Europe is currently facing the deepest challenge to its political system since the end of the Cold War and the economic integration of much of the continent. The fundamental foundations of many European welfare states are cracking as one nation after another stumbles over their inability to deliver on generous promises made by past generations. Public debt threatens to collapse these states which has hobbled their own economies all while surrendering their monetary freedom by adhering to the common Eurozone currency.
Debt is the driving agent of this entire crisis. In order for each Eurozone state to finance its public debt, they must sell bonds on the open market and investors buy these bonds for a rate of return in the form of a fixed interest yield. If investors lose faith that a certain nation will be able to repay the principal on its bonds, they will demand a higher interest yield as a hedge against the risk of default.
For example, when Greece reaches a certain level of governmental debt to gross national product, investors lose faith in the soundness of that debt, then panic and sell their bonds, thus flooding the market and dropping the price of those bonds while forcing the Greek government to pay ever-higher interest rates to attract debt purchasers. At a certain point the country in question cannot borrow at such prohibitive interest rates, and debt-reliant daily government operations shut down.
This country is now bankrupt, and has three options: default on its previous debt obligations, print and inflate their currency to pay off the debt, or a combination of the two. However, Eurozone countries surrendered control over their currency with the adoption of the Euro and hence are unable to inflate their way out of the crisis, while defaulting on debt would lead to their expulsion from the European Union (EU).
Many Eurozone countries have reached this impasse over the last few years but were rescued by governmental bailouts by the so-called troika of the EU, European Central Bank and International Monetary Fund. These institutions finance these bankrupt nations by purchasing their government bonds at below-market rates, in effect bailing out their recipients’ governmental profligacy. Through the taxpayer-financed European Financial Stabilization Mechanism, healthy (healthier?) European economic powerhouses such as Germany are transferring their citizens’ tax dollars to irresponsible and bankrupt Mediterranean nations.
These broke countries can be summarized by the helpful acronym of C-PIIGS; Cyprus, Portugal, Italy, Ireland, Greece and Spain. Greek bondholders suffered a 75 percent default loss on their bonds, while the Greek government received a €110 billion ($146 billion) bailout in May of 2010, with another €130 billion ($172 billion) in February 2012 in return for a regimen of so-called austerity.
Greece’s shrinking economy, around the size of Maryland, is still nowhere on track for fiscal independence and will likely need more bailouts before eventually dropping out of the Eurozone altogether.
Meanwhile Cyprus demands a bailout of €10 billion ($13 billion), half of its annual economic output, while the Spanish financial sector is begging for a banking bailout between €70-80 billion ($91 to $104 billion), and the Spanish government will also likely soon need additional hundreds of billions in emergency financing. Ireland and Portugal have also received billions in bailout funds, while Italy is next in the queue for crisis.
The whole time, the Eurozone is officially in recession, and many of the crisis’s worst affected nations are in the deepest slump; caught in a bleak feedback loop of increasing debt, shrinking economies, and vanishing tax revenues.
In an act of dire desperation, this summer European Central Bank Chief Mario Draghi swore to “do whatever it takes” to preserve the Eurozone, in effect promising to fire up the Euro printing presses in order to create the money needed to buy the sinking bonds of profligate nations. With unlimited future help promised, investors calmed, bond yields relented, and pressure for Spanish fiscal reform abated. However, words will not quench this crisis for long.
Thus through not only more taxes, but also monetary devaluation and inflation will the tight-fisted Germans, Finns and Dutch be paying for the free-spending ways of their Mediterranean neighbors.
The underlying fundamental reason for this sovereign debt crisis is the long-term fiscal unsustainability of many welfare states which are out of synch with their respective national output and levels of production. If left unchecked, government obligations usually grow faster than the tax base’s ability to support them, which inevitably leads to a debt crisis as creditors refuse to finance the debt of a sinking fiscal ship. Taxes are also no panacea, since Europe has some of the highest on earth, but still convulses with financial meltdown.
Europe’s lesson for us is simple: The electorate must choose fiscally sound and monetarily sober representatives who use prudence and caution before embarking on governmental spending sprees.
Keep this in mind for November.