Thursday, September 8, 2011

Europe's Shotgun Wedding

Here's a longer than usual post on Europe:

Europe’s Shotgun Wedding

It is difficult to deny the parlous state of the European project. The sovereign debt crisis in the Eurozone periphery is placing enormous strain on the institutions of the European Union and on the relationships between member states. The powerlessness of the EU’s executive and legislative institutions has been set in stark relief by the activism of the barely accountable European Central Bank, which is reaching way beyond its mandate to keep European banks and sovereigns afloat. Meanwhile the hostility of Germans and Finns to the bailouts of the peripheral countries is matched by the resentment felt by those suffering the spending cuts demanded in return. The European project appears to be falling apart.

And yet, there are good reasons for believing that European integration could be about to accelerate. Not of course, because of any putative sense of European solidarity and togetherness on the part of voters or political elites: appeals to national self-interest have rarely been so popular. Further integration may not be desired by anyone, but it could be forced upon Europeans by the consequences of its decision two decades ago to adopt a common currency. Europe has often moved forward through an inexorable logic in which past decisions to pool sovereignty have consequences which necessitate further moves in an integrationist direction (the so-called ‘spillover effects’). Monetary union may prove yet another example of this. The decision to create a single currency has, in the space of just a decade, generated its own (catastrophic) spillover, and the logical, perhaps the only, response is to enhance the role of European institutions to resolve the second order effects of the creation of the Euro.

Critics of the EMU project argued back in the 1990s that the Eurozone was not an ‘optimal currency area’, and that monetary union without the development of supranational institutions to manage fiscal and redistributive policies would prove disastrous. Ignored at the time, this argument appears close to unanswerable in hindsight. Monetary union not only failed to bring about a convergence in inflation rates between Eurozone nations, it achieved the opposite effect, as destabilizing capital flows from surplus countries (chiefly Germany) led to an economic boom in Ireland, Greece and Spain. The resulting trade deficits run by periphery countries in the 2000s proved unsustainable, and the post-2007 credit crunch slammed their economies into reverse, wrecking their fiscal balances and spooking bond markets.

Although well understood by economists, the current account balances inside the Eurozone have been almost entirely ignored in the public debate, in favour of a simplistic narrative in which spendthrift Southern Europeans are entirely responsible for their current debt problems. In the case of Greece, this narrative clearly has some merit, with successive governments running structural deficits in good times while concealing the true state of public finances. But Spain ran a substantial budget surplus in the years preceding the crisis and had a debt to GDP ratio almost half that of Germany. There was no reason at all for Spain’s leaders to fear an abrupt descent into the fiscal abyss, and the markets took the same view, pricing Spanish bonos as barely any riskier than German debt. Even Italy, despite carrying the third largest public debt in the world, had in fact stabilized its public accounts before Euro entry and ran consistent primary surpluses right until the credit crunch. German and French breaches of the Stability and Growth Pact confirmed that the GIIPS (the four Southern European member states and Ireland) were, on the whole, no more inept at managing their public finances than the Northern Europeans.

The budget deficits facing the peripheral countries are largely a consequence of the crisis, not its cause. They are a reflection of the collapse in internal demand resulting from an unexpected correction in Eurozone current accounts. The unexpected end to the capital flows from Northern Europe which had financed large trade deficits in the first years of monetary union caused a dramatic collapse in investment and output, tearing a hole in tax revenues and forcing up government spending. Exhorting periphery states to embrace austerity is only likely to make deficits worse, because there is no alternative source of demand to drive economic activity.  Potential export markets are themselves depressed, and cutting wage levels in the periphery to regain competitiveness, in the absence of Eurozone inflation, would have brutal contractionary effects even if were at all politically feasible. Even without the complication of sovereign debt risk, the prospects for the periphery would have been a grim menu of deflation and a long wait for external demand to appear from somewhere. But doubts about government solvency in the periphery remove even that unattractive option.

So the recent attempts to repair the damage within the existing framework of monetary union, through limited bailouts from Northern taxpayers in exchange for austerity packages in the debtor countries, appear doomed. The costs of the bailout strategy have spiralled as more countries have been dragged into the self-fulfilling prophecy of sovereign default risk. Greece, Portugal and Ireland, amounting to only 7 % of Eurozone GDP, could perhaps have been rescued by decisive action, but the addition of Spain and the Italy to the danger list makes the bailout strategy entirely incredible, with predictable consequences in the bond markets. With the spreads of both of the larger GIIPS heading north, two much more radical scenarios, with entirely opposite implications, have emerged.

The first scenario is disintegration: the reversal of the process of ever greater European economic integration and cooperation.  In this scenario neither core nor periphery member states are prepared to meet the costs of staying together: German, Dutch and Finnish taxpayers refuse to sign up to the rescue of the profligate South, whilst in the periphery austerity packages founder on the rocks of collapsing output and/or political instability. The result is sovereign default in Greece, and some or all of the other periphery countries. But this would not in itself solve the crisis, since the competitiveness problems would remain, and periphery governments would still face the problem of financing budget shortfalls without the help of the private markets. If we add to this the resulting chaos in the Eurozone financial system, default could well lead to the exit of Greece and others from the Euro itself.

There are very strong reasons for believing that European leaders will avoid such an outcome at all costs, since it damages everyone. The periphery countries would benefit enormously from having their own currencies, since it would make the price and wage adjustment they require economically feasible and politically survivable. The example of the UK, which suffered a far worse financial crisis than any of the Eurozone states but avoided (so far) a run on its debt, is an appealing one. However the GIIPS cannot easily emulate the UK because they have to extract themselves from the Euro first, and doing so would likely cause such financial disruption as to outweigh the benefits of competitive devaluation. Perhaps more importantly, the creditor countries also have every incentive to avoid Euro exits. Germany is on the hook in two ways: first its trade surplus is almost entirely with the Eurozone, so Euro exits would undermine its main export markets. Second, German and French banks are exposed to periphery government debt to the tune of hundreds of billions of Euros. Default and or/exit would bring down the German banking system, requiring colossal bailouts at a time of declining growth prospects. In this respect, it is worth remembering that Germany’s own debt/GDP ratio is already a far from virtuous 81 %.

The incalculable risks of this first scenario mean that the alternatives, however unpalatable, will prove more appealing. A second scenario can be traced, in which further integration provides the Eurozone with the necessary policy instruments to address the imbalances and weaknesses revealed by the crisis. What exactly would this integration involve? The most immediate problem – the risk of sovereign default in the periphery – will inevitably require a degree of burden-sharing and risk-pooling, most likely through the emission of Eurobonds backed by the governments of the entire Eurozone. In this solution, demanded insistently by Italian Finance Minister Tremonti, peripheral government debt would be backstopped by German’s fiscal credibility, reducing debt servicing costs (whilst raising yields on German debt). Whatever form this pooled sovereign risk involves, EU institutions will have to be redesigned in order to manage it, enhancing supranational authority.

Simply staving off default will not end the crisis. The Eurozone also needs to resolve the imbalances which left the periphery so exposed after the credit crunch. The German economic model, based on high savings rates, wage moderation and fear of inflation, interacted fatally with a periphery lacking a sound basis for converting capital flows into productivity gains. The result was a brutal shock for the GIIPS when the money dried up, without the appropriate policy instruments (monetary policy, competitive devaluation) to allow for adjustment of relative wages. If Germany will not countenance the higher German and Eurozone inflation needed to accelerate the process of adjustment, then some way needs to be found to channel German surpluses to the periphery. Some kind of pooled fiscal sovereignty, on a far larger scale than anything so far attempted in the EU, would appear the most effective way of achieving this.

Why on earth should Germany accept an increase in debt servicing costs, an increase in domestic inflation, and tax increases to pay for economic recovery in the South? Because the alternative is worse. German virtue is the flip-side of the periphery’s vices: Germany’s trade surplus is the counterparty to the periphery’s trade deficits, and the excessive debt taken on by the GIIPS was loaned in large part by German banks. The collapse of the Eurozone would mean insolvency for German financial institutions accompanied by job losses in the manufacturing sector. European integration means that no member state can isolate itself entirely from problems in another. The more serious the problem, the more grief is shared amongst states whose economies are deeply inter-connected.

Of course, it is one thing to recognize the nature of the problem, another entirely to adopt the appropriate solutions, particularly when none of them are remotely appealing. Further integration has all the features of a shotgun wedding, the core and periphery tying the knot out of desperation rather than desire. For the wedding to go ahead, European leaders and voters need to be convinced that the alternative would be even worse. At the moment there is no evidence that we are close to this realization. European leaders, Mrs Merkel in primis, have an awful lot of explaining to do.