Special Report on Greece Crisis

1. The Eurozone is a political project, not an economic one

If you try to understand the Eurozone as an economic policy idea, you'll quickly start to see that it's a pretty
stupid idea. That will lead naturally to the conclusion that its architects were stupid people, and that the
policymakers in Brussels and Frankfurt who oversee it today are also stupid people. And if you try to
understand everything that's going on through the lens of stupid people doing stupid things, you'll end up
misunderstanding the situation.

The single most important thing to understand about the Eurozone — the group of 19 European Union
member states who use the euro as their official currency — is that it's primarily a political project, not an
economic one. And despite the considerable problems with European economies, it gives every indication of
succeeding in its political goal of pushing deeper and deeper integration of European countries.

Ireland's main trading partners are the United States and the United Kingdom. Finland's main trading
partners are Russia and Sweden. Economics simply can't explain why they would want to be in a currency
union with Italy and Portugal and Greece.

The Eurozone's member states — Portugal, Spain, France, Luxembourg, Belgium, the Netherlands, Germany,
Italy, Austria, Ireland, Finland, Cyprus, Estonia, Malta, Greece, Slovakia, Slovenia, Lithuania, and Latvia —
have all forsworn sovereign control over monetary policy and handed it over to the European Central Bank
in Frankfurt. The ECB sets interest rates, controls the quantity of euros in circulation, and generally performs
for its members the functions that the Federal Reserve does for the United States or the Bank of Japan does
for Japan.

As an economic policy, this is an idea with some serious flaws. The Eurozone is not what economists call
an optimal currency area — its economies are too big and disparate.

One way this flaw plays out is that Europe has very limited labor mobility compared with, say, the United
States. If the economy is strong in the Netherlands but weak in Spain, it's difficult for Spanish people to
simply move to Amsterdam, as they don't speak Dutch. European countries maintain separate welfare
states, and have very different average living standards. Consequently, economic conditions can be very
different in one part of the Eurozone than in another, making it difficult for the ECB to create policy that is
appropriate everywhere.

These problems are why economics writers fall all over themselves these days to come up with stronger
condemnations of the Eurozone's fundamental flaws. Matt O'Brien calls it "a doomsday device for turning
recessions into depressions," which is pretty good.
But European Economic and Monetary Union isn't a blunder, it's an incredibly ambitious political idea. In the
late 1940s and early 1950s, European leaders decided that World War II was not just a uniquely horrible
event but the culmination of a centuries-long process of great-power rivalry. They committed to the
construction of a series of institutions — first the European Coal and Steel Community, then the European
Economic Community, then the European Union — that would make war impossible. By integrating the steel
industries of France and Germany, it would be impossible for either country to produce war material
without the cooperation of the other. Deeper integration in subsequent decades only makes military
hostility even more difficult.

The slogan underlying these efforts is "ever closer union," and the monetary union is a step toward that
goal. And indeed, while the past five years have been a time of economic trouble for members of the
Eurozone, those very troubles have pushed the member states toward even closer forms of political and
economic integration on subjects like budget discipline and bank regulation.

The political meaning of the Eurozone and the European Project differs a bit from place to place. To France
and Germany, it means the end of war. To Ireland, it means independence from the United Kingdom. To
Finland and Latvia and other eastern states, it means independence from the Russian sphere of influence.
For Spain and Portugal, it means the end of dictatorship and integration into the realm of democracies. For
Greece, it means (unlike Turkey) certification as a real European country.

These big political ideas are what drive the Eurozone and the vast majority of mainstream European leaders.
It's why these countries are willing to put up with a lot of pain to keep the Eurozone alive. Everything beyond
the survival of this dream — including the practical economics — is secondary.
 2. The Eurozone crisis isn't really over

One view is that the Eurozone crisis is a thing of the past, something that began in 2010 but was brought to
an end in 2013. If you're adopting the viewpoint of a banker, a bank regulator, or a Treasury Department
official who needs to worry about the American economy, then this makes sense. Europe's economic
problems no longer pose a threat to financial stability in the United States. On the other hand, the
unemployment rate in the Eurozone is still over 11 percent, extremist political parties are on the rise, and in
the hard-hit countries, GDP is still way below its 2007 level.

On the optimistic view, the crisis consisted of the acute risk that a Greek default on its national debt would
lead to a cascading series of defaults in Portugal, Spain, Ireland, and maybe even Italy. That series of defaults
would crush the European banking system, possibly bankrupt the government of France, and create huge
ripple effects in Asia and the United States. Even worse, the mere fear of this scenario was becoming a self-
fulfilling prophecy. Investors worried about a Spanish (and Irish, and Portuguese, and Italian) default were
pushing up borrowing costs and therefore making a bankruptcy more likely.

That Eurozone crisis is over.

European Central Bank president Mario Draghi brought interest rates down with a promise in July 2012 to
do "whatever it takes" to prevent the cascading series of defaults. That cured the immediate panic and
bought European policymakers some valuable time. That time has been put to good use in terms of creating
financial stability. The very small country of Cyprus was put through a managed default without sparking
Europe-wide bank runs or a wave of other national defaults. That served as proof of concept that
mechanisms could be put in place to make a Greek default survivable, should such a thing come to pass.
Long story short, the specific thing that people worried about when the phrase "Eurozone crisis" started
showing up in the news in 2011 now seems very unlikely to ever happen.

In another sense, however, the economies of the euro area continue to be in crisis:

Like the United States, the Eurozone economy suffered a serious recession in 2008 and 2009. Like the United
States, the Eurozone economy began to recover in 2010.

Unlike the United States, though, the Eurozone economy then started getting worse again midway through
2011. And while the Eurozone labor market has been improving all throughout 2014, the unemployment
rate is still higher than it was at the peak of the original recession. In Spain, the unemployment rate is 24
percent. In Greece, it's 26 percent. In France, it's "only" 10.5 percent, but joblessness is on the rise.

This situation — call it the European Depression — is different from, but related to, the original Eurozone
crisis. And it's not over at all. In fact, in some countries the economic situation seems to be getting worse.
 3. An election in Greece caused the latest outbreak of drama

On January 25, a formerly marginal left-wing party called Syriza swept into office in Greece and unsettled the
political arrangements that were used to avert catastrophe. The bailout deals that halted the Eurozone
sovereign debt crisis have left Greece saddled — in theory at least — with a level of debt that everyone
knows the Greek economy can't support.

Officials at the European Central Bank in Frankfurt and the European Commission in Brussels have dealt with
this, so far, through a variety of "extend and pretend" tactics. In other words, Greece was given enough
financial assistance to keep rolling the debt forward but not enough to actually solve its debt problems.

The result is a kind of hostage situation: Greece either follows the economic reform script written in
Frankfurt and Brussels, or its economy gets it. In practice, this means Athens has given up a tremendous
amount of political power to faraway bureaucrats — a situation that didn't sit great with the Greek people,
particularly as unemployment skyrocketed.

For awhile, the tactic more or less worked. Greece's main right-of-center party (New Democracy)
collaborated with its traditional left-of-center rival (PASOK) and also a smaller further-left party (Democratic
Left) on implementing a reform agenda of tax hikes, spending cuts, and deregulation. But the agenda — and
its human consequences — has not been popular. Syriza's leader, Alexis Tsipras, swept into office
threatening to blow up that arrangement.

But after winning, he was forced to substantially back down from his campaign promises. Tsipras ran on a
platform of ending austerity, rolling back labor market reforms, and putting a stop to privatization. In the
end, he settled for much less than that. Relative to the previous government, he secured a little flexibility on
the budget and future privatizations but was basically forced to indefinitely postpone Syriza's left-wing
program.

The reason he had to abandon his campaign pledges is that, in essence, Greece had no leverage. Tsipras also
promised to stay inside the Eurozone, and it was clear that some Eurozone member states wouldn't have
minded a Greek exit particularly. That left him with a strong democratic mandate for change but no means
to force foreign leaders to come around to his point of view.
 4. Debt didn't cause the crisis

A common misconception, at times perpetrated by high-ranking European officials, holds that Europe's
economic crisis was caused by a crisis of excessive borrowing and sovereign debt. This is backward. It is true
that Greece and some other countries were engaged in excessive borrowing before the crisis hit. But Spain,
for example, was actually running a budget surplus until its economy collapsed. It was the severity of the
recession that created the debt problem and not the other way around. In other words, structural flaws in
the Eurozone's architecture — not irresponsible conduct by individual governments — are the root source of
the trouble.

Economic collapse is generally going to lead to a huge budget deficit problem for almost any country. Some
of this is just mathematical. When GDP falls, your debt-to-GDP ratio grows. Beyond that, unemployed
people collect social assistance benefits rather than paying income taxes. Depressed areas see falling
property values and diminished real estate taxes. Economic disaster leads to budget disaster.

Some European countries, most notably Greece, were headed toward budget disaster regardless. And it's
doubtful that countries like Spain would have been able to achieve their mid-aughts budget surpluses
without the economic boom induced by Euro membership. But looking backward, the key source of acute
deficit problems in 2010 was the very weak economies in Portugal, Ireland, Italy, and Spain — not
irresponsible budget practices. And the key source of those problems was the flawed design of the
Eurozone itself.
 5. The single currency itself caused the original Eurozone economic crisis

The full details of Europe's economic problems are complicated, but the original source of the trouble is
actually quite simple. The main tool modern countries use to recover from recession is monetary policy, but
the nature of the Eurozone is that when countries fell into recession they didn't have central banks of their
own that could help promote recovery. Outsourcing monetary policy to the European Central Bank in
Frankfurt left Ireland, Portugal, Greece, and Spain defenseless against the 2008 recession.

More broadly, the crisis had its origins in a pattern that's actually been quite common in the era of financial
globalization.

What happens is that some country has something happen — political or economic reforms or a natural
resource boom — that makes its economy suddenly look more promising. Consequently, foreign investors
decide they want to get in on the opportunity. Being foreigners, the investors typically lack detailed
knowledge of where the specific economic opportunities are, so they lend money to local banks. Local
banks, stuffed with foreign cash, start a boom of cheap credit. This credit becomes its own source of
economic strength — lots of people get mortgages, for example, so there's a homebuilding boom.

Then some kind of bad news hits, and some of the foreign investors get nervous and start pulling their
money out. Then other foreign investors realize how much of the recent economic growth has been a
consequence of the credit boom, rather than of any change in the fundamentals. Then they get nervous and
also start pulling out. Soon the credit bubble has collapsed, leaving huge problems in its wake.

You can see this bubble and its subsequent collapse in several Eurozone countries in this chart of bond
yields. The introduction of the euro caused a surge of investor enthusiasm about some new member
countries that previously had a reputation for bad economic management, and their borrowing costs fell to
German levels. Then the collapse of Lehman Brothers caused a collapse of enthusiasm.
This basic pattern has played out many times over the decades. And it happened in southern Europe after
Greece, Italy, Spain, and Portugal signed up for the Eurozone monetary union with Germany and other
countries that enjoyed a better reputation for macroeconomic management. In the case of Ireland, this was
joined by a lot of "Celtic Tiger" hype fueled by people excited by the Emerald Isle's low corporate income
taxes.

After the collapse of Lehman Brothers and various other pieces of bad economic news, everyone got more
risk-averse, and the money started flowing out.

What normally happens when the panicking foreigners all pull their money out is that you get a currency
crisis. Everyone is selling your local money and putting their investment back into dollars (or yen or
whatever) so the value of your currency collapses. This is typically very unpleasant, involving rising prices
and falling living standards. The silver lining is that the cheap currency makes your locally produced goods
and services cheap for foreigners to buy. Consequently, you start exporting a lot of stuff (or hosting a lot of
tourists), and people who lost jobs working on foreign-financed investment projects get jobs providing goods
or services to foreigners.

That's where the Eurozone crisis ends up being different. A lot of the "foreign" money pouring into Greece
and Spain was coming from places like Germany and the Netherlands. And all those countries use the same
currency — the Euro. Consequently, when the foreign money went back home, the suffering countries didn't
get the export boost that's associated with a cheaper currency, because they still had an expensive currency.
The credit boom ended and people lost their jobs, but there was very little reemployment.

For years now, officials at the European Central Bank in Frankfurt and the European Commission in Brussels
have been trying to address this problem with "structural reforms" and "internal devaluation." That means,
basically, cutting wages, prices, and government benefits within the struggling country so as to imitate the
impact of a decline in the value of a currency. One problem with this is simply that it's logistically difficult
and politically contentious; people don't like having foreigners come in and slash their salaries. Another
problem is that while currency devaluation reduces both wages and debts, "internal devaluation" reduces
wages while leaving debts in place.

This program of austerity and structural reform has worked best in Ireland, where the unemployment rate
really has fallen substantially from its 15 percent peak. Still, Irish unemployment is far higher than the
unemployment rate in the US or UK, where independent monetary policy has been used to combat
joblessness. That Ireland's years-long spell of double-digit unemployment is considered a Eurozone success
story goes to show just how bleak the overall situation is.
 6. The crisis nearly became a global catastrophe

For a brief period of time, the Eurozone's woes became an obsession of policymakers all around the world
because it looked like they might cause a global banking crisis in which national bankruptcy would lead to
bank runs, which would lead to new bankruptcies and catastrophe without end. That didn't happen, but you
have to understand those fears to appreciate the still-high stakes in the crisis and why policymakers
sometimes seem smug about an economic situation that is still rather dire.

Fear of defaults: As debt-to-GDP ratios soared in crisis-hit countries, investors began to fear that those
countries would default on their debts. That made it more expensive for those countries to pay for ongoing
budget deficits, which made default more likely. There were real, fundamentals-based reasons to worry
about the sustainability of European borrowing, but all those problems were being exacerbated by this self-
reinforcing cycle.

Fear of bank runs: A Eurozone member state that defaulted on its debts would likely be forced out of the
Eurozone and onto a new devalued currency. That would be terrible news for anyone with money stored in
the defaulting country's banks. Consequently, as default seemed more likely, people wanted to withdraw
money from the local banking system. Those withdrawals threatened runs on the local banks, which would
have required bailouts to prevent economic collapse — bailouts that countries already at risk of defaulting
on their own debt couldn't afford. Meanwhile, banking systems increasingly starved of funds couldn't make
loans to local businesses, further exacerbating the economic problems at the root of the crisis.

Fear of contagion: A Greek default, devaluation, and series of bank runs would not, on its own, be a huge
deal for the global economy. But if Greece defaulted, that would make investors more worried about Ireland
and Portugal. Those worries about Ireland and Portugal would make defaults and bank runs in those
countries more likely. Those defaults would increase fears about Spain and Italy. And if Italy went bankrupt,
then who would really be safe? Belgium? France?

Europe's potential catastrophe

Policymakers around the world worried about a scenario in which a single national default (most likely in
Greece) would create bank runs in other countries, which in turn would force new defaults. Those defaults
would create their own bank runs and an even bigger waves of defaults. Defaults by countries the size of
Italy and Spain would cause massive losses to foreign banks and trigger a new round of global financial crisis.

In the interests of avoiding mass panic, non-European leaders generally tried to project an air of public calm
about this. But certainly the American government spent much of 2010 and 2011 terrified of a true disaster
emanating from the other side of the Atlantic and lobbied as hard as possible for a solution that would avoid
as much.
 7. Europe now has even bigger economic problems

Even as the risk of a Greek default setting off a chain of financial and banking crises has diminished since
2013, the Eurozone's overall economic problems have in many ways gotten worse. Unemployment rates
have been high and at times rising in countries that weren't at the epicenter of the sovereign debt crisis at
all.

Each country, of course, has its idiosyncratic problems, and France in particular is never short of detractors
in the English-speaking world on the grounds of its heavily regulated economy. But the point is that weak
labor market performance is quite widespread in Europe at the moment, including in countries with left-
wing and right-wing governments, and in countries that were stricken by the sovereign debt crisis along with
countries that weren't.
The basic problem is pretty clearly an overall lack of demand, as can be easily seen from the low and falling
inflation rate in the Eurozone. Even in Germany's relatively healthy economy with a low unemployment rate,
inflation is well below the European Central Bank's 2 percent target.

What's less clear is what to do about it.

One point of view is that central banks can always generate more demand when they want to, so this
entire aspect of the problem can be laid at the feet of the European Central Bank. Another viewpoint is that
Europe fundamentally needs more stimulus from fiscal policy, which would essentially require German
taxpayers to finance Spanish borrowing and would thus be very politically challenging.

What can't be doubted is that the ECB has been much less aggressive than the US Federal Reserve, the Bank
of England, or the Bank of Japan in trying to stimulate demand. At the same time, the Eurozone has ended
up with very high unemployment and very low inflation.
 8. Europe's institutions are clumsy at making decisions

Decades ago when he was secretary of state, Henry Kissinger scoffed at the notion of "Europe" being a major
actor in world affairs, asking, "Who do I call if I want to call Europe?"

Since Kissinger's day, Europe has become a much more real set of institutions, with real power and real
influence over the lives of tens of millions of people. But Kissinger's basic question — who is in charge —
remains not really answered. Final decisions are made by the 28 member states themselves, and on
important questions the decision must be unanimous. In that sense, the European Union continues to
operate like a classic international club.

But in other respects it looks much more like a state, and has sprouted an array of state-like institutions. For
example:

 The European Parliament, which meets in Brussels and Strasbourg and crafts European legislation
 The European Commission, a bureaucracy that works in Brussels and is organized into a Cabinet of
commissioners who run departments
 The European Central Bank in Frankfurt, which sets monetary policy for the Eurozone and is
increasingly prominent in European bank regulation
 The Eurogroup, which is composed of the 19 finance ministers of countries that use the euro as their
currency, and which exercises political control over currency matters
 The European Court of Justice in Luxembourg, which serves as the final court ruling on European
legal matters

These institutions often come up in news stories about European matters, and they play important roles. But
ultimately, big decisions are made by unanimous agreement among the governments of the member states.

In principle, this could operate very poorly with the EU stuck in perpetual gridlock. In practice it's not as bad
as it could be. European politics isn't nearly as polarized as American politics so disagreements often aren't
so severe. And the EU has strong consensus norms that discourage countries — especially the smaller ones
— from taking lonely stands. But it's still an awfully clunky process. There is nobody you can turn to for a
quick decision, and no real room for outside-the-box thinking, stark choices, or big changes of direction.
 9. Syriza's strategy could have worked — five years ago

Back in 2010, something like the strategy Syriza has been pursuing could have worked. Defaulting on
Greece's debts to private creditors would have been disastrous for Greece. But it also would have been
disastrous for other debt-burdened European countries such as Portugal, Spain, Italy, and (at the time)
Ireland. And it would have potentially been costly to less-indebted European governments that might have
needed to bail out banks hurt by Greek default.

Consequently, it might well have been cheaper for Germany and others to simply give the Greeks a bunch of
money than to deal with the consequences of Greece defaulting.

Today, though, things look pretty different.

The main reason is that while Eurozone officials haven't restored decent economic conditions, they have
done an awful lot to reduce the risk of contagion. Some of this has to do with the undertaking of
formal "stress tests" that should provide some peace of mind regarding the soundness of European banks,
even in the event of a Greek default.

Less formally, there have been two big intervening events. One was the collapse and bankruptcy of a major
Portuguese bank, the Banco Espírito Santo. The other was the debt default of Cyprus, a very small Eurozone
state that was used as a kind of controlled experiment in sovereign debt contagion. Both events went down
without triggering bank runs in Spain or any other major problems.

Consequently, the economic basis for achieving better terms by threatening a murder-suicide of the
European economy has evaporated.

In political terms, Greece's best hope is probably that the mission of the European Union is "ever closer
union." Direct fiscal support for Greece is hideously unpopular in northern Europe, as is the idea of having
the European Central Bank monetize Greek debt. But both would, in fact, be a form of ever closer union. By
contrast, kicking Greece out of the Eurozone is the opposite of ever closer union. So in a sense, the broad
current of history is on Syriza's side. But everything else in short-term political and economic dynamics cuts
the other way.