Grave euro doubts remain

Published in Business Spectator (Melbourne), 19 August 2010

The stronger the fears about a double-dip recession in the US grow, the better it looks for the euro. Only a few months ago, experts were discussing the possibility of a quick break-up of Europe’s monetary union. The same experts have now shifted their attention to the US dollar. However, this does not mean that the euro is off the hook. Far from it.

The public drama may have disappeared from the international scene, but those closely following developments in the Old World are still spotting harbingers of severe difficulty. Monetary union was meant to unite Europe. In reality, it is driving European countries further apart. It is for this reason that even seemingly positive news can mean trouble.

Last week’s German growth figures were a good example. Under normal circumstances they would have been a reason for celebration. Driven mainly by exports to Asia, the German economy grew by 2.2 percent in the second quarter.

For the whole year, research institutes are now expecting a growth rate near the 4 per cent mark. These are fantastic figures for an economy that only a few years ago was dubbed ‘the sick man of Europe’.

Unfortunately, circumstances are anything but normal and so celebrations of Germany’s strong performance have been muted. The reason why Germany’s excellent data are not unproblematic is that they are very different from the growth rates in other parts of Europe. From April to June, Spain virtually stood still at 0.2 per cent growth while the Greek economy actually contracted by 1.5 per cent.

If the euro crisis earlier this year has taught us anything, it is that such differences between European countries were the root of the monetary union’s problems. Instead of being an area in which economic data converged, the euro zone countries were becoming more different over time. Nevertheless, they were still united under a one-size-fits-none monetary policy.

It now looks likely that such divergence will persist for a long time. While Germany benefits from a combination of a low exchange rate and strong demand for its products from Asia, other European economies are implementing painful austerity packages and consequentially experience sluggish growth. As a result, the gap between them is widening.

UBS analysts have just revealed what this means for Europe. In their August Research Focus report they point out that Europe has disintegrated into three quite distinct groups of economies. The first consists of countries with minor fiscal deficits and substantial current account surpluses. These are the countries best able to compete globally: Austria, the Netherlands, Germany and Finland.

A second group has higher budget deficits and a weaker current account position. To this group belong countries like France, Belgium and Italy.

The real problems, however, lie in the European periphery, UBS’s third group. These economies are the least competitive as evidenced by massive current account deficits. They are also the countries with the worst fiscal positions. In this category we find Spain, Portugal, Ireland and Greece.

As the UBS report explains, the problems of the European periphery are not predominantly fiscal: “The peripheral nations’ problems are routed primarily in the private sector – as the one size fits all euro zone interest policy encouraged various consumer and housing booms,” the UBS experts write. The economic crisis revealed how uncompetitive the productive sectors of these economies had become during the boom years. Thus the most important challenge for the European periphery is not fiscal consolidation but restoring their competitiveness.

Under normal circumstances, this would have happened almost automatically through an adjustment of the exchange rate. Unfortunately, this path is now blocked by their membership of the euro.

This only leaves two alternative options. Either the euro area transforms into a transfer union in which the members of the first and maybe even the second group keep the periphery afloat. Or the countries of the third group will bring about a real devaluation of their wages and prices through tough austerity measures, tax increases and economic reforms. A quick glance at some of the events of the past weeks shows that neither of these options is particularly likely.

Last week, the Slovak parliament voted against the country’s participation in the EU bailout package for Greece. Remarkably, only two MPs were prepared to approve Slovakia’s modest contribution. Although the package will still go ahead without the funds from Bratislava, the Slovak decision carries wider significance. It marks the end of pan-European solidarity. Full-blown fiscal federalism on a European scale looks virtually impossible now. If the Slovaks refuse to pay for the periphery, why should the Austrians, Dutch or Germans do so?

Meanwhile, the beneficiary of the package rejected by the Slovaks shows why real devaluation may not work, either. Since the beginning of the year, there have been no fewer than six general strikes in Greece. In July, a strike of truckers brought the country to a near standstill and caused severe fuel and food shortages. Hardly a week goes by without protests against Athens’ measures. All this is happening at a time when the Greek government’s reforms have barely just begun. Whether they will eventually succeed in restoring Greece’s competitiveness is a different question altogether. In other words, the strategy real devaluation strategy preferred by the EU Commission and the IMF may fail – and not only in Greece but in other periphery countries as well.

There are good reasons for grave doubts about the future of the euro. As the pressures build up, one or more countries may come to the conclusion that they would be better off outside the euro.

For this case the UBS experts have a bold advice, namely that Germany would be “the most sensible leaver”. Only a German exit from the euro zone would free the rest of the continent from its monetary straightjacket. Once Germany had left, the others could devalue and finally regain their competitiveness.

But UBS also states why such a sensible solution will not happen: “The union’s main motivation has always been political.” Which is a nicer way of saying that economic rationality has never been a significant factor in Brussels.

Europe may have become an economic disaster zone. But at least the economic illiteracy of its leaders keeps it somewhat predictable.

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