Monday, November 14, 2011

The EU Debt Crisis: A Minute With Political Scientist William Bernhard

William Bernhard, an EUC-affiliated faculty member, discusses the EU's economic crisis, contrasting the situation in Europe with that in the United States and exploring the implications of the crisis on EU politics and strength. The full interview is posted below. 

Editor's note: Every day seems to bring new headlines in the European Union's sovereign debt crisis. A potential default by Greece had put that country at center stage, but the spotlight recently shifted quickly to Italy. Both countries' leaders are in the process of stepping down as a result. EU leaders have developed plans for a financial 'firewall' to contain the problem, but details and funding have remained uncertain. William Bernhard is the head of the political science department at the University of Illinois and is an expert on central banking and the link between politics and markets in the European Union. Bernhard was interviewed by News Bureau social sciences editor Craig Chamberlain.

Of the 27 EU countries, 17 use the euro as common currency and so are tied together in the eurozone. News reports suggest that a default by Greece ' and even more so Italy ' could bring down the entire eurozone system. Why and how would this happen? How does a relatively small nation like Greece pose such a threat?

Global financial markets are so integrated that a Greek default would spill over to other countries ' what financial economists call 'contagion.' Banks from across Europe hold Greek debt. That debt represents part of the banks' assets ' returns that the banks have been counting on. In the most recent bailout agreement, the banks accepted that they would have to take a significant loss on those assets, a 'haircut' in financial jargon. That leaves the banks in a precarious position, making it more difficult for them to lend to the private sector or to purchase government debt from other countries.

As a result, other countries will be affected. Less lending will prolong the economic slump in Europe and the world. Governments in high-deficit countries, such as Italy, which count on borrowing to pay their bills, will have a more difficult time finding banks to purchase their debt. In a worst-case scenario, some of these large banks may go under, which could precipitate a significant banking crisis and even the collapse of the single currency.

Austerity measures in Greece, required for it to obtain bailout funds, have produced massive street protests, along with complaints these measures are destroying the Greek economy. Just how severe are these measures? And is there no alternative?

The austerity measures require cutting social spending, chopping public employment and raising taxes. These are significant policy changes that require Greeks to rethink their relationship between the market, government and citizens. For a long time, the Greek government has provided for many citizens, insulating them from the risk and volatility of global markets. The government will no longer be able to do that.

The response of the Greek people is not surprising ' they had been counting on those policies for their quality of life. Here at home, think about the controversies generated by proposals to change social security or the pension system in Illinois ' the beneficiaries of those policies have made plans assuming certain policies would be in place. It would be traumatic to pull the rug out from them.

Interestingly, polls suggest that Greek citizens detest the austerity requirements of the recent bailout agreement, but want to remain within the eurozone ' a very difficult circle to square. These conflicting attitudes create credibility issues with markets, which question whether the Greek government will actually have the will to follow through on their commitments. In turn, Greek politicians have been searching for ways to convince markets and other EU leaders that they are serious.

Comparing the U.S. and the EU, what makes the situation in Europe so difficult?

In the U.S., we have a strong federal government with relatively clear political accountability. It doesn't seem like it sometimes, but we know who's in charge. We've got a nationally elected president, who's presumably concerned with the welfare of the country as a whole. We've got two parties that span all 50 states. Between the president and the parties, there are incentives for politicians to think about the economy as a whole. Moreover, the federal government has an authority and an ability to act.

In the EU, the policymaking process is more diffuse. It's not entirely clear who's in charge, who's accountable for the economic performance of Europe as a whole. The Council of Ministers, which includes representatives from each of the member states, is the main policy body. But think about if the 50 state governors in the U.S. got together to negotiate over national policy. What would that be like? It would be a mess, because each one would be concerned about what's going on in their state rather than what's going on with the whole.

In the EU, there's more of a collective-action problem when it comes to thinking about the crisis. You see this in Germany. It's going to have to come through in some way financially as part of the solution to this crisis, and a lot of German politicians say, 'not our problem, it's not good for us, we've taken care of ourselves.' The EU doesn't have the institutional accountability or ability to think about the whole ' that's a big difference.

Are there other factors at work?

In the U.S. there are some adjustment mechanisms that kick in that help level out some of the differences in economic performance between different regions. One of those involves the transfer of funds through the federal government. If Texas is booming, it's going to send more tax receipts to Washington (D.C.). Then Washington, almost automatically ' through unemployment insurance, welfare spending and a variety of different things ' is going to spend that money in Michigan, where the economy is struggling.

In the EU, there is no equivalent mechanism. When the EU countries need to think about how to pick up Greece, they have to come up with an explicit agreement to make these transfers. Because it happens automatically here in the U.S., it eases the adjustment.

A second means of adjustment that we have in the U.S. is labor migration. When the economy is bad in California, for instance, you can pick up and move to North Dakota, where the economy is going pretty well. There are minimal barriers to doing that. It's very easy to move. In Europe, they don't have that same sort of labor mobility. Someone in Greece cannot pick up and easily go work in Finland, because they don't speak the language, and the cultural differences are larger as well.

Some have talked over the years about the EU moving toward becoming more of a 'United States of Europe,' with greater integration of financial and tax policies. Could that happen as a result of this crisis?

With the establishment of the euro, people talked about the very scenario that we're seeing. Member states with more balanced fiscal positions, such as Germany and the Netherlands, were concerned that they would get stuck paying the bills of the high-debt countries. Things had gone smoothly, however, until the global financial crisis brought it to the fore.

How could this crisis result in a stronger Europe? Member states may agree that the EU needs more authority over national-level fiscal policies ' that is, taxing and spending ' to prevent this sort of crisis from ever happening again. That would be a big step toward political integration, as decisions about taxation, government spending, and representation are at the heart of any democratic government.

On the other hand, this crisis could still end with some countries leaving the eurozone and returning to a national-level currency. That scenario would mean a very different future for European integration, perhaps one involving different levels of membership in the European Union.

Editor's note: To contact William Bernhard, call 217-333-2602; e-mail bernhard@illinois.edu.

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