What Is the Next Sick Economy of Europe?

BY jbreslow  May 27, 2010 at 11:05 AM EST

Attention has shifted from the financial troubles in Greece to other troubled euro zone countries. Debt concerns in countries such as Spain, Italy, and Britain continue to jitter global markets, even as those countries consider new austerity measures to bring their finances under control.

In Berlin on Thursday, U.S. Treasury Secretary Timothy Geithner said that the United States and Europe broadly agree on what steps are necessary for reform, but that a “global approach” to reforming the global financial sector was needed in the run-up to next month’s G-20 meeting in Toronto.

To get a sense of which European countries are in the worse shape and what it means for the global economy, we spoke to Domenico Lombardi, a nonresident senior fellow at the Brookings Institution and an expert on the European economy.

Can you walk us through the situations of those various states in most trouble? Italy, Spain, Portugal, Ireland, even Britain?

DOMENICO LOMBARDI: The crisis in Europe is no longer confined to Greece. What was originally a budget crisis in a relatively small economy of the euro area has become a systemic crisis involving the whole euro area. In particular, Portugal, Spain, Italy and Ireland are all affected by potential contagion.

Clearly the issues are a little bit different because in Spain the problem is mainly an unsustainable debt born by the private sector, while in Greece [it] is more an unsustainable debt born by the public sector.

In Italy, it is mainly an issue with the public sector and also the inability of the Italian economy to generate enough growth to serve this increasing pile of debt. However, what is really linking all these countries is that because the Europeans did not act timely in containing the spillovers of the Greece crisis, now essentially this crisis has spread to the other countries of the euro area and assumed really systemic proportionS.

Several of these countries have proposed austerity measures. Do they go far enough? Are they realistic or even politically feasible?

DOMENICO LOMBARDI: Many countries that may be hit by the crisis — like Italy, Portugal, Spain — have adopted or are implementing additional budget measures. This is an important measure, especially in the short-run, because they need to cut down their budget deficits and they need to improve their fiscal position.

However, as important as these measures may be, they are not enough by themselves, because what financial markets are really wondering is to what extent these countries will be able to grow at such a rate that they will be able to serve an increasing pile of debt. This is really the key issue.

Just to make an example, the U.S. and Greece were running the same budget deficit in comparison to their own GDP last year, and yet no one even for one minute would doubt that the U.S. could find itself in the same situation as Greece for many reasons, one being that the U.S. economy is a very vibrant one, has a high potential rate of growth and therefore it is better able to handle an increasing pile of public debt. This is really what European economies lack at the moment — a high potential growth that would help them to stabilize the increasing public debt.

The European Central Bank and the International Monetary Fund have stepped in with a $1 trillion rescue package aimed at stabilizing the euro zone. Yet global markets remain on edge on fears of the continent’s debt troubles. Have the ECB and the IMF done enough to stem the crisis?

DOMENICO LOMBARDI: The ECB has shown increased activism in the recent crisis. In my view the ECB interventions truly reflect the gravity of the situation that Europe is going through right now and those interventions are aimed at reshaping the normal channels of monetary policy transmission.

The IMF is also ready to intervene heavily should the crisis get worse. It has already done so vis-à-vis Greece. It is interesting that an institution that was deemed irrelevant by most of its shareholders until a couple of years ago now is back lending to the heart of Europe, to an euro-area country and possibly lending to other euro-area countries in the coming months. This is certainly a reflection of the activism shown by the institution under the current leadership.

Where might the next major crisis be — the next ‘Greece’, if you will?

DOMENICO LOMBARDI: At this moment, the crisis has already become European in full respect. The euro is a global currency. It’s the second largest currency in the world after the dollar so whatever happens to the euro has repercussions for all the other economies in the world.

We see that even in Beijing they are following the European crisis with increasing concern because they have seen their own currency, the renminbi, has been appreciating vis-a-vis the euro in a non-negligible way over the last few weeks. If the European economy does badly, they will be exporting less to Europe, which is really their most important trading partner. Therefore, they might feel less inclined to appreciate their own exchange rate vis-a-vis the dollar, as the Americans have requested several times, not least in the context of the recent high-level meetings they held in Beijing in the beginning of this week.

What does all this mean for the U.S. and global economy?

DOMENICO LOMBARDI: This crisis clearly at this stage has spillover effects not just in the euro area but also vis-a-vis third countries, including the U.S. And there are at least a couple of channels through which the U.S. economy may be affected.

First, there may be a chilling effect in its own banking sector. Americans banks are not directly exposed to Greece. However, they are exposed to other European banks which in turn are exposed to Greece. In the absence of enough information, this may generate a chilling effect and therefore break down transactions in the financial markets even if it’s on the other side of the ocean.

There is also another effect, and that is because the euro is going to stay weak in the near future, European manufacturers will increase their competitiveness in selling their goods abroad and therefore they will be slightly better off than U.S. manufacturers. Clearly this may be a problem for an economy like the U.S., which needs to export more in order to create more jobs. And indeed, President Obama has made increasing exports really one of the goals of his own economic strategy. So all in all, we have seen that by not containing the crisis early enough, the crisis has now spread to the euro area and is threatening the stability of the global economy.