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Europe’s double conundrum

William Miller | Tuesday, October 4, 2011

There seems to be a lot of good news coming out of Europe in the past couple of days. First, Greece recently passed a new string of austerity measures, most notably a new property tax, aimed at closing its budget deficit. This will likely satisfy the troika, composed of the International Monetary Fund, European Central Bank and European Union, which administers the bailouts given to Greece. As a result, Greece will likely receive the next part of its bailout package, about $8 billion, which will keep the Greek government solvent until December.

Second, the German parliament recently passed the European Financial Stability Facility (EFSF) with an overwhelming majority. The fund will be used to buy the bonds of distressed countries (lowering their borrowing costs), to give loans to countries that can’t borrow from the markets at reasonable rates and to recapitalize European banks if necessary.

Unfortunately, this news is too little, too late. Europe is stuck in an impossible cycle. Even as the PIIGS (Portugal, Ireland, Italy, Greece and Spain) try to cut spending to get their deficits under control, a recession appears to be setting in across the continent. This recession will hurt economic growth, lowering the amount of money that European governments collect from taxes and reducing Germany and France’s willingness to continue bailing out other governments. It also appears unlikely that Greece will be able to make good on its debts, which would unnerve markets and lead to trouble for Italy and Spain. Long story short: Europe is in for trouble.

Let’s look at this situation a little more closely. The European recovery, which has been powered by Germany’s remarkable economic run, is losing steam. Consumer spending is falling in Germany, economic growth has come to a standstill in France and the Eurozone as a whole is only projected to grow by 0.3 percent in the second quarter. This is especially bad for countries like Italy and Spain, which are cutting government spending to reign in deficits. The more that government spending is cut, the slower the economy will grow in the short run. As a result, the government will take in less revenue, leading to a pernicious cycle in which deficits become more and more difficult to reign in.

Meanwhile, Greece, the focal point of this entire crisis, is not going to get any better. Greek government debt as a percentage of GDP now stands at 150 percent, which is actually higher than when Greece got bailed out. This is because its GDP has shrunken dramatically in the face of lower government spending.

What’s more, the ruling Greek Socialist party is struggling to enforce even the moderate initial cuts demanded by the troika. This does not bode well for the future, especially when the government is forced to consider even more painful cuts. This includes laying off government workers, which is actually banned by Greece’s constitution except in extraordinary circumstances.

Current austerity measures have already elicited a tremendous (and at times, violent) response from public labor unions and large elements of Greek society. Future responses will only increase, making the situation more and more difficult for the Greek government.

What, then, will be the outcome of the Eurozone crisis? While the specific answer is hard to predict, it seems almost a foregone conclusion that Greece will either default on its debt or force investors to take haircuts (e.g. only receive a certain percentage, say 40 percent, of what they were originally promised) on their investments. The distinction between these two is of critical importance. European banks are highly exposed to the Greek crisis, holding tens of billions of dollars worth of Greek debt. If these banks were forced to take a total loss on these loans, it is likely that they would need to be recapitalized, which would be a highly expensive process akin to the TARP program initiated here in the United States. What’s more, a disorderly default would unnerve financial markets, perhaps making it necessary to bail out Italy and Spain. These countries, which have debts in the trillions, not billions, may be beyond the capacity of Europe to save.

Pain is coming for Europe regardless of what happens. Greece, Ireland, Portugal and possibly Italy and Spain are in for years of painful cuts in spending and slow economic growth. Germany and France will continue to face the question of how much they should help out other countries, even as their own economies begin to suffer. The answer to this question will determine whether or not the European Union stays together. The most likely outcome will be a hybrid. The European Union will continue to exist, but it is unlikely that the process of creating a “United States of Europe” will continue much further.

William Miller is a sophomore majoring in Arabic and political science. He can be reached at wmiller3@nd.edu

The views expressed in this column are those of the author and not necessarily that of The Observer.