By HAL S. SCOTT
Originally published by The New York Times Global Edition on August 15, 2012
Europe’s failure twice plunged the world into war. In today’s globalized economic world, Europe’s failure to resolve its financial crisis could plunge the world into economic chaos. This is a global crisis — not a euro-zone crisis — and we must take international action to deal with it.
One fundamental parallel with the two world wars is the tension between Germany and other European states. While successfully integrated into Europe, Germany remains the Continent’s most powerful economic force, with higher productivity and economic growth rates and lower inflation than the other major European countries, including France, Italy, Spain and Britain. In the periods leading up to the world wars, Germany’s neighbors rightly feared and deeply resented German military power. Today, they fear German economic power even while they plead with Germany to come to their aid.
Germany can only go so far in bailing out Europe. The cost of recapitalizing European banks (despite overly optimistic stress tests), including those in Germany, is estimated to be €420 billion under an adverse scenario, just for non-performing loans. The cost of marking down — let alone writing off — sovereign debt would be much greater. As of last November, 20 of the largest banks in the European Union carried $4.2 trillion in PIIGS (Portugal, Ireland, Italy, Greece, Spain) sovereign debt, about seven times the amount of their $620 billion in equity.
The amount of potential budget support for countries with unsustainable debt is also substantial, up to €1.4 trillion for 2012 and 2013, excluding any support for Greece. This does not count losses of the European Central Bank from its operations to bring down the yield on new sovereign debt issuance.
Bailing out Europe is beyond the practical capacity of Germany, whose G.D.P. is approximately €2.6 trillion, a level that is far from assured as Europe crumbles around it.
Just as importantly, Germany faces severe political constraints on rescuing Europe. The German government is fortunate that the pro-European Social Democrat opposition party has not attacked its economic support for Europe. But Chancellor Angela Merkel faces deep divisions within her own party, fueled by the constant negative drumbeat of the Bundesbank. If Germany does too much for Europe it could sink Merkel. If Germany does too little for Europe, it could cause deep resentment from those it refused to help.
Too big a reparation burden on Germany after World War I contributed to the rise of the Nazis; in contrast, after World War II, we used the international approach of the Marshall Plan to rebuild Europe. Instead of placing another impossible burden on Germany, we must again take international action.
Various solutions to Europe’s problems that do not depend entirely on Germany are being considered in Europe while the rest of the world gives counsel from the sidelines, but these proposed solutions are insufficient and uncertain. Debt can be restructured, as with Greece, but this makes future borrowing more expensive, negatively impacts bank capital and risks contagion. Moreover, this does not address the root cause of the crisis — uncompetitive economies and overspending. Banks can raise some additional capital, but not nearly enough. Austerity measures are politically difficult to sustain and, for those who believe in stimulus, counter-productive for economic growth.
The European Central Bank can finance countries unable to borrow at affordable rates but this raises the specter of inflation and increases the debt burden of the sovereigns they are financing.
The option of using exchange-rate adjustment, by abandoning the euro straightjacket of immutable fixed exchange rates, is beset by operational problems. The effective re-denomination of debt and temporary capital controls would require international approval.
More fundamentally, it is feared that even a partial euro-zone breakup could be the start of the end of the European Union, a major step backward from decades of integration.
What is needed is an international approach, led by the United States, China and Japan, channeled through the International Monetary Fund, and perhaps considered at an international conference — Bretton Woods II.
Such a conference would examine the need for revision of current international exchange-rate arrangements, focused on but not limited to the euro. It might require that all monetary unions with incomplete fiscal consolidation have a mechanism to adjust individual members’ exchange rates, like the Exchange Rate Mechanism, not the euro. It could discuss how to restrain the growth of unsustainable debt, perhaps increasing creditor rights and imposing limits on international market access and support from central banks. It could also address measures to stimulate the global economy.
Nothing can be done by the United States and China until the transition to newly chosen governments is complete, and time is needed for participants to formulate international solutions. Nonetheless, there should be a call today for a conference in 2013, with the reasonable hope that the European Central Bank can provide necessary liquidity in the interim.
Hal S. Scott is professor of international financial systems at Harvard Law School and the director of the Committee on Capital Markets Regulation.