Europe’s Financial Crisis Never Really Went Away
The European “crisis” is back. Actually, it never went away — and won’t for many years. The problems are so deep and pervasive that there is no easy or obvious solution. Government debt and deficits in many countries are not sustainable, but the usual remedies of cutting spending and raising taxes — a.k.a. “austerity” — may make matters worse by deepening already severe recessions. Europe is caught in a trap that promises more political and social unrest.
The wonder is that, for a few months, there was a sense of complacency. Interest rates on vulnerable debtor countries Spain and Italy declined. Fears about European banks eased. Some commentators said “the worst is over.”
Well, probably not. Interest rates are headed up again, while European stocks have taken a pounding.
The momentary optimism reflected an unprecedented move by the European Central Bank (ECB) — Europe’s Federal Reserve — to make low-interest loans of 1 percent available to strapped banks for three years. In late December, more than 500 banks borrowed 489 billion euros (about $635 billion); and in February, 800 banks borrowed 530 billion euros ($690 billion).
The ECB “dumped tons of cash onto the banks,” says economist Jay Shambaugh of Georgetown University. As he notes, this had two beneficial effects. First, it relieved fears that some banks wouldn’t be able to repay maturing loans. Second, it helped reduce interest rates on government bonds because banks used the new cash to buy bonds. (Bond rates move in the opposite direction of prices; if bond prices rise — because investor demand increases — then interest rates fall.) For the banks, this seemed to present a huge profit opportunity: borrow at 1 percent; buy bonds yielding 5 percent or more.
But all this, though reassuring, barely affected debtor countries’ underlying problems.
Spain is the latest focus of concern. On March 2, Prime Minister Mariano Rajoy announced that the country would miss its 2012 budget deficit target of 4.4 percent of the economy (gross domestic product) and wanted to raise that to 5.8 percent of GDP. After complaints from other European leaders, the target was set at 5.3 percent of GDP. But this required more austerity in an economy in deep recession