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The European debt crisis

This post was originally published on November 10, 2011.

This week, a dramatic series of events unfurled across Europe, which threatened to push the continent’s debt crisis to new heights. Even as Greece ushers in a new interim prime minister and Italy battles spiraling borrowing costs, European leaders continue to dither at a seemingly endless procession of summits while the eurozone slouches toward a double-dip recession. Some have even begun to think the previously unthinkable by asking if this is the “finito” for the euro.

But what do these problems in Europe mean for the U.S. and its stalled recovery? To understand the potential impact, here are five things to know:

1. A united Europe

The European Union, as it’s currently configured, consists of 27 member states. Seventeen member states of the EU, including Germany, France, Italy and Greece, belong to the eurozone; they share the euro currency and a common monetary policy set by the European Central Bank (ECB).

The first offshoot of European integration came in 1952, in the form of the European Coal and Steel Community (ECSC), which established a common market in coal and steel for member countries: France, Germany, Italy, Belgium, the Netherlands and Luxembourg. In the wake of two devastating world wars, the ECSC’s architect, Robert Schuman, sought to create a single market for these two essential wartime materials as a safeguard against further conflict.

Fast forward to November 1989, after the fall of the Berlin Wall, when the specter of a rootless Germany spurred many previously skeptical states to fast-track planning for a monetary union. The culmination of these efforts can be seen in the 1992 Maastricht Treaty, sometimes called the Treaty of Europe. A turning point in the history of European integration, the treaty formally established the European Union and set a timeframe for the rollout of the euro currency, which was introduced in 1999 and put into circulation in 2002.

After weeks of political turmoil, Lucas Papademos was named as the prime minister of the new Greek interim government on Nov. 10, 2011. Photo: AP Photo/Thanassis Stavrakis

2. Ground zero: Greece

Greece was granted eurozone membership in January 2001 after implementing a series of economic reforms — on paper, at least. With its admittance into the eurozone, Greece gained access to virtually unlimited credit at low interest rates. Greece’s continued access to artificially cheap credit, even after officials confessed to fabricating figures, enabled the government to ignore surging domestic costs (for a large public administration and generous pension programs, among other expenses) and corruption (including widespread tax evasion) for far too long.

By 2009, many national economies started to buckle under the strain of the global financial crisis, and Greece was no exception. In additional to the global downturn, Greece also faced widening bond spreads. The news only got worse that October, when the newly elected Socialist Prime Minister George Papandreou released a new government budget for 2009, which revealed an existing deficit of 12.7 percent of GDP, three times the EU limit. (In April 2010, the EU’s statistical office revised Greece’s debt estimate once again to 13.6 percent.)

In May 2010, Greece received a $152 billion bailout from the “troika” of the ECB, EU and the IMF in exchange for rolling out deep cuts to public spending programs. This past June, the Greek government passed another round of public spending cuts in order to qualify for a second bailout package of $157 billion.

These measures have not been without their detractors. Some economists like Nobelist Paul Krugman question the efficacy of these austerity measures as a way of restoring market confidence. Critics of austerity argue that when people lose their jobs, they stop buying goods and paying taxes, which lead to bigger deficits. This downward spiral often necessitates steeper cuts and additional bailouts.

3. The euro: Flawed by design

The lax enforcement of the EU’s budget rules points to the eurozone’s critical design flaw as it is presently conceived. The EU, unlike the United States, is not a federation. Eurozone countries share the euro and a common monetary policy, but each member state sets its own fiscal policy (i.e., decisions about tax collection and expenditure). Understood this way, it’s not surprising then that Greece’s sovereign debt crisis struck at the very heart of the eurozone: It exposed the structural weaknesses of a single monetary policy that must work in coordination with 17 separate fiscal policies.

While a growing number of European leaders, including German Chancellor Angela Merkel, have called for greater fiscal and political integration among member states as a way out of the crisis, some critics question whether there is enough popular support among the citizens of member states to form “an ever closer union.” The Financial Times’ Gideon Rachman observed that, “The fact that national loyalties are much stronger than any common European loyalty means leaders are constrained in the solutions they can feasibly consider.”

The mounting frustration with harsh austerity measures and high unemployment rates, highlighted by the ever-more frequent protests in cities across the continent, also point to the growing — and dangerous — chasm between economic governance and democratic principles in beleaguered eurozone countries like Greece and the EU as a whole. The outrage expressed by Merkozy at former Greek Prime Minister Papandreaou’s hasty proposal for a referendum on the October 26 bailout deal — which was just as hastily withdrawn — recently drew fire from critics for its political hypocrisy.

4. Contagion

Some may ask how a country the size of Greece (pop. 11 million) can pose such a formidable threat to the European and global economy. The answer is simple: a Greek default (once thought unlikely but now a very real possibility in light of recent political upheavals) would cause investors and speculators to lose confidence in other troubled eurozone countries like Ireland and Portugal.

But the elephant on the life raft is Italy. As the eurozone’s third largest economy (and the world’s eighth), the country is both too big to fail and too big to rescue with its $2.6 trillion debt. This week, even as Italy’s picaresque prime minister agreed to step down, interest rates on Italian bonds soared to unsustainable levels, thus making Italian debt prohibitively expensive to finance.

Many economists now fear that Italy will default unless it can reduce the cost of borrowing money by regaining investor confidence through the implementation of unpopular austerity measures. However, it remains unclear if Silvio Berlusconi’s successor will be able to muster the popular support needed to push through such programs quickly enough to satisfy the markets.

5. How this affects the U.S.

Put simply by Robert Reich, “A Greek (or Irish or Spanish or Italian or Portuguese) default would have roughly the same effect on our financial system as the implosion of Lehman Brothers in 2008. That is, financial chaos.”

The collapse of Lehman Brothers in September 2008 — and its harrowing aftermath — revealed just how interconnected the world’s financial system had become. Many believe that a European state default, and its ripple effects, would produce another “Lehman moment,” possibly on the order of several magnitudes.

What this means on a practical level is that the financial system would freeze up: banks would be less willing to lend to each other, and as a consequence, would be less willing to extend lines of credit to businesses and individual households.


  • Lucas

    The media and special interests outside the eurozone are exagerating this. Greece, is roughly 2% of the economy of the eurozone, and 1% of the EU. Many cities in the US have default their debt, (Harrisburg, PA; Vallejo, CA, now, but many during their history), and the dollar it’s not going to dissappear, even if this would happen at great scale. Also many countries have default in history, and everything is ok. You’re quoting Prof. Reich, he also said last year, the fear to the Euro is overblown.

  • Concerned Citizen

    A great synthesis of an important topic – a must-read for all Americans concerned about the health of our economy…as the financial meltdown showed, we’re all in it together. 

  • Anonymous

    In the U.S., rich states subsidize poor states. This type of “transfer union” does not exist in the eurozone yet. This type of fiscal integration would require major treaty changes, as well as the buy-in of taxpayers in wealthier European countries like Germany to subsidize their counterparts in less competitive Southern European countries. Many do not think there is enough support among taxpayers in richer countries for this change to happen anytime soon. In fact, this reluctance speaks to a larger question of whether a pan-European identity can ever successfully supplant national allegiance.

  • Williamnathanhale

    This is a sound assessment from the perspective of History and contemporary Economics. Kudos, kudos

  • Williamnathanhale

    Interpretations are by nature ‘subjective’.  Unfortunately the solution to this problem (or crisis) depends on Investors’ confidence.   Obviously trust has to be restored with the right kind of political leadership….  Where can it be found and who can provide it? wnh

  • Anonymous

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  • Bianca

    Germany has already subsidized the poorer countries by their higher GDP and stronger currency, bowing to the Euro and supporting the weaker currencies.  Once the DM was changed to the Euro, the prices were doubled in the German economy.  Vendors simply kept the prices higher in Euros, when they should have calculated per the going currency rate.  Only a few vendors practiced open policy by showing the DM-Euro conversion calculations.  Ask any German how they feel about the conversion to Euros.   

  • Wdougr

    It is in everyone of us, to participate with what ever you can imagine and put into action.

  • Wdougr

    As we are all in this together couldn’t we start taking action as one body of knowing what is the right thing to do and have our government representatives speak and act in our behalf instead of squabbling like selfish children with their own distortions and special interest pushing for the 1%.

  • François Paganel

    “Germany has already subsidized the poorer countries by their higher GDP
    and stronger currency, bowing to the Euro and supporting the weaker

    Which kind of “support” ? Can you be more specific? And why do you think the higher GDP of any country can help any other more than another one ?

    “Once the DM was changed to the Euro, the prices were
    doubled in the German economy”.

    Prices are what the customer is ready to pay. So do you suggest people had become temporarily richer, or thought so, with the arrival of the euro ?

  • Harrison Terran

    To counter the global economic “slowdown” our politicians need to address the issues with greater professionality. Perhaps they should engage the services of specialists
    in the economic crisis, as some counties already do in the USA, for example: by engaging the services of the Orlando Bisegna Index, they have resolved deficit problems and reduced unemployment. There’s no reason why a successful local/regional approach couldn’t then be applied on a national scale.