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2011: The Year Ahead - Predicting the fate of the Eurozone

European economy | 2011: The Year Ahead - Predicting the fate of the Eurozone Ian Fraser and Anthony Harrington

As we move into 2011 the world is rapidly polarizing into those who think that the Eurozone is going to disintegrate or fragment this year and those who believe it can muddle through, given enough good will. In the latter camp, not unexpectedly, is Jean-Claude Trichet, the President of the European Central Bank.

On 13 December, Trichet reminded attendees at a meeting of the International Club of Economic Journalists that the European agenda was “a visionary one” which “despite all the current challenges… is being pursued with determination.” This is a key point that outside commentators, particularly US commentators, tend to overlook when they predict the inevitable demise of the eurozone and the euro. They tend to be somewhat blind to the scale of the political commitment among Europe’s biggest economies to the euro project.

As Trichet noted, all sides in the “fate of the euro” debate recognise the cause of the present dilemma. As he rather delicately puts it: “… the tensions we are experiencing today in the Euro area sovereign debt markets find their deep causes in (some member) countries’ policy slippages of the past years”. He adds: “We know that for several years fiscal policies in some European countries have breached both the letter and the spirit of the Stability and Growth Pact (which) calls for budgets that are close to balance or in surplus over the cycle, deficits always below 3% of GDP and a public debt level of below 60% of GDP.”

Member countries which are in difficulties have allowed wages to “outpace both domestic inflation and euro-average union labour costs”. “Such competitiveness losses cannot be sustained forever,” he noted, so “sooner or later adjustments in unsustainable economic policies have to be made”. The trick, he suggested, is for the eurozone as a whole to engage in “reinforced macroeconomic surveillance” of each by all, with mavericks being firmly steered back into line. As he puts it, “(this) requires peer pressure and consequences to deal with deviant behaviour, and it requires reliable statistics,” which means no fiddling of the books, à la Greece a few years ago.

If only this level of surveillance had been in place in the build up to the euro’s launch on January 1 1999, and over the ensuing 11 years, the shambolic situation we saw in 2010 with forced bailouts of “deviant” nations like Greece and Ireland may never have happened. 

However, to ensure the euro can survive, the electorates of economically strong countries like Germany would have to be persuaded that it is in their long-term interests to behave in a “communitaire” way - in other words to lend their support, or allow their political leaders to lend their support, to a what a “Marshall Plan”-style programme of economic reinvigoration for their more troubled neighbours. The hedge fund manager Omar Sayed described this option, reported in an earlier blog post “There is a way out of Europe’s debt slavery” (via John Maudlin’s “Outside the Box”).

"Under this option the EU would float its own euro-bonds for the periphery or guarantee that periphery debt is EU debt. They could cut interest on loans to help states better balance budgets. The EU could also lighten up on austerity and take a more active role in fiscal programs and auditing. Then, focus on fixing the periphery's lack of export competitiveness. The EU is sitting on billions of unspent redevelopment funds that could be channeled into projects… The idea is that rather than make periphery nations deflate, you help them grow and pay their way out of debt… For EU integrationalists, this could be a dream come true, a way to homogenize fiscal accounts and assume greater EU sovereignty over individual states."

By way of contrast, those who believe the euro was a doomed idea from the start, since monetary union without fiscal union is a contradiction in terms, regard talk of peer pressure and “communitaire” support for the weak as so much pie in the sky. The Legatum Institute, a US think tank, comes at things from the potential impact the sovereign debt crisis is likely to have on the European banking system.

“Although Europe’s peripheral economies are relatively small in size, their overall public and private sector debt is large. A substantial portion of that debt sits on the balance sheets of West Europe’s banking system. As such, the present debt crisis in the European periphery has the potential to precipitate a major European banking crisis that would almost certainly reverberate throughout the global financial system. It would do so in much the same way as the 2008 sub-prime crisis in the United States precipitated a global banking crisis.”

Of course, having the potential to inflict misery is not the same thing as actually inflicting misery. If the EU is able to hang together and provide continuing support to its more troubled members, then the present debt crisis shouldn’t get out of hand. However the Legatum Institute does not have much confidence in this “shoring up” process. It’s analysis of the problem is identical to Trichet’s but it goes on to make a very important point:

“The major part of the periphery’s budget deficits constitutes “primary” or non-interest payment transactions. As such, even a far-reaching debt restructuring can at best be viewed as a partial solution to the periphery’s budget problems in the sense that it will not obviate the need for further substantial budget retrenchment. Countries in the periphery might do well to consider the advantages of an early exit from the Euro, which might facilitate the needed fiscal adjustment without provoking the deepest of domestic economic recessions.”

This is undoubtedly the Achilles Heel of the Eurozone. The break, if it comes, is not likely to come from the fact that the big hitters in Europe lose heart or patience. It is far more likely that the popular mood in one or more of the peripheral countries, Portugal, Italy, Ireland, Greece and Spain, will flare up against the extreme – and more or less unending – austerity being forced upon the periphery by the centre.

As the Institute points out, the PIIGs suffer from a solvency problem, rather than a liquidity problem. “(A)bsent a debt restructuring and an exit from the Euro, the correction of the periphery’s public finances cannot be achieved without provoking the deepest and most prolonged of domestic economic recessions. Papering over these solvency issues by simply advancing these countries large amounts of EU-IMF official financing will not address their underlying solvency problem.”

Further bailouts just kick the can further down the road. They postpone a default and the inevitable “full-blown banking crisis in Western Europe” that a default would bring about. But bailouts cannot solve the solvency problem. Only a massive lowering of state spending, with all that means in terms of a huge drop in the living standards and social safety nets of the citizens of the PIIGS, can solve that.

The logic of this solution also entails substantial wage “adjustments” to make the periphery more competitive. So far, no democracy in the Western world has succeeded in both dramatically lowering the living standards of the majority of its voters and retaining its position in government. You have to be a dictatorship or a one party state to pull off that kind of trick. We are in for an interesting couple of years…

Further reading on the Eurozone sovereign debt crisis and the European economy:


Tags: banking , central banks , economic recovery , EU , fiscal union , sovereign debt
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