The Nature of the European Debt Crisis

For many years, my wife and I have been members of a small foreign policy discussion group, one of thousands across the country. The sponsor, the Foreign Policy Association, a non-partisan foundation established by Woodrow Wilson to promote discussion of foreign policy issues, provides a briefing book each year containing thoughtful analyses of hot current issues.  This year, its analysis of the European Debt Crisis, is the most lucid, and excellent, discussion of the topic I have yet encountered.  The author, Erik Jones, is director of the European Studies Program of the Johns Hopkins School of Advanced International Studies, and is located at Oxford; he is ideally situated to observe the European thrashings about, and it shows.  Jones is an economist, so his analysis suffers from one or two of the natural flaws of his profession, but it addresses the real point of the crisis as well as it can be stated.

Jones begins with a brief review of the evolution of the EU, important because it reveals, as I mentioned in a prior post, how the EU has evolved into a betwixt-and-between organization, too loosely related for a political union and too tightly tied for an economic interests only union.  The result is a union where the members, particularly the rich countries, pay lip service to common principles but ignore them in favor of their own national interests when convenient.  Yet they are tied by a common requirement to maintain stable values for the Euro.  Jones in passing points out that the common belief that the European crisis results from an overload of “welfare state” entitlements is a fiction, since the wealthiest economies in Europe provide more entitlements than the poor ones; German workers have more benefits than do the Greeks. The crisis stems from drastic changes in financial liquidity.

Europe maintained stable relationships with non-European economies under the Maastricht arrangement, but internally underwent an enormous flow of capital from northern Europe to the Mediterranean countries, often through under-the-table loan arrangements. This created huge opportunities for investments and public benefits in countries like Greece and Spain and Portugal; southern Europe was financing its growth with international capital, both from northern Europe and from America.   For a time, all Europe prospered, with productivity and GDP’s rising.  Jones points out that the Greek economy was slowly but steadily improving, and that the “cooked-books” accounting of the Greeks was what everyone, including international investors, knew that they were doing and had always done. But when the international finance crisis erupted in 2007, precipitated by Lehmann Brothers,  international investors experienced a crisis of confidence, precipitated by uncertainty about German-Greek financial relationships (that loose “union” arrangement), and pulled a flood of capital back out of southern Europe to “safer” places.  This starved southern Europe for the capital they had been running on and raised interbank lending rates so high in southern Europe that the collapse began.  National economies were overwhelmed by flows in liquidity.  Thus, in Jones’ analysis, the extremely high international flows of capital, dependent on maintaining investor confidence, were the cause of the crisis, not the actions of individual countries, who were doing what they had been doing all along. And that confidence was shattered by the uncertainties of the structure of the EU itself.

Jones is a gentleman, and thus does not mention the nature of those “international investors”; that is a limitation of his analysis.  Those investors are not retirees counting their dividends and worried about loss of income; they are major international banks and corporations and hedge funds.  They are huge; the 50^th ranking corporation on the Fortune 500 List has annual revenues about equal to the GDP of Sweden.  Any one of the larger banks or corporations by itself could shake the economy of a small country.  David Rothkopf, in Power, Inc., estimates that these days there are only about 15 national economies too large to be overwhelmed by the largest of the corporations.  The corporations are moving about, without regard to national boundaries or national interests, huge capital flows, which mostly consist of financial derivatives.  Rothkopf estimates that at any one time there are $14 in derivatives for each $1 in actual currencies worldwide.  Bloomberg News reported that the loans from Goldman-Sachs that got Greece in trouble were mostly based on one of the most complex of the derivatives.  As Warren Buffett noted, derivatives have become a “weapon of mass destruction.”

Domestic national economies cannot absorb these unregulated international flows of capital without repeats, in ever larger forms and farther places, of the European debt crisis. And the consequences are ever growing forms of human misery.  Unemployment in Greece recently was 25 percent and 27 percent in Spain.  The loss of public services from governments strapped by lack of liquidity makes the misery only worse.  The EU, as I’ve said before, needs to get its act together, “to form a more perfect union”, but that is only the start.  More and more, the private, unregulated investment decisions of corporate managers can shake nations.  International regulation and consequences are urgent.  One small step might be to require that sovereign debt be financed without use of derivatives.  Commonly regulated international financial institutions are needed. The G-7 must get involved.  Europe’s problems extend far beyond Europe; recent concerns from financial analysts have been expressed that many “third world” economies are running on capital inflows from Europe and America, and a drying up of those capital inflows could destroy the economies of nations around the world.  We can no longer ignore each other’s misfortunes.