After days of drama-filled meetings, in late October eurozone leaders announced the latest “comprehensive” rescue plan. Although it was an improvement over earlier efforts, this package, too, came up short in that it failed to calm the markets and offer the eurozone a path back to economic growth. And without growth, there will be many more months of crisis.
The stakes are very high. The fate of the US economic recovery rests in part on whether Europe can keep its intertwined banking and debt crises from spiraling into full-fledged financial contagion, which would deal a damaging blow to an already fragile US economy. Yet the United States has little influence over European policy. Not only is Washington’s advice viewed with suspicion in Berlin and Paris (Europeans still rightly complain about the economic shock visited upon their economies by the collapse of Lehman Brothers); with austerity-drunk Republicans in charge of Congress, the United States can’t do much to help rescue Europe.
The most we can do at this point is draw the right lessons from the crisis for our economy and try to nudge policy in the right direction (while encouraging the Federal Reserve to support Europe’s efforts at stabilization). Indeed, there is a danger that we will only compound the problem with bad advice and inappropriate policy. So what are the most essential lessons to draw from the crisis?
First, this is not principally a crisis of runaway social spending or even a government debt crisis, although it has become one for some economies. Contrary to what is often asserted, many of the countries in trouble did not have irresponsible fiscal policies, as Martin Wolf of the Financial Times has noted. Greece did, but Spain and Ireland ran budget surpluses before the crisis and had very low levels of government debt. Ireland’s debt was a mere 12 percent of GDP, while Spain’s was 31 percent, well below Germany’s 53 percent. Italy had a high debt-to-GDP ratio but a very modest budget deficit. As much as anything, these economies were victims of a credit boom and bust born of too cheap interest rates and excessive lending, followed by an especially severe recession and a financial panic. The lesson here is not about the importance of fiscal consolidation but the dangers of credit and asset bubbles that are often the product of weak financial-market regulation and of imbalances, in this case between the core European economies, which ran current-account surpluses, and peripheral deficit countries, which absorbed those surpluses.
The second lesson is that governance matters. Europe’s problem is not too much government but too little. The reason the eurozone has struggled so mightily with the threat of financial contagion—whether it be organizing an orderly Greek default or assembling a stability fund of sufficient size—is that it does not have the government institutions needed to act decisively and quickly enough to calm the markets. If the eurozone had had a common treasury it would have been able to assemble an adequately resourced European Financial Stability Facility much earlier, avoiding the run-up in interest rates. Or if the European Central Bank had been a true lender of last resort, it would have been able to stanch market speculation by buying sovereign bonds more aggressively or by guaranteeing future sovereign debt.