Yesterday, the announcement of a 750 billion euro bailout from the European central bank and the IMF to troubled southern European economies seemed to reassure the markets. The interest rate on Greek government debt fell 5%, the euro gained against the dollar, the spread between German and Spanish bonds shrank, and bank share prices rose by almost 10%. No wonder: 750 billion euros is a lot of money. It’s almost triple the Greek GDP. Bond speculators betting on spiralling southern European debt edged away, acknowledging that the central bank had the money and the will to defend eurozone bond prices.
Unfortunately, $1 trillion doesn’t buy as much reassurance as it used to. Today, the euro is sinking again, and financial markets have opened lower. We should all be glad the European finance ministers who met last weekend had the foresight and courage to put together this unprecedented loan guarantee. Without it, the “PIIGS” nations–Portugal, Italy, Ireland, Greece, and Spain–would have come under enormous attack from speculators. It is not inconceivable the euro could have fallen apart. It didn’t, but the eurozone remains essentially unstable.
Let’s go back to the roots of the crisis. The creation of the eurozone caused the rates for government borrowing across Europe to begin lining up with each other. In the days of the boom, investors were willing to lend to Greece, Italy and Spain at interest rates very close to the Germans. For a while, everybody won: German banks found a market for their excess capital; the PIIGS saw enormous inflows of cash; intra-European exports were the engine of growth for the German economy. But unfortunately, all that money rolling into southern Europe created wage inflation. Because Greek workers are not nearly as productive as Germans, but their wages grew closer to German levels, the cost of production in Greece rose much faster than Greek productivity. The country became feeble in world markets: imports rose, exports declined, the deficit skyrocketed.
There are two ways to pay back foreign debt: borrow more or export more. For much of the decade, the PIIGS could carry on doing the former, and do it cheaply. But with the credit crunch, investors started to realize that maybe Greece wasn’t as creditworthy as Germany. As tax revenues fell and expenses rose, the Green…