From the April 2012 issue of Research Magazine • Subscribe!

European Stagnation

The euro zone is failing to come to grips with its crisis.

When the financial system faces a major bankruptcy, one that is large enough to threaten its health, it often makes sense to buy time. Regulators, central bankers, multilateral lenders and governments, which are left to deal with the situation when the private sector messes up, usually throw a lifeline to the near-bankrupt borrower, allowing creditors to recapitalize, put aside reserves and prepare to absorb the eventual losses. 

This makes any bankruptcy more costly. Buying time entails throwing more good money after bad, and in the end losses will be larger, sometimes substantially. But they will also be spread over time and shared by the private and public sector. The regulators will not have to step in to rescue the wobbly financial system, which they would have to do if a bankruptcy, like that of Lehman Brothers in September 2008, occurs without adequate preparation. 

When it is a company or a financial institution that is threatened with bankruptcy, the bad debt resolution is fairly straightforward. Corporate entities can be liquidated, even if, as in the case of Lehman, the process takes some three years. Remaining corporate assets can be sold off to satisfy creditors and the debt is eventually wiped out or written off. That was also what happened with collateralized debt obligations, which were at the heart of the 2008 financial crisis.

Sovereign nations are different from companies. Countries don’t go away and can’t be liquidated. They don’t run out of money because they can usually print more. Nor do creditors have recourse to the bulk of national assets, to seize and auction off. Nations continue to carry their debts no matter what. Delaying an inevitable sovereign bankruptcy may better prepare creditors, but the longer the delay, the greater the debt burden requiring resolution.

The debt crisis in Latin America showed that debt forgiveness and debt restructuring do not work, and the only way for sovereign nations to get rid of their debt problem is to grow out of it. Until growth picked up, Latin borrowers kept running into trouble. In the 1970s, they loaded up on syndicated loans; then in the 1980s they borrowed by issuing government bonds. The vicious cycle of debt restructuring went on and on.

Growth Solution

Only when Mexico effected major economic reforms in the 1990s and began posting strong growth did its debt burden melt away. Brazil began generating economic growth early in this century, with similar results. Today, these former basket cases enjoy higher debt ratings and are able to borrow much cheaper than some of the so-called core euro-zone nations.

Argentina, on the other hand, failed to grow in the late 1990s and slid into crisis in 2001. Stiffing bondholders in the subsequent debt restructuring didn’t really solve its debt problem and, unless that country achieves more solid economic performance, it will face another bankruptcy or debt restructuring very soon.

In Latin America, the situation could drag on for more than two decades because individual governments had monetary tools at their disposal to postpone drastic measures. Brazil, Mexico and Argentina kept printing money, introducing new currencies and destroying their value almost as soon as they entered into circulation, and eliminating private savings by means of hyperinflation.

The euro zone’s situation is different. The Greek government can’t print euros, can’t devalue and can’t unleash an inflationary spiral because it is locked into the euro strait jacket. This circumstance should have actually worked into Greece’s favor, preventing Latin America-style drift, but policy mistakes in Brussels, Frankfurt and Berlin actually turned this advantage into a disaster.

The euro zone crisis began two years ago and it was evident from the outset that buying time would do nothing. With government bond yields for peripheral euro zone countries — the so-called PIGS (Portugal, Italy, Greece and Spain), as well as Ireland — rocketing, delay in resolving the crisis only meant that their overall debt burden continued to escalate. Germany and France, the European Union’s leading nations, behaved like the dog owner in an old joke, who liked his boxer puppy and didn’t want to cut his tail, so clipped it just an inch at a time.

Even as fiscal austerity and lack of investor confidence pushed highly indebted economies into a severe recession, the interest rates they had to pay on their debt were averaging 5-6%. Even in mid-February, after markets calmed down, Portugal faced rates of around 12%, and Greece 33%.

Now, two years have been lost and a debt spiral has set in. The more tax revenues governments seek, the greater the burden that shrinking economic activity puts on their budgets. Even more alarming, the debt spiral affects not just Greece or Portugal, but also Germany and France, which are dictating austerity measures that effectively bankrupt Greece.

The Greek economy shrank by 7% in the fourth quarter, but that’s no longer the euro zone’s biggest problem. By end-2011, Germany’s industrial production was flat, and its economy contracted quarter on quarter in the October-December period. The French economy expanded during the same time period, but marginally so. Yet, Germany’s debt measures 80% of its GDP, while France’s debt is closer to 90%, both well above the 60% mark generally considered prudent. German long bond yields are extremely low, at around 1.9% as of mid-February, but with a shrinking economy it’s still a dangerous situation. France is paying over 3%, which is twice the pace of its economic growth.

Stalling Innovation

The E.U. can resolve its looming regionwide debt crisis only by growing out of it. This is why 2011 data from Dow Jones VentureSource make such alarming reading. Venture capital investment in Europe was down 14% last year, to the lowest level since 2000, when data collection began. Deal flows shrank by 19%. Traditional favorites of venture capital investors in Europe, which besides Germany include non-euro U.K. and Sweden, suffered sharp declines in funds inflows.

Venture capital flows indicate innovation and technological sophistication, which Europe needs to compete internationally and grow at a pace that could at least in theory reduce debt burdens across the euro zone. At present, however, not only is the region entering a recession, but its flagship companies are faltering. PSA Peugeot Citroën, the blue chip French automaker, saw its profits nearly halved in 2011, largely due to a sharp deterioration of the European automotive market in the final months of the year. Its debt tripled over the past year and the company announced that it will scale down its crucial expansion plans in India.

Equally indicative is the fate of Nokia, the Finnish company which is still the world’s largest producer of cellular handsets; its market position has been severely undermined in recent years by the success of more technologically sophisticated North American phone manufacturers.

Such bleak trends have emerged clearly in 2011 corporate reporting season. German engineering companies retain some cachet and can benefit from the rise of the newly wealthy in Asia, Latin America, Eastern Europe and elsewhere. But their European markets — including Greece, Italy and Spain, which used to borrow heavily to buy German cars — look set to remain dead in the water. Europe’s crisis will likely undermine these companies’ ability to innovate and hence charge a premium on their products in a highly competitive global environment.

Alexei Bayer is an economist and author based in New York City.

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