A 3-D tour of Europe

Oh, those naughty Europeans and their complicated alliances. Sounds like 1911, doesn’t it? Today’s alliance, of course, is the eurozone—the band of once-plucky nations that gave up sovereignty over their currencies in exchange for a higher-growth future. It worked for awhile, until certain unpleasant fiscal realities got pointed out in public. It was never a secret, but we all pretended not to notice that countries that had no fiscal business being members of a currency union were let in anyway.

Well, the markets won’t pretend any more that the debt of Ireland, Portugal, Italy, Spain and Greece is just as good as the debt of Germany, France or other eurozone members. In fact, the markets have basically refused to buy any more of the stuff. Something has to give, because these countries’ governments rely heavily on borrowing to pay their bills. And the exact path of change is still very much up in the air, so I thought it would be nice to give you a quick tour of the possibilities. I call this a 3-D tour of Europe, since the main choices all begin with “D.”

The first possible path is deflation. This is actually what the rest of the eurozone has been urging on the economies of Greece, Spain, Italy, Portugal and Ireland, mostly in the form of drastic cuts in government spending. These countries heavily rely on government spending for employment and economic activity, so this is basically a recipe for severe deflation. Aggregate demand would fall sharply, causing a massive recession in most of these nations.

The response to date has been pretty predictable—rioting in the streets, followed by as much government backsliding as possible. In Greece, they’re rioting like the warm-up for a G-20 summit, and in Italy, Silvio Berlusconi sneaks seven or eight billion euro back into the budget every time the IMF monitor runs out for an iced latte. So it’s highly unlikely that any of these countries will be able to follow through on the breathtaking amount of budget-cutting that they’ve been asked to do.

The next path is default. This entire crisis was caused by the bond market suddenly waking up in early 2009 and saying, “Holy flaming cheese! There’s no way that the Greeks are ever gonna make good on all their IOUs!” And since it looks like these countries won’t be able to cut enough of their other spending to pay their bonds, defaulting on them is looking more and more likely.

The problem with default, though, is that big banks in the relatively healthy parts of the eurozone loaded up on these bonds because of the juicy interest rates they offered. French banks in particular look vulnerable to defaults—Greek government debt must be “le Big Mac” of the bond world. Defaults on Greek, Italian and other government bonds would lead to big losses at some of Europe’s largest banks, which could trigger runs on them, in which everyone who loaned money to the banks demands to be paid back at once.

In addition to dragging the banks down, a default would also be a direct hit to European governments. They, along with the IMF, have already sunk billions of euros into multiple rounds of bailouts for these countries. So the governments could sustain a double whammy from default—not only would they be out the cash that they loaned, they’d also have to dump billions more euros into rescuing their own banks. So default doesn’t seem as likely as many think it is.

That leaves the final “D”—devaluation. Countries like Greece, Spain and Italy could always go back to what they did in the past in this situation: intentionally weakening their currencies. This makes their goods cheaper on world markets, which boosts exports, and it also makes paying back those bonds a breeze (as long as the printers deliver the new sacks of currency on time). The only small hitch to this plan, of course, is that none of these countries have the authority to devalue the euro. The value of the euro is controlled by the European Central Bank, not the individual countries’ central banks.