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May 29, 2012 7:35 pm
How will the crises inside the eurozone end? Many people have asked me this question in the US in recent weeks. How, in particular, might the eurozone move from crisis into stability? To address this question, we need to distinguish three aspects of the turmoil: where the eurozone is going; where Germany wants the eurozone to go; and where the eurozone needs to go.
The eurozone’s current position seems depressingly clear. A number of member countries, two of them – Italy and Spain – being large, already have, or are on the verge of having, governments unable to manage their public debt unassisted. Much of that debt is held by their banks. Many of these have been damaged, particularly in countries that experienced huge real-estate bubbles, large fiscal deficits or both. Governments with weak creditworthiness feel compelled to rescue fragile banking systems that are, in turn, expected to finance the governments trying to support them: the drunks are seeking to stay upright by leaning on one another.
Governments are also required to attempt fiscal austerity when private sectors are retrenching: between 2007 and 2012, the financial balance of the private sector shifted from deficit towards surplus by 16 per cent of gross domestic product in Spain (see chart). Austerity further weakens both economies and banks. This, in turn, raises unemployment and lowers government revenue, rendering fiscal austerity ineffective. Meanwhile, slack demand in the core reinforces economic weakness in the periphery, rather than offsets it.
With banks impaired, private demand damaged, government demand contracting and external demand weak, the fragile economies are likely to have smaller output and higher unemployment two or three years hence than now. The reward for pain today is pain tomorrow.
Whether or not Greece is “saved”, for the moment it is hard to believe today’s eurozone would survive this, particularly when the principal argument in its favour – that for economic and financial integration – is being destroyed. Businesses, particularly financial institutions, increasingly seek to match assets and liabilities by country. Equally, only the bravest business will plan production in the belief that exchange rate risk has been eliminated. With a rising share of cross-border risk now assumed by the European Central Bank, the way to break-up is becoming more open.
This looks like a long day’s journey into night. It might take weeks, months or years. But the direction, alas, seems ever clearer.
Now turn to the second issue: how does Germany want the eurozone to be organised? This is how I understand the views of the German government and monetary authorities: no eurozone bonds; no increase in funds available to the European Stability Mechanism (currently €500bn); no common backing for the banking system; no deviation from fiscal austerity, including in Germany itself; no monetary financing of governments; no relaxation of eurozone monetary policy; and no powerful credit boom in Germany. The creditor country, in whose hands power in a crisis lies, is saying “nein” at least seven times.
How, I wonder, do Germany’s policy makers imagine they will halt the eurozone’s doom loop? I have two hypotheses. The first is that they believe they will not. They expect that life for some of the vulnerable economies will become so miserable that they will leave voluntarily, thereby reducing the eurozone to a like-minded core, and lowering risks to Germany’s own monetary and fiscal stability from any pressure to rescue the weak economies. The second hypothesis is that the Germans really think these policies could work. One possibility is that the weaker countries would have so big an “internal devaluation” that they would move into large external surpluses with the rest of the world, thereby restoring economic activity. Another possibility is that a combination of radical structural reforms with a fire sale of assets would draw a wave of inward direct investment. That could finance the current-account deficit in the short run, and generate new economic activity in the longer run.
Maybe German policy makers believe that it will be either harsh adjustment or swift departure. But “moral hazard” would at least be contained and Germany’s exposure capped, whatever the outcome.
Yet the “exit of the weak” option looks very risky and the “painful adjustment and fire-sale” option so implausible as to lead swiftly back to exit. The danger, moreover, is not just to the weaker countries. Germany sends just 5 per cent of its exports to China, compared with 42 per cent to the rest of the eurozone, much of which would be disrupted by a meltdown. What has already happened has weakened its export-dependent economy: German GDP was only 1 per cent higher in the first quarter of 2012 than four years earlier. Beyond these narrowly economic dangers from damage to the “irrevocable” union would surely lie an enduring political disaster for the eurozone’s economic hegemon.
In brief, the eurozone is now on a journey towards break-up that Germany shows little will to alter. This is not because alternatives are inconceivable. What is needed is to turn some of the Nos into Yeses: more financing, ideally via some sort of eurozone bond; collective backing of banks; less fiscal contraction; more expansionary monetary policies; and stronger German demand. Such shifts would not guarantee success. But they would give the eurozone at least a chance of avoiding the cost of partial or total break-up. To work in the long run, such shifts would also require greater political integration.
In October 1939, Winston Churchill said: “I cannot forecast to you the action of Russia. It is a riddle, wrapped in a mystery, inside an enigma; but perhaps there is a key. That key is Russian national interest.” The key in Europe today is Germany’s perception of its national interest. Once it becomes evident that their conditions will not work, German leaders will have to choose between a shipwreck and a change in course. I do not know which Germany will choose. I do not know whether its leaders know. But on that choice hangs the fate of Europe.
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