Euro Zone Fears Still High Despite Recent Debt Plan

European Commission President Jose Manuel Barroso announced Thursday that Europe is closer to solving the euro zone crises after an agreement has been reached in Brussels. On the other hand, numerous economists, including New York Times columnist Paul Krugman, are still skeptical about how effective such an agreement might be. In Krugman’s words, “The bitter truth is that it’s looking more and more as if the euro system is doomed. And the even more bitter truth is that given the way that system has been performing, Europe might be better off if it collapses sooner rather than later.”

Today, the main threat is not necessarily Greece, but the failure of the economies of Italy and Spain. Italy is the third largest economy of the euro zone, and any run on its banks spells disaster for the rest of the European economies. Given that the reaction to the Greek crisis was weak and relatively late, one can imagine what a broader crisis means. France is already struggling with its debt and it is almost impossible for it to bail out its southern neighbors. Germany has been reluctant since the beginning of the crisis to provide help to the failing economies.

But the bailouts that Germany is required to fund are the price that it has to pay in order to save the euro. This comes despite the unpopularity of these bailouts with German voters and the well-founded fears concerning the situation of some of the essentially broken European economies. Even more ironically, European leaders called upon the U.S. and China to support the crisis deal.

Of course, one should not forget the exceedingly productive role that the UK might play, which consists of looking half-suspiciously and half-mockingly upon what the rest of Europe is doing.

The main ailment of the EU is the existence of a monetary union without a fiscal one. When the euro was created, investors and policymakers wrongly believed that the Greek debt will be as safe as the German debt. This led to a boom in lending to Europe’s peripheral economies. But when the crisis started in the U.S. and spread towards the EU, the lending frenzy stopped, economic activity and tax revenues declined, debt spiraled, and the confidence fairy deserted this part of the world.

The solution to this problem would have been easy and straightforward if Europe were a fiscal union. In this case, states with a budgetary surplus would fund those with a deficit. However, two obstacles stand in the way of such a union. First, Europe is not a single country and it does not have the coherence of, say, America and the states which compose the U.S. union. Secondly, countries like Greece have been fiscally profligate even in the good days. Although some countries with limited debt such as Spain and countries with high debt but limited deficits such as Italy might emerge from the crisis, Greece will still pose a threat to the rest of Europe.

So far, the response of the European Commission was to impose fiscal austerity on its member states while providing bailouts to debtor countries until the private sector starts lending again. However, too much austerity might have undesirable effects. If public sector spending is being slashed in debtor countries (e.g. Greece) and the private sector is not lending, then how are jobs and growth supposed to be created? The answer would be through exports to creditor countries (e.g. Germany, France, etc.) as Krugman notes. But if these creditor countries are also imposing austerity and consumers are unwilling to buy these exports, then Europe as a whole will be driven back into recession. Of course, public spending as opposed to austerity also has limits defined by how much debt a country can accumulate without suffering from a loss of confidence.

After the extensive talks in Brussels, European leaders agreed to the following: Banks holding Greek debt would accept a 50% loss, a mechanism to boost the euro zone's main bailout fund to about 1 trillion euros ($1.4tn), and banks must also raise more capital to protect them against losses resulting from any future government defaults.

Now, let’s wait and see if the confidence gods and fairies will smile upon Europe.

Photo Credit: Wikimedia Commons