. Consumer confidence is down. And, despite last week’s rally, the U.S. stock market has given back nearly all the gains it made in the first three months of the year. This is partly due to mounting worry about the fiscal cliff facing this country at the end of the year. But it is mainly a consequence of Europe’s “viral spiral.”

As for the political consequences of a U.S. slowdown, it doesn’t take a Ph.D. in political science to see why the White House is worried. Even when people were still talking about recovery, President Obama was neck and neck with Mitt Romney on his handling of the economy, the No. 1 issue in voters’ minds. Back in 1980 Ronald Reagan asked Americans the question that ensured Jimmy Carter was a one-term president: “Are you better off than you were four years ago?” Asked the same question in last month’s Washington Post–ABC News poll, just 16 percent of Americans said they are.

The law of unintended consequences is the only real law of history. If the disintegration of Europe kills the reelection hopes of a president Europeans fell in love with four years ago, it will be one of the supreme ironies of our time.