Tuesday, February 9, 2010

Europe's Porcine Predicament

Having spent most of my academic career studying Southern Europe, I should be excited that Southern Europe is in the headlines. Obviously, it's for the wrong reasons - their budget deficits are spooking investors and threatening the stability of the euro area. On top of that, someone with an eye for an acronym and a thinly veiled contempt for Mediterranean civilization has christened this group of countries the PIGS - or PIIGS if we include the Irish, who share a big fiscal crisis with a recent history of poverty, migration and having to put up with Northern European condescension.

Anyway, the story is an interesting one, particularly since Spain, Greece and especially Ireland were looking like spectacular success stories until a year or so ago. As ever, it takes Paul Krugman to explain what's going on: these countries are the victims of the kind of asymmetric shock that many theorized long ago could make the Euro unworkable. Unlike the UK, which has also suffered a huge demand shock and has desperate fiscal problems, Spain and Greece cannot adjust their currency, which remains locked at the same rate to that of Germany and other trading partners. So, either wages have to drop in nominal as well as terms (anyone volunteering?) or unemployment will have to rise sharply. As indeed it has. What's more, a historic deficit of investor trust makes government borrowing more expensive for these countries - even though Spain was running a budget surplus until 2008 and had rather low public debt (must be because they speak Spanish in Argentina).

The interesting question is, how long can Italy, the paradigmatic fiscal basket case of Europe's Southern frontier, stay out of this? Italy's demand shock has been less acute, because it didn't enjoy the pre-2009 boom, for a variety of reasons. But its fiscal position is still bad, and its political system is even less equipped to manage shared sacrifice than Spain or Greece. It has the same competitiveness problems of the others, and a bigger public debt. We'll see.