Europanic is back in style. After a monthslong reprieve initiated by the European Central Bank’s decision to offer the continent’s banks nearly unlimited quantities of low-interest medium-term loans, the sovereign debt crisis has returned. This time ground zero is Spain rather than Italy, but the pattern is familiar. Interest rates on Spain’s debt went up a little, putting further strain on Spain’s budget. That called its solvency into question and pushed up rates further still. And as interest rates rise, Spanish banks’ viability comes into doubt, squeezing credit to the domestic economy and further weakening the budget. Depending on how you look at it, it’s a sovereign debt crisis, a banking crisis, or a simple growth crisis, but in any case, there is a risk of national default, total bank meltdown, and perhaps the collapse of the single currency or even the larger European project.
The key symptoms include a Spanish bond auction on Wednesday that drew little demand from investors, and a flight back into U.S. Treasury bonds and away from European debt. And of course while Spain is a big deal on its own terms, lurking behind it is the reality that if Spain goes down, the larger economies of Italy and even France will be pulled into the muck.
Fundamentally, the crisis recurred because the last “solution” to the crisis solved nothing. It was a half-genius, half-mad suture to narrowly address the banking crisis. Given enough free money from the ECB, any bank has the ability to stay solvent. That calmed nerves, and the newly solvent banks were quietly encouraged to load up on European government debt, which helped bring interest rate spreads down. At the time, critics assailed this as little more than an effort to kick the can down the road, and they were right. But oftentimes in a panic situation, down the road is exactly where you want the can to go. If resolving the underlying problems with Europe’s economic framework were easy, it would have been done already. Solving hard problems takes time, so stopgap time-buying measures are welcome. The trouble is that months later, not only are the fundamental issues still with us, it’s difficult to say that any progress at all has been made.
Simply put, Europe’s current institutions are unworkable. The aim of kicking the can down the road must be to create better ones. Before the crisis, capital flowed from Germany (and to an extent small countries such as Austria, Finland, and the Netherlands) into the so-called “peripheral” countries. By importing capital, the peripheral countries were able to import more than they exported, and their citizens consumed more than they saved. In Greece and Portugal, this entailed a great deal of government borrowing, but in Spain and Ireland, the borrowing was largely in the private sector. Then came a loss of confidence in the soundness of this lending, and the capital stopped flowing in.
This kind of “sudden stop” of external financing is sadly common in the annals of international finance. What normally happens is the indebted country finds the value of its currency plummeting. Real wages tumble, and workers can buy less as the value of the currency falls. Eyeball deep in debt, the country’s citizens find themselves working longer for less. Perhaps politicians are inspired by the suffering to enact smart policy reforms that speed the recovery of pre-crisis living standards or perhaps not.
But Spain and Italy and Greece don’t have an independent currency to collapse. In this, they’re hardly unique. In a large country like the United States, sometimes investment flows in to a given area and then halts, damaging the local budget and employment situation. But in the U.S., a jurisdiction facing a sudden investment decline—think of Florida or Arizona today—still benefits from a continued stream of Social Security and Medicare checks. What’s more, unemployment insurance, food stamps, and Medicaid ensures that the worse you get hit, the more federal assistance you get. Last but by no means least, when the local economy collapses, you can always move to another state. And indeed, leaving has long been an important part of America’s adjustment process. Regions whose industries are in decline lose people, regions that prosper gain people, and a desire to not see the entire population flee acts as something of a check on malgovernment.
Europe has none of these protections. Not only are Europeans habitually less mobile than Americans, they have the unfortunate habit of speaking different languages. A person from Lisbon or Seville or Naples is going to have a tough time getting a decent job in Amsterdam or Munich or Helsinki, since few Europeans speak German and nobody speaks the other Northern European languages.
Europe is trapped in a vise between currency values that can’t adjust, populations that can’t move, and regions that don’t support each other financially. This vise has led to, among other things, extremely challenging sovereign debt loads. But rounds of budget cuts treat the symptoms without doing anything to facilitate the underlying adjustments that need to happen. Nor are the linguistic and cultural barriers to intra-European migration going to vanish any time for the foreseeable future. German taxpayers could simply finance open-ended transfer payments to their poorer cousins the way Massachusetts subsidizes Mississippi, but eventually their patience will stop. Americans in Massachusetts and Americans in Mississippi do feel themselves part of the same country, sharing language and culture. Germans and Spaniards do not feel the same. And, in fact, all possible solutions tend to founder on this same point. Germany could tolerate higher inflation or flip its tax system around to accommodate southern Europe’s needs, but German voters want the German government to respond to their needs. The impulse is understandable, but the practical consequences are disastrous. The single currency was set up as a political project intended to drive deeper political integration. The recurring debt crises we see today are the fruits of the risky bet that Europeans could unite across national borders. It’s been a costly gamble so far and there’s no sign that it’s going to start paying off any time soon.