Today, the US situation has, to an extent, stabilized. On Wall Street, for the movers and shakers at least, it is business almost-as-usual. However, Europe is in turmoil. Plagued by sovereign debt and bank instability, the continent lurches from crisis to crisis.
Three leaders have toppled, France was stripped of its coveted AAA credit rating as part of a nine-country downgrade by Standard & Poor’s and the future of the euro itself has been thrown into question.
Franklin Allen, professor of finance at The Wharton School at the University of Pennsylvania and a leading expert on the causes of financial crises, says that basic mistakes were made in the eurozone project, such as allowing both Italy and Greece to join despite neither satisfying the entry criteria. However, he argues, it is not the mistakes as such, but rather fundamental design flaws that are undermining confidence in the 17-nation fiscal union.
Foremost among these flaws, as Allen observed in 2008, is that no European institution can respond in a timely manner to systemic threats. In comparison, when Bear Stearns wobbled in March 2008, the US Federal Reserve stepped in and, over an intense weekend, pushed through a solution that saw JP Morgan Chase take over the stricken trading house. “I think this is a large part of the problem,” says Allen during a recent interview in his book-lined office at the University’s prestigious Steinberg Hall. “The European Central Bank (ECB) could step in, but this is controversial because it’s not their role and there would be a huge political cost to pay.”
But Allen argues that decisive action is necessary when situations deteriorate, as was the case last November, for example, when the yields on Italian government bonds spiked to 7.5%. “One way of solving Europe’s problems is to allow the ECB to do what the US Federal Reserve has already done. The Fed printed $2 trillion, and if the ECB printed €2 trillion, Europe might just get through the problem,” suggests Allen.
But while the Fed’s actions have been a windfall for bankers, they have not solved the problems of the United States. “That’s true,” he acknowledges, leaning back in the chair and pausing. “But for the US much less is at stake. The United States is not going to break up; rather it’s always been a question of just how bad the situation would become. But for the EU, it’s a different issue. We are in a situation where things can get out of hand by accident. Italy came close to falling off the cliff and being unable to raise money. Each time it’s getting more serious, and Italy was very scary.”
SO IS THE EUROPEAN DREAM OF A MONETARY UNION DOOMED?
Allen does not believe so. “I think there’s a good chance it will survive as the principle of solidarity is strong in Europe,” he says. “But I wouldn’t be surprised to see the eurozone reduced to a northern region consisting of Austria, Finland, Germany and the Benelux countries. I think Greece will go out and it is possible Italy and Portugal may do as well.”
While the euro is far from a “zombie currency” (dead, but just not knowing it), its difficulties raise a fundamental question: Was the idea of a pan- European currency a mistake? “No, I think the euro is a good idea,” answers Allen emphatically. “Politically, though, Europe is still 20 to 30 years from where it needs to be to do it. It needed time for the countries to come closer together in terms of the effectiveness of their institutions. The crisis has really shown there is not enough fiscal discipline and that the institutions aren’t able to cope with peripheral nations.”
WHAT OF THAT VALUABLE COMMODITY, TRUST?
Surveys show there has been a decided and steady decline in the public’s trust in the European Union and its main institutions since 2009 (Eurobarometer 75, Spring 2011). “That is hardly surprising,” Allen comments. “The whole fiasco with stress-testing is a good example.”
To recap, stress tests conducted by the European Banking Authority in 2010 gave the Irish banks a pass. Three months later, the Irish government was forced to nationalize Allied Irish Bank, the country’s second-biggest bank, while the publicly owned Anglo Irish Bank, the country’s largest, needed a massive €7 billion ($8.9 billion) injection to stay afloat. The government itself then turned to the EU and IMF for rescue.
Further testing in July 2011 failed eight of 91 European banks and noted 16 were borderline. Dexia, the Franco-Belgian bank, was not one of these. Barely three months later, the bank was in deep trouble and unable to raise the cash it needed to stay afloat, largely because the market was concerned about its €3.4 billion ($4.3 billion) exposure to Greece. “Initially, they failed to stress-test sovereign debt. In 2011, they did this, but didn’t test the macro scenario. They cannot simply stand up and tell the truth. So, there is little wonder that there’s a huge lack of trust in European institutions.
At the moment, say critics, Europe is on a trajectory that does not bode well. “If they fail to address fundamental issues threatening the euro, if they fail to recreate trust in the European institutions, then they face a disorderly break-up of the single currency,” Allen concludes. “Nobody knows what the consequences will be, other than that the outcome could be very ugly.”