The future ofEuropefrom this point in its history has both an economic and a political dimension. In this article I consider only its economic dimension.
On 1 January 1999, 17 of the 27 countries in the European Union created the eurozone with a common currency – the Euro. The Euro was considered an important milestone in the European integration project. The eurozone united money markets without, however, at the same time uniting their fiscal systems.
Many free market economists opposed the formation of a common European currency on two grounds. First, it would not allow weaker members enough levers to adjust to various idiosyncratic shocks they would inevitably face. Second, it would lead to the creation of a vast Leviathan government bureaucracy. Recent developments showed this view has turned out to be correct. So canEuropesolve the liquidity crisis in the money markets and the solvency crisis of the countries in its southern periphery?
Table 1 gives the current account balance of the 17-country eurozone area with the rest of the world in the past two decades. The average annual current account balance were USD3,720 millions in the period 1991-2000 and USD24,322 millions in the period 2001-2010. In each of the two decades the eurozone area had surpluses and the amounts had increased by a staggering factor of six times. This means that the eurozone area was actually exporting capital to the rest of the world. There is not shortage of capital in the eurozone.
Germany Benefits from Euro
The overall situation of current account surpluses in the eurozone area masks the deep structural divergence that took place over these two decades between the core eurozone countries in the north and the southern periphery countries. Table 2 presents the list of average annual current account deficit and surplus countries in the eurozone area for the two past decades. Table 2 also provides the amount of the current account balance in USD and a ranking of the size of the deficits and surpluses among 170 countries in the world for which current account balance figures are available (such figures are not available for Belgium in the 1990s).
The most significant change is that Germany and Austria went from being deficit countries in the 1990s to become surplus countries in 2001-2010. In particular, Germany changed from being the second highest ranked current account deficit country to become the second highest ranked current account surplus country in the world.Germany’s average annual deficit was USD 21.3 billions in the first decade and its average annual surplus was USD 139.4 billions in the second decade.
In the first decade,Germany’s current account deficit was even worse thanSpain,Portugal, andGreece. Part of the problem was the effects of unification at the price of replacing the East German Mark with the Deutsche Mark at par value. In the second decade, German competitiveness was raised by outsourcing production to Eastern Europe and by holding down domestic wage increases. But a significant advantage for Germany was the enormous advantages of the Euro as the single currency. Nearly all ofGermany’s growth in the second decade can be explained by its rising trade surplus which, given monetary policy driven almost exclusively by the needs of slow-growing and consumption-repressedGermany, came at the expense of the rest ofEurope.
At the same time,France,ItalyandIrelandwent from being surplus countries in 1990s to become deficit countries in 2001-2010. What explains the change in their economic performances? The current account deficits for Spain, Portugal and Greece also increased many folds over the two decades, especially for Greece. Note also the case of Austria, a country with policies that mirror that of Germany, and shares the same German pattern of switching from deficits in the 1990s to surpluses in the first decade of the 2000s. The evidence thatGermanybenefitted from the Euro at the expense of peripheralEuropeis compelling.
So how can we explain the European crisis? One commonly held view is that it was caused by the dysfunctional social-political systems which encouraged the irresponsible spendthrift habits of Europeans living in the periphery, in sharp contrast to the hard-working and thrifty habits of those in the countries of the center. According to this theory it is unfair to demand Germans to clean up the mess.
The problem with this view is that it fails to explain what happened after the year 2000 to cause Italians, French and Irish to change their behavior to turn current account surpluses into deficits, and to turn ordinary Greeks, Portuguese and Spaniards to run even larger deficits. The view that the periphery countries had spendthrift habits is undoubtedly true, but why did their behavior made a turn for the worse after 2000. And why did the Germans suddenly morphed after 2000 to turn deficits into surpluses.
An alternative view is that the imbalances were caused by the creation of the Euro and the gearing of monetary policy to German needs at the expense of the periphery, which led to the severe internal imbalances. These imbalances created employment growth in the countries that suppressed consumption, and forced the countries that did not do so to choose between accumulating debt and precipitating unemployment. Of course since the periphery countries had no control over monetary policy, the choice was largely made for them by the European Central Bank with its excessively low interest rates, and their debt levels surged in consequence.
This alternative view is straightforward, and if it is correct, it places responsibility for saving the Euro squarely inGermany’s hands. The only way to save the Euro (and incidentally to prevent Germany’s banks from being forced to absorb huge losses on peripheral European debt) is for Germany to spur consumption and investment enough to reverse the current account surplus. This would require the European Central Bank to embark on an expansionary monetary policy. Only this will allow peripheral Europe to grow and to earn the euros needed to repay the debt. Mario Draghi, the new head of the European Central Bank, is offering a simple deal: if fiscal policy becomes hawkish, monetary policy will be dovish.
Maintaining Investor Confidence
The misalignment of internal real exchange rates betweenGermanyand the periphery means there is a balance-of-payments crisis, even though the current account balance of the eurozone with the rest of the world has been largely in balance since the year 2000. The crisis will be over, if and only if the periphery countries regain competitiveness and economic growth. This will of course take time. At present, their structural external deficits are simply too large to be financed voluntarily.
One has to make a distinction between a liquidity crisis and a solvency crisis. The periphery countries in Europe are experiencing a solvency crisis on account of the large fiscal deficits they are running and the huge public debts that have been accumulated. Providing additional foreign borrowing to these countries will simply postpone the eventual debt restructuring and forgiveness. It will ensure many years of stagnation. It will not reduce the threat of default.Greeceneeds to restructure its debt, and so doesItaly.
Europeis not short of capital and in fact is a net exporter of capital. The reason peripheral European governments cannot get financing is not because there is a lack of capital or liquidity, but simply because their solvency is questioned by investors.
To put it in different terms, if California experiences a solvency crisis, it should default and restructure its debt. If it experiences a liquidity crisis in which it is unable to bridge a short-term financing gap, it should turn to the US government, or more likely to its creditors. The same logic should be applied to Europe’s periphery economies. Unfortunately, one of the unresolved problems withEuropeis whether it is a single country.
If it is thenItalyis just the European California and should not have to turn to the IMF orChinafor help. If Europe is a collection of separate countries then anyone of them can go to the IMF, in which case the IMF should be free to propose currency devaluation as one of its conditions for lending. Europe now appears to be neither thanks to s semi-finished integration project. This ambiguity is what the market is most troubled with.
IfEuropeaspires to continue with its integration project then it must save the Euro. It means the European governments should help out whichever government that is the European California. The European integration project may be misguided, but a catastrophe in the markets would plungeEuropeinto another recession, and hurt badly the world economy as well?
Joint Responsibility for Public Debts
In the end this isGermany’s crisis to resolve. If the Germans come to saveEurope, they must reverse their policy, loosen up monetary policy, and start running large current account deficits even if that comes with slower German growth.
Taking this path means that for some or all of the sovereign debts of individual member countries have to be replaced by Euro bonds guaranteed by the European Union as a whole (mainlyGermanyandFrance). Germany’s Council of Economic Experts has proposed joint liability for all eurozone debt above 60% of a country’s GDP, while each country would still have to manage payments on its debt below this threshold level. Even with high interest rates of 7% or more, weaker countries might be able to manage interest payments on debt equal to 60% of its GDP. Presumably the interest rates will fall when the European Union is guaranteeing a good portion of the total debt. The European Union’s share of the debt would be paid off over a 25-year time period through tax revenues set aside for this purpose.
In the short run this is likely to reduce significantly the crisis. This is especially so if taxpayers in Germany and elsewhere do not rebel either at the additional taxes they will have to pay to fund the sovereign debts of weak members, or if banks get off lightly despite their risky investments in sovereign debt. In the longer run, this plan for Euro bonds backed by joint liability of European Union countries would require joint control over issue of debt above the 60% mark since that debt would be the obligation of all eurozone countries.
China Can Have a Larger Role
This would necessarily lead to some type of at least temporary fiscal union regarding sovereign debt issue. Many have recognized that fiscal union is a necessary part of any long-term solution to maintaining the Euro. The Euro bond approach set out in the previous paragraph is an indirect way to achieve at least partial fiscal union. It will be helpful in the short run.
If Europe no longer aspires to continue with the European integration project now then the Euro will break apart and peripheral Europe will almost certainly default on its obligations toGermany. Two or several currencies will emerge. A return to separate currencies in the middle of the crisis is likely to be highly disruptive.
Either way Germany loses. And the choice may not be entirely Germany’s alone. Europe must let the market know which way it is heading quickly. And time is running out.
China’s position at the last G20 meeting is the correct one to take. Europe must decide. And until it does China will be waiting. Why should China lend to a periphery country that will not be able to repay? But if Europe is asking China to lend into a fund that is effectively guaranteed by Germany, then there should not be much Chinese reluctance. In that case,Europehas made known its decision to save the Euro and to continue with the European integration project.
In that case Europe does not really needChina’s money. Germany probably would have little difficulty in borrowing on its own. But bringing in Chinese money would be good politics to sell the decision to save the Euro to domestic taxpayers. Engineering an appropriate platform forChinato participate needs a great deal of persuasive story telling to reassure a highly skepticalUSgovernment.
China should use current events to play a bigger and more decisive role in global finance, and that as a surplus nation it is very much inChina’s interest to provide financing to the eurozone. And America should also see a resolution of the European crisis where China can have a positive role to contribute as an opportunity to build mutual trust in a crisis where everyone has a huge stake. But the main issue is thatEuropemust decide what it wants to do with its integration project.
Whether fiscal union alone will preserve the Euro in the long run remains in doubt. Weaker member nations will continue to be stressed by shocks to their economy and to their fiscal balance sheets, with many of these shocks not easy to anticipate in advance. The crisis helps demonstrate that a common currency makes adjustment to individual country shocks far more difficult than when countries can devalue their own currencies. This will continue to be a crucial weakness of the Euro unless labor and product markets become much more flexible in the eurozone, and unless labor mobility across member nations increases greatly. But this is not going to be today’s urgent problem.