Today Europe is living through a difficult time. Germany’s finance minister, Wolfgang Schäuble, has called the recent elections for the European Parliament “a disaster,” going on to conclude that “all of us in Europe have to ask ourselves what we can do better…we have to improve Europe.” But what is happening in many parts of Europe today is not just a pathology; it is the predictable pathology that ensues whenever a country’s citizens suffer a protracted stagnation in their incomes and living standards.
The origins of this stagnation in large parts of Europe are broadly understood. Six years ago, Europe was caught in the backwash of the financial crisis created in the American mortgage market and the US banking system more generally. Problems that were already serious in one European country or another—fiscal imbalance, or eroded competitiveness, or an American-style construction boom, or a badly run banking system—made some parts of Europe especially vulnerable. The effects of the American recession exacerbated those problems wherever they existed. Then, in the familiar way, both monetary and fiscal policies in Europe did much to maintain stagnation. But a large part of the story is a failure to deal with the sovereign debt crisis that Europe has also now been confronting for more than half a decade, ever since it became clear that the governments of some European countries had borrowed money they could not repay.
The eurozone, consisting of eighteen European countries that use the euro as their currency, constitutes a remarkable experiment in this regard. The fact that it is a monetary union without a fiscal union behind it is entirely familiar. But a little-discussed implication of this anomaly is that the economy of the eurozone has no government debt. By “government debt” I mean obligations issued by a public entity empowered to print the currency in which the obligations are payable. All the other major economies we know—the US, the UK, Japan, Sweden, Switzerland, and many others—have government debt in this sense.
In the eurozone, by contrast, public sector debt is entirely what Americans call “municipal debt”—that is, obligations issued by public entities, in this case countries, that are not authorized to print the currency owed. It is this feature that makes the bonds issued by Massachusetts or New York or Texas subject to default in a way that US government debt is not. The bonds of all eurozone states, even those currently regarded as most secure, like Germany, are issued in euros and likewise subject to default in the same sense. It would be difficult to exaggerate how unusual an experiment this situation represents. I am unable to think of another modern example of a major economy with no government debt to anchor its financial structure.
A further unusual aspect of Europe’s situation in this regard is that what amounts to municipal debt issued by the countries with the weakest fiscal structures is, increasingly, owed not to market investors generally but to official lenders, including the European Central Bank, the International Monetary Fund, and the two special facilities set up collectively by the European governments to buy the troubled bonds. This ownership matters because, unlike private market investors, official lenders in principle do not accept defaults. For a country not to pay what it owes private investors is bad enough; but not to pay other governments or especially the IMF is simply unacceptable.
To a certain extent, of course, this is a fiction. But widely maintained fictions often guide actions, especially in public decision-making, and sometimes they do so with highly unfortunate consequences. This particular fiction also strengthens the commonplace European presumption—which strikes many Americans as bizarre—that sovereign default by a eurozone member state would necessarily cause the country’s exit from the currency union.
From time to time in America’s history, US states have defaulted on their general obligation bonds, and it may happen again. In the recent financial crisis, the two states whose bonds the market deemed most subject to this risk were Illinois (because of unfunded pension obligations) and California (because of the state’s overall budget imbalance at the time). It would not have occurred to an American that if, say, Illinois defaulted on its bonds it would, on that account, have to exit the dollar currency union. But this principle seems to be the working assumption in much of the current European discussion of the troubled countries’ debt.
The route by which Europe arrived at this situation is well known. The governments of fiscally strong countries, such as Germany and France, lent, or perhaps gave, funds to the governments of fiscally weak countries, such as Greece and Portugal, allowing them to service their existing debt and to issue new debt. (Since then, France’s economy and fiscal position have weakened, and the country’s support for the kind of policy discussed here has created turmoil in French politics—leaving Germany as the only large country still wholeheartedly favoring fiscal austerity today.) This process also allowed the governments of the fiscally strong countries in effect to bail out their own lending institutions—which were holding the weak countries’ bonds—without acknowledging doing so, thereby maintaining another fiction that may or may not be useful.
The fiscally strong countries provided these transfers and new credits mostly in exchange for undertakings by the weak countries aimed in principle at making them better able to manage their debt. Those commitments included, first, the imposition of fiscal policies heavily involving reductions in government spending, and second, “structural reforms” of the economy such as freer labor markets and new systems for limiting wages and pensions. But the problem with such spending cuts is that they depress economic activity (and tax revenues along with it). The problem with structural reforms is not just that they are politically difficult to carry out, but that even when implemented they take a long time to lead to economic expansion. Moreover, even then they are often expansionary in ways that mostly benefit employers at the expense of employees, and therefore exacerbate already unwelcome trends in income distribution.
This approach to Europe’s debt crisis, and even more so the underlying attitudes it reflects, are counterintuitive in yet another way. The standard presumption in economics, based on the conception of “commerce” articulated by David Hume and Adam Smith and their contemporaries, is that market transactions involve two parties, each of whom acts voluntarily and with adequate information to make a choice. In the case of credit transactions, this means presuming that both borrowers and lenders acted voluntarily. Among borrowers there are familiar exceptions, such as the inherited debt of deceased parents or the “odious debt” issued by a country’s prior regime, and for just this reason they are usually treated differently.
Similarly, there is a stronger case for the presumption that institutional lenders such as banks and insurance companies—as distinguished from individuals—act voluntarily, and with objective information. This difference in information and expertise provides a standard rationale (along with risk diversification) for the role of such “intermediaries” to stand between the individual savers who provide funds in the financial markets and the businesses and other borrowers who use those funds.
By contrast, today’s public discussion surrounding the European sovereign debt crisis mostly presumes that when a bond is in trouble, the lenders—especially institutional lenders—are victims. In parallel, there is an almost religious presumption of guilt on the part of the borrowers.
From a historical perspective there probably is something religious about these presumptions. Although Jews, Christians, and Muslims all long regarded lending with suspicion (and most Muslims still do), by the beginning of the nineteenth century evangelical Protestants had mostly come to regard borrowing as sinful, even when the debt was serviced and repaid on a timely basis. Nonpayment, of course, elevated the negative moral connotation to an entirely different plane. As the nineteenth century moved on, in one European country after another—and in America too—the active frontier of this debate was often the movement to introduce limited liability for what we now think of as corporate borrowers and investors in equities. (If a company fails to pay its debts, its shareholders ordinarily have no obligation beyond their initial investment.) Limited liability represented a retreat from what historians often refer to as “the retributive philosophy” of evangelicalism, according to which sinners must be punished.
By midcentury public attitudes had begun to change, however, driven in large part by the new awareness of the possibilities for ongoing economic growth and waning ambivalence toward it. Even so, religiously motivated opposition to borrowing persisted, especially borrowing by national governments. As the historian Henry Roseveare described this opposition in the UK:
An ethic transmuted into a cult, this ideal of economical and therefore virtuous government passed from the hands of prigs like Pitt into those of high priests like Gladstone. It became a religion of financial orthodoxy whose Trinity was Free Trade, Balanced Budgets and the Gold Standard, whose Original Sin was the National Debt. It seems no accident that “Conversion” and “Redemption” should be the operations most closely associated with the Debt’s reduction.
Today a reversion to the “retributive philosophy” of the nineteenth century—to the view, in the words of another historian of that day, that “a just economy was more to be sought after than an expanding one”—is clearly in evidence in Europe’s approach to its sovereign debt crisis. Whether Europe’s economy has thereby achieved justice is a matter open to discussion. It has clearly forgone expansion.
The consequence is ongoing stagnation of incomes and living standards for the majority of the population in a number of European countries. The median household income in the UK, adjusted for what little inflation there has been, peaked in 2007 and has yet to regain that level. France, Italy, and the Netherlands have not experienced complete stagnation by this measure, but the real median income in each has only minimally increased. Ireland, Greece, and Portugal have all experienced stagnation, or worse, in real median income over this period. Spain did too for a half-decade, only last year finally enjoying a solid increase.
A parallel stagnation of incomes has taken place in the United States as well, but America’s federal fiscal structure provides built-in ways of alleviating the consequences that Europe lacks. When citizens in one state lose their jobs and otherwise suffer reduced incomes, they pay less in taxes to the federal government while the federal government helps pay their unemployment benefits and, if necessary, welfare support. And for the retired elderly, both Medicare and Social Security retirement benefits come from the federal government. The European Union has no such arrangements.
Further, in Europe’s fiscally weak countries the usual frustration over stagnant incomes and living standards is today compounded by the sense of being dictated to, perhaps even exploited, by foreigners. Twenty-five centuries or so ago, if another city-state had conquered the Athenians, the then-conventional tribute would have required some hundreds of Athens’s finest youth to trek off to the victors’ lands, to do forced labor, and an equal number of Athens’s fairest virgins to travel along as well, for purposes best left unspecified. Today’s political conventions are sharply different, but the resulting flows of young people seeking work are similar.
And as Wolfgang Schäuble has emphasized, the all-too-familiar consequence of this economic stagnation is a turn away from (small-L) liberal values, based on tolerance and commitment to an open, democratic society, toward xenophobic populism on either the right or the left. The same pathology has emerged before, again and again, in one country after another around the world. Europe today increasingly looks to be on the verge of repeating some of the worst elements of the experience of the years between the two world wars, with not only the rise of extremist political movements in many countries but also cross-border communication among them.
There are differences, to be sure. In the 1930s the central point of that communication was the rising Nazi movement and then government in Germany, while today it looks as if the facilitating vehicle will instead be the European Parliament, as more and more members of extremist anti-European parties are elected to it. But the effects are similar, and so are parts of these groups’ programs, today including the campaign to roll back both immigration within the EU and the EU’s regulatory authority, not to mention the attack on the entire European Union project.
What can Europe do? The European Central Bank’s monetary policy is already expansionary, sending interest rates to record lows as in the United States, and depressing the exchange rate of the euro. More recently, the ECB has pushed the boundaries of expansionary policy in more innovative ways, imposing a negative interest rate on European banks’ holdings of reserves (in other words, charging banks when they keep funds idle), and buying loans from banks in order to enable them to increase their new lending. By now, there is little further that monetary policy can do. Europe as such has no fiscal policy, and most of the individual European countries are committed to contractionary tax and spending policies.
The urgent need today, therefore, is for debt restructuring and relief for the fiscally weak European countries. Debt restructuring means that the fiscally weak countries would be allowed to pay interest on their obligations at a lower rate, or stretch out the payments over a longer time. Debt relief means that they would be required to pay only part of what they owe. Both would help. (In a similar way, in the United States today there is still a need for relief for underwater homeowners, whom the bailout of US lenders a half-decade ago largely neglected. But the need in Europe is more acute.)
Again looking back to the interwar period, there is ample precedent, within Europe, for both debt restructuring and debt relief. The reparations due from Germany under the 1919 Versailles Treaty were quickly transformed into Germany’s obligation to service two series of bonds, scaled to reflect the recovering country’s ability to pay. In the end neither series of bonds was ever fully paid. Initially, Germany’s Weimar government paid what was due to foreign bond holders at the same time as German states and local governments were borrowing from abroad, so that the net result of the international flows mostly evened out (although within Germany there was a substantial shifting of burdens). The 1924 Dawes Plan and then the 1929 Young Plan further reduced what Germany owed, and each arranged for yet a new foreign loan.
The Lausanne Conference in 1932 ended all German reparations payments, in exchange for which Germany deposited with the recently established Bank for International Settlements bonds representing a small fraction of what was originally due; the deposited bonds were never sold to investors or otherwise allowed to go into effect, and some years later the BIS burned them.
By then Germany had acquired other foreign debts, however. The Nazi government initially serviced these obligations but blocked the conversion into foreign currency of the Reichsmarks with which it made the payments. It then began making payment half in Reichsmarks and half in nonconvertible scrip issued by the German central bank. After a series of further steps, in 1934 Germany defaulted on both the Dawes and the Young loans.
After the war, the London Debt Conference in 1953 took up the matter of Germany’s unfulfilled commitments, including government debt, state and local debt, and even private debt. The London agreement reduced the amount due by at least half (most likely more, depending on the calculation) and rescheduled the remainder so that no payments of principal were due for five years and the rest were strung out over thirty years. A significant part of the debt was further deferred, with no interest due along the way, until such time as the reunification of Germany might occur—which turned out to be nearly four decades later. The United States also converted most of the loans that had been extended under both the Marshall Plan and the US program for Government and Relief in Occupied Areas into grants.
As one historian of this process, Timothy Guinnane, summarized the approach taken to Germany’s postwar debt relief:
At the time of the London conference most observers had in mind long years of what they viewed as Germany’s irresponsible treatment of foreign debts and property owned by foreigners.
the entire agreement was crafted on the premise that Germany’s actual payments could not be so high as to endanger the short-term welfare of her people…. Reducing German consumption was not an acceptable way to ensure repayment of the debts.
The contrast to both the spirit and the implementation of the approach taken to today’s overly indebted European countries is stark.
There is no economic ground for Germany to be the only European country in modern times to be granted large-scale debt restructuring and debt relief, and certainly no moral ground either. The supposed ability of today’s most heavily indebted European countries to reduce their obligations over time, by such measures as shrinking their expenditures and restructuring their economies, is yet another fiction—and in this case not a useful one.
As the last decade’s financial crisis fades into the past, and market interest rates—in Europe kept low by the European Central Bank—move up to more normal levels, these countries and others too will find their debt increasingly difficult to service. In the meanwhile, the contractionary policies they have been forced to adopt are depressing their output and employment. And the predictable pathology following from stagnant incomes and living standards is already evident.
The Nobel Prize–winning American economist James Tobin often remarked that there are worse things than 3 percent inflation, and from time to time we have them. Indeed, we just did: in much of the economically advanced world, including the US and most countries in Europe, the loss of output and employment and the forgone profits and incomes and investment triggered by the financial crisis of the past decade have exceeded any experience since World War II.
In the same vein, there are worse things than sovereign debt defaults, and from time to time we have them too, today in the form of stagnant economies and xenophobic extremism. Europe’s own history offers strong precedents for dealing with such debt in ways that will encourage economic growth, as opposed to continuing to foster the popular resentment that follows from living under conditions offering little visible hope for a more prosperous future. Let us hope the Europeans remember their history.*
This article draws on my keynote address at the Bank for Interna- tional Settlements conference on “Debt” in Lucerne, June 26, 2014. I am grateful to Timothy Guinnane, John Olcay, and Peter Temin for helpful conversations. ↩