By Simon Johnson
Most of the current policy discussion concerning the euro area is about austerity. Some people – particularly in German government circles – are pushing for tighter fiscal policies in troubled countries (i.e., higher taxes and lower government spending). Others – including in the new French government — are more inclined to push for a more expansive fiscal policy where possible and to resist fiscal contraction elsewhere.
The recently concluded G20 summit is being interpreted as shifting the balance away from the “austerity now” group, at least to some extent. But both sides of this debate are missing the important issue. As a result, the euro area continues its slide towards deeper crisis and likely eventual disruptive break-up.
The underlying problem in the euro area is the exchange rate system itself – the fact that these European countries locked themselves into an initial exchange rate, i.e., the relative price of their currencies, and promised to never change that exchange rate. This amounted to a very big bet that their economies would converge in productivity – that the Greeks (and others in what we now call the “periphery”) would in effect become more like the Germans. Alternatively, if the economies did not converge, the implicit presumption was that people would move – i.e., Greek workers go to Germany and converge to German productivity levels by working in factories and offices there.
It’s hard to say which version of convergence was more unrealistic.
In fact, the opposite happened. The gap between German and Greek (and other peripheral country) productivity increased, rather than decreasing, over the past decade. Germany, as a result, developed a large surplus on its current account – meaning that it exports more than it imports. The other countries, including Greece, Spain, Portugal and Ireland, had large current account deficits – they were buying more from the world than they were selling. These current account deficits were financed by capital inflows (including from Germany but also through and from other countries).
In theory, these capital inflows could have helped peripheral Europe invest, become more productive, and “catch up” with Germany. In practice, the capital inflows – in the form of borrowing – created the pathologies that now roil European markets.
In Greece, successive governments overspent – financed by borrowing — as they attempted to stay popular and win elections. Some of these same politicians will likely return to power following the elections last weekend.
Greece has already adopted a considerable degree of fiscal austerity. Now it needs to find its way to growth. Cutting the budget further won’t do that. “Structural reform” – a favorite phrase of the G20 crowd – takes a very long time to be effective, particularly to the extent that it involves firing people in the short-run. Throwing more “infrastructure” loans from Europe into the mix – for example, via the European Investment Bank – is unlikely to make much difference. Additional loans of this kind are likely to end up being wasted or stolen as more and more well-connected people prepare for the moment when the euro is replaced by some form of drachma.
In Spain and Ireland, capital inflows – through borrowing by prominent banks – pumped up the housing market. The bursting of that bubble has contracted their real economies and brought down all the banks that gambled on loans to real estate developers and construction companies. Their problems are not much to do with fiscal policy. As conventionally measured, both Ireland and Spain had responsible fiscal policies during the boom – but they were building up big contingent liabilities, in the form of irresponsible banking practices.
When the banks blew up in Ireland, this created a fiscal calamity for the government – mostly due to lost tax revenue. It remains to be seen if Ireland can now find its way back to growth.
Spain still needs to recapitalize its banks – putting more equity in to replace what has been wiped out by losses — and, most important, must also find a renewed path to private sector growth. Investors are rightly doubtful that the current policies are pointed in this direction.
In Portugal and Italy, the problem is a long-standing lack of growth. As financial markets become skeptical of European sovereign debt, these countries need to show that they can begin grow steadily – and bring down their debt relative to GDP (something that has not happened for the past decade or so). Fiscal austerity will not help, but fiscal expansion is also unlikely to do much – although presumably it could boost headline numbers for a quarter or two. The private sector needs to grow, preferably through exporting and through competing more effectively against imports.
Peripheral Europe could, in principle, experience an “internal devaluation”, in which nominal wages and prices fall, and they become hypercompetitive relative to Germany and other trading partners. As a matter of practical economic outcomes, it is hard to imagine anything less likely.
Some politicians still hint they could produce the rabbit of “full European integration” of the proverbial magic hat. What does this imply about quasi-permanent transfers from Germany to Greece (and others)? Who pays to clean up the banks? What happens to all the government debt already outstanding? And does this mean that all Europe would now adopt German-style fiscal policy?
These schemes are moving even beyond the far-fetched notions that brought us the euro. “Europe only integrates in the face of crisis” is the last slogan of the euro-enthusiasts. Perhaps, but crises have a tendency to get out of control – particularly when they produce political backlash.
Most likely, the European Central Bank will provide some big additional “liquidity” loans to bring down government bond yields as we head into the summer. We should worry about how long any such feel-good policies last. Historically, August is a good month for a big European crisis.
At these difficult times approach, some people will admonish governments to stand up to markets. But when you are relying on capital markets to finance a large part of your continuing budget deficit and your debt rollover, this is empty bravado.
European governments should never have put their heads so far into the lion’s mouth with regard to public sector borrowing. But the politicians – and many others – convinced themselves that they were all going to become more like Germany.
Peripheral Europe will never be like Germany. It’s time to face the implications of that fact.
An edited version of this post appeared this morning on the NYT.com’s Economix blog. It is used here with permission. If you would like to reproduce the entire blog post, please contact the New York Times.