This article was first published by Knowledge@Wharton on October 12, 2011.
European and US markets remain inextricably linked and a common effort might be the only way to solve the financial crisis.
Concerns about Europe continue to drag down capital markets in the United States, which had begun to recover earlier this fall after a bitter congressional debate over the debt ceiling and a subsequent credit downgrade. And while U.S. markets were relieved that German and French leaders agreed on Sunday to come up with a plan to stabilize a simmering sovereign debt crisis in time for next month's G-20 meeting, many obstacles to a resolution of Europe's complex economic problems remain.
Perhaps improbably, global financial markets are now focused on Slovakia, the last hold-out among the 17 eurozone members who must sign on to trigger a $600 billion European bailout plan. The Slovakian parliament voted against the plan on Tuesday on grounds that the country is too poor to bail out its wealthier neighbors, leading to a shakeup in government. However, parliament leaders now indicate they intend to approve the measure by Friday.
But even as U.S. officials and investors watch Europe struggle to shore up its financial system and avert another shock to the deeply entwined global economy, signs of a subtle transatlantic "blame game" have surfaced. Last week, President Barack Obama called on European leaders to "act fast" to resolve the mounting crisis. In September, at a meeting of European finance ministers in Poland, U.S. Treasury Secretary Timothy Geithner said Europe was facing "catastrophic risk" as he pushed for a U.S.-style bailout. Geithner received a chilly response. Swedish finance minister Anders Borg retorted: "We need to make progress, but it's quite clear the U.S. has a big debt problem, and the situation would be better if the U.S. could show a sustainable way forward."
Wharton finance professor Bulent Gultekin notes that following World War II, the United States enjoyed unquestioned leadership and moral authority in Europe, which enabled it to lead in the creation of a new world economic order during the 1944 conference at Bretton Woods, New Hampshire. However, according to Gultekin, the U.S. war with Iraq and its own financial crisis in 2008 have eroded the nation's standing as the world's financial leader. "So when the secretary of the Treasury goes to Europe to tell them what to do, they are not going to listen to him like they used to," he says.
Avoiding Signs of Pride
Wharton management professor Mauro Guillen, director of the School's Lauder Institute, says that if the United States wants to have a positive impact on Europe, the first step is to avoid any signs of "implicitly taking pride" in Europe's woes. He notes that Europe accounts for about a quarter of the global economy. Indeed, Goldman Sachs recently downgraded its U.S. growth forecast for the first quarter of 2012 to just 0.5%, because instability in Europe is likely to bring the U.S. economy to the "edge of recession" by early 2012. "[Europe] is a major customer of U.S. goods," says Guillen. "Oftentimes, we start thinking that if somebody else is suffering, we're going to gain. This is stupid."
The global downturn started in the United States three years ago, and officials here now have experience in developing approaches to the meltdown that might be useful to their counterparts in Europe, Guillen points out. However, he adds that the United States is in no position to offer financial support. "We can help in terms of providing an encouraging collaboration, but we don't have the money. There are similar fiscal problems here." Other countries, such as China and affluent nations in the Middle East, could help support Europe with bond purchases. And while governments should maintain close contact with private financial institutions, he emphasizes that governments themselves need to act as the leaders in resolving global financial crises.
According to Wharton finance professor Franklin Allen, Geithner and President Obama were right to express alarm, although he agrees that there is little that U.S. officials can do to help. "The situation in Europe is dire, and I think [U.S. officials] can't really do much other than stress that there are huge dangers out there."
A full-scale collapse in Europe has the potential to be a bigger threat to the global economy than the fall of Lehman Brothers, Allen says. Nonetheless, European leaders have been extremely slow to react to the threat — or they are in deep denial. So far, Germany and France have only agreed to a "plan to make a plan." Even though the possibility of a colossal European debt unraveling has been evident for 18 months, he adds, officials seem to have been hoping to stumble upon a "magic bullet — but there really isn't one out there."
The recent rescue of Dexia, the Belgian bank that underwrites significant municipal debt in Europe, is an example of European leaders' lack of credibility, Allen notes. For months, they had insisted Dexia was fine. Ireland, too, is an example: Irish banks passed European stress tests, but later needed additional funding. European leaders "have got to realize there is a serious problem here, and they can't keep flip flopping. It's unbelievable that serious governments can do this."
Markets were buoyed earlier this week after German Chancellor Angela Merkel and French President Nicolas Sarkozy agreed to come up with sustainable plans to solve Greece's debt crisis, recapitalize banks and improve economic coordination in the eurozone before a G-20 summit in Cannes begins on November 3. Meanwhile, the global economy awaits the next vote in Bratislava, Slovakia, that could expand the powers of the European Financial Stability Facility (EFSF) to buy the debt of stressed nations, aid troubled banks and offer credit lines to governments. Currently, the EFSF is limited to selling bonds that can be used to finance loans.
Jay Bryson, global economist at Wells Fargo Securities, says the weekend agreement between France and Germany is significant because France has always been more reluctant to accept the severity of the situation and the need for swift action. Now, perhaps under the threat of a downgrade of its own debt, France is on board with Germany to drive action to halt the instability in Europe. Bryson notes that the problems in Europe have become an ongoing threat to global markets that bubble up every few weeks, triggering a new wave of unease in world markets. "I think it's still going to be two steps forward and one step back. There's still a lot of uncertainty out there."
A Unified Approach
Gultekin suggests that U.S. leaders could work behind closed doors with European finance officials, particularly those from Germany and France, to emphasize the threat of contagion and add a sense of urgency to Europe's slow decision-making process. The United States could perhaps initiate change, he says, by working through the International Monetary Fund and other international institutions, indicating that the U.S. will not stand idle if the current problems erupt into a full-blown crisis in Greece or elsewhere. The U.S. needs to approach the crisis as an international issue and respond with a unified approach, not address it country by country, he adds.
European leaders seem to be interested in listening to advice from U.S. officials, Gultekin notes, but eventually Europe will devise its own solutions in its own time frame. "It's not going to happen instantly. Their institutional structures are not geared to make a decision overnight. Even [in the case of the U.S.], it wasn't that fast. We had to have major bankruptcies before the legislature did something."
The main difference between the financial system in the United States and Europe, Gultekin points out, is that while Europe has a unified currency, it has no central fiscal authority. As a result, buy-in from each of the 17 individual eurozone member states is necessary to initiate what are often politically painful policy changes to resolve the debt problems. Ultimately, he says, Europe must find a way to integrate fiscal policy with monetary authority, as in the United States. "The question is, how are you going to get there? How are you going to make that happen politically? Could [the U.S.] help them do that? We might, but we can't do it by telling them what to do publicly." European voters are already angry and frustrated by austerity programs initiated as a result of the crisis. "If there is the appearance that this was forced upon them, it's going to backfire."
Mark Zandi, chief economist at Moody's Analytics, agrees with Gultekin that U.S. leaders should not take a public stance on Europe's financial problems. However, he suggests that the U.S. Federal Reserve should continue to provide dollar liquidity to the European financial system. U.S. policymakers can also help the situation in Europe by taking steps that might avert another recession at home, including an extension of the current payroll tax break. "If we go back into recession, it will complicate things enormously for Europe," Zandi says, adding that a mild European recession is now inevitable, but it will not be strong enough to also push the United States into recession.
Off the Rails
Still, Zandi notes, a lot can go wrong. For example, Greece could pull out of the eurozone before the so-called "troika" of European financial institutions — the European Union, International Monetary Fund and European Central Bank — can arrange a deal to stave off a default by Europe's most troubled borrower. He warns that the troika cannot push Greece too hard on fiscal austerity, or Greece may just decide to strike out on its own. A defection would be extremely painful for the Greek people for a time, but a euro breakup would also inflict deep financial harm across the entire continent.
The Slovakia vote illustrates the difficulty that European finance leaders will have in working out unified, long-term solutions to the eurozone's debt problems, Zandi says. The countries that use the euro currency are each wrestling with their own domestic political issues that could upend a recovery. Additionally, the banks may be in more trouble than European stress tests so far indicate. "It's possible that once they really stress these banks, the capital hole is so deep that it's going to be difficult for the Europeans to fill it. There are a lot of things that can go off the rails."
According to Guillen, the crisis in Europe could spur the United States to play a constructive role in creating a new global financial leadership group. He suggests that a new group of the top global economic players — China, Japan, the European Union, the United States and possibly Brazil and India — should come together to create better cooperation in international finance. Brazil and India are large, growing economies that may not have major foreign reserves now, but will in the near future. "We need to start preparing for the next 15 to 20 years. Why wait to bring them into these negotiations?" For much of the past 50 years, he adds, the so-called G-5 (France, Germany, Japan, the United Kingdom and the United States) have learned how to interact with one another and come to agreements. Those five nations once controlled 90% of the world's finances, but today the figure is more like 30% to 40%, he says.
As China, India and Brazil grow in importance, they should begin to take a more important role in international finance, Guillen adds. "The problem is, we haven't built the structures or the institutions to deal with such a big crisis. We should have built them five or six years ago. We knew China was big — and India — but we didn't do anything, and now we're stuck in a situation without the structure and the routines to deal with this."