Parallel to the downgrade of America’s credit rating and its aftermath, there has been another predominant topic in the recent economic news: the European sovereign debt crisis. What appeared to be an internal Greek problem at first glance in early 2010 has now transformed into a serious European issue calling out for a diligent denouement. Considering that continental boundaries are not an obstacle to the spread of a financial crisis, the effects of Europe’s recent struggle on the U.S economy should be considered.
The first sign of trouble was the discovery of Greece’s true economic situation at the beginning of 2010. Information about extensive concealing and misreporting of the level of borrowing, performed by the government with the help of Goldmann Sachs, reached the surface. Up to late 2007, Greece was one of the fastest developing economies in the Eurozone. After the introduction of the Euro in 2001, the sharp drop in interest rates for government bonds allowed Greece to borrow immensely. Cheap lending, unrestrained spending on luxury goods, increase of salaries and social benefits are some of the factors that led Greece’s economy to be uncompetitive with its EU partners. As Professor Thanos Veremis of the University of Athens pointed out during his guest lecture hosted at UC Berkeley School of Law (Boalt Hall) on October 25th, an “artificial paradise” was created during that time. According to Professor Veremis, the lack of charismatic political leaders in Greece and the resulting political mismanagement contributed to the deteriorating economic situation of the country. The late-2000 financial crisis had a particularly large effect on Greece because tourism and shipping, being major industries, experienced a significant drop of revenues. The government’s fraudulent efforts to comply with the guidelines of the European Monetary Union resulted in the previously mentioned scandal of 2010.
Even though Greece has been blamed for “commencing” the crisis, the country is neither the only one affected nor the only one to blame. Professor Veremis underlined that the vicious mechanism of excessive lending and import, which made the Greek economy sick, was strongly encouraged by northern European countries. Being exporters of goods and creditors, Greece profited significantly. Whereas the Greek debt seems to be manageable by European resources, an aggravation of the situation in the rest of the southern countries could badly shake the Union’s economy.
The seriousness of the situation makes it understandable that the leaders of the two biggest countries in the European Union, German chancellor Angela Merkel and French President Nicholas Sarkozy, are desperately engaged in finding a solution. Given the considerable possibility of a Greek default that would impact not only the countries of the Eurozone but all members of the Union, there is an urgent need for a solution framework. There are basically two approaches to resolve the problem.
Proponents of the first approach argue that the best option would be a withdrawal of the euro and a reintroduction of a national currency in Greece. This approach stresses the negative effects of a common currency, which is primarily the lack of control over liquidity shortage. The support of a country’s central bank in the Eurozone is eliminated, as its role is vested in the European Central Bank.
The second course of policy, currently being pursued, sets forth a Greek bail-out. During the European Council and Euro Area summit held on October 26th in Brussels, European leaders agreed on a plan including a 50% write-down of Greek debt from the private sector. Further, the European Financial Stability Facility (EFSF) will be restructured to leverage its resources. The EFSF is a special purpose vehicle financed by members of the Eurozone that is encumbered with the task of providing help in case of a financial crisis. The means the EFSF has to conduct the task are limited given that it primarily issues bonds and other financial instruments to raise funds and provide loans. Currently, the EFSF has about €440 billion at its disposal, a sufficient amount to bail out Greece but clearly an insufficient amount to bail out Spain or Italy which are among the largest four economies of Europe. A solution emerging from the summit of European leaders of October 26th is intended to attract investment in risky bonds by providing an insurance that would be offered by the EFSF in case of failure.
Further, the crisis has triggered European politicians to contemplate a significant step towards stronger integration within the Union or at least a European a fiscal union. As professor Veremis noted during his lecture, the discrepancy between the pace of market integration and the pace of policy integration in the EU has contributed to the crisis; therefore, a fiscal union seems to a desirable direction of development. However, Professor Katerina Linos, expert in European Law at Boalt, comments that “France and Germany should proceed carefully with proposals for a fiscal union, lest they deepen rifts between states that form part of the Euro-zone, and states that are part of the EU but do not use the Euro.”
The uncertainty of the crisis’ development stretches out in time and inevitably spreads to other countries, especially affecting their capital markets. How threatening the current situation could be to non-European countries depends upon their exposure to European debt. The U.S. banks are said to be “safe” because they do not possess significant amounts of European government bonds. Nevertheless, one should not ignore the fact that U.S. banks do have significant trade relations with European banks that hold risky government bonds. Therefore, a domino effect could hit the American banking system.
Another aspect of the European crisis is the reduction of export volume the U.S. will have to face. First, the devaluation of the euro, which has recently proved to be significant, will weaken the market competitiveness of U.S. export products. Secondly, a weak European economy will result in low demand for imported goods.
Considering the seriousness of Europe’s situation and its potential impact on the global economy, all eyes are now turned to the European leaders who will hopefully meet the high expectations they are burdened with.