Speech delivered to the Centre for Independent Studies (Sydney), 30 August 2011

Almost two years ago, Robert Carling and I predicted that the next big economic crisis would happen on both sides of the Atlantic. We are witnessing exactly that. Tonight, I am going to predict how the current European debt crisis is going to unfold.

Predictions are, of course, always difficult. The added difficulty with the European debt crisis is that it’s economic andpolitical. If Europe’s debt problems were confined to economic issues, they would be much easier to fix.

Europe’s economic issues involve a large number of discrete political actors: 27 EU member states and 17 Eurozone member states, each with its own government and parliament and some with constitutional courts. Then there is the European Parliament, the President of the European Council, the head of the Euro Group, the high representative of the European Union for foreign affairs, the European Commission, the European Central Bank, the European Financial Stability Facility, and the International Monetary Fund. And let’s not forget the markets, big institutional investors, ratings agencies, banks, insurance companies, lobby groups, the media, and individual companies. That discussions about the future of the Euro are held in French, German, English, Spanish, Italian and other languages probably does not help, either.

All in all, we are looking at a system of enormous complexity in which no single institution or person is in charge of dealing with the euro crisis. This chaos, although fascinating armchair entertainment, makes it difficult to predict the future of Europe.

Nevertheless, I am going to take a stab at a plausible scenario.

The topic tonight is of course ‘Trans-Atlantic Fiscal Follies: The Sequel,’ but I will also have to talk about ‘monetary follies’. In any case, the distinction between fiscal and monetary policy does not hold any longer in Europe now that the European Central Bank has become involved in the business of indirectly funding mainly Southern European governments through sovereign debt purchases.

Europe is not facing one crisis but at least three separate but interrelated crises. They are interrelated but not identical.

The first crisis is the most apparent: the debt crisis. Many European countries—not just Greece and Ireland but also stronger countries such as France and Germany—are heavily indebted. The official average debt of the Eurozone stands at more than 85% of GDP. The European Stability and Growth Pact allows a maximum of 60%—a level that many economists regard as the most that a country can reasonably sustain without debt becoming a burden on growth.

The second crisis is a crisis of monetary union. The European Union consists of 27 member states, 17 of which share the euro as their common currency. Economists have long argued that such monetary unions between countries can work only in an ‘optimum currency area’. Such an area is characterised by labour mobility, price and wage flexibility, the possibility of horizontal fiscal equalisation, and synchronised business cycles. The conditions in the Eurozone are far from these optimum conditions. On the contrary, Greece and Germany or France and Portugal share little else except their joint euro membership. Despite this, they are operating under the same interest and exchange rates. These rates are too high for some members and too low for others, making it almost impossible to get the monetary policy just right for the whole continent. European monetary policy will always favour some countries at the expense of others.

The third crisis is of the lack of competitiveness in the European periphery. There have always been structural differences in Europe. Previously, such differences in competitiveness were reflected in long-term adjustments of exchange rates. The slide shows how strong these developments were by comparing the exchange rate of the German mark to other currencies in 1963 and then, 35 years later, in 1998 at the eve of monetary union:

	France 100 FRF	Italy 1000 ITL	Spain 100 ESP	UK 1 GBP	US 1 USD
1963	81.36 DM	6.41 DM	6.65 DM	11.16 DM	3.99 DM
1998	29.82 DM	1.01 DM	1.18 DM	2.91 DM	1.76 DM
Devaluation	-63.3%	-84.2%	-82.3%	-73.9%	-55.9%

The massive devaluations of other currencies against the German mark indicate the very tight monetary policy regime of the old German Bundesbank and the high competitiveness and productivity of the German economy compared to the rest of Europe.

European economies like Italy and Spain but also France, had to continually devalue their currencies to remain competitive with Germany. Once the monetary union was introduced, such devaluations were no longer possible. Germany’s neighbours had to make themselves more competitive by reforming their product and labour markets, deregulating their economies, and improving their whole system of governance. Sadly, this never happened.

In addition to the three simultaneous crises of debt, monetary disparities, and competitiveness, there is a fourth crisis waiting to happen. Europe’s banks are undercapitalised, and in their current state they would not be able to absorb a sovereign default. The last round of the EU banking stress test, tellingly enough, did not even attempt to model such an event.

The economic problems for European policymakers are compounded by the added complication of the political desire to persevere with the project of monetary union at all cost. If countries like Greece left the Eurozone, it would bankrupt many of the banks who have lent money to Greece. At least that’s what France fears.

Germany fears something completely different—that a departure of weaker Eurozone members would lead to a massive appreciation of the euro and undermine the competitiveness of German exports. With exports accounting for almost 50% of Germany’s GDP, the Germans rightly fear losing the competitive advantage of their subdued exchange rate.

At the same time, neither France nor Germany has an interest in permanently paying for weaker Eurozone countries. The French can’t afford it and keep their AAA rating; the Germans don’t want to be punished for their economic strength.

An analysis of the specific national interests of all Eurozone member states shows how different they are.

The Italians and the Spanish demand the introduction of eurobonds—jointly guaranteed government bonds—so they can pay lower interest on their own government debt. The Germans and the Dutch reject this because it would increase their borrowing costs.

Here’s another example: inflation rates are moving in different directions in the Eurozone. In the last quarter, inflation went up in Germany, Belgium, Estonia, the Netherlands, Austria and Finland but fell in other Eurozone economies. Consequently, there are calls for monetary tightening in some countries while others need to avoid it at all cost.

The Eurozone crisis is so messy because the interests of the different players are not only discrete but completely incompatible. Worse, there is no one solution that would work for everybody.

This is the main reason why for the past one and a half years, EU policymakers have only been buying time while glossing over the most acute problems of the Eurozone. First, they gave financial assistance to Greece so that its crisis would not spread to other countries. Then the European Central Bank tried to drive down yields on euro periphery bonds by purchasing them on the secondary market.

This strategy failed for Ireland and Portugal. Both had to seek refuge under the umbrella of the European Financial Stability Facility. However, that did not calm bondholders’ nerves for too long, and eventually the European Central Bank extended its bond purchases to Spain and Italy.

There is a pattern in these policies. European governments and the European Central Bank get involved only when it becomes absolutely unavoidable to avoid imminent disaster. And even then, they only do what is needed to calm the crisis for a few weeks without ever addressing the underlying fundamental problems: debt, monetary union, and the competitiveness divergence.

The question now is for how long can this game continue. Can Europe just keep kicking the can down the road? Is there a limit to buying time? Will it eventually find a real, lasting solution to its three crises?

The answer to these questions is simple. Yes, Europe has been kicking the can down the road. But it has reached the crossroads where markets are forcing it to decide between abandoning the project of monetary union in its current form or moving towards a full fiscal and political union.

Faced with this choice, I am convinced that they will give up monetary union. I don’t believe the euro will survive another year in its current form, mainly because of the diverging interests I described earlier.

Markets are nervous about the ability of some European governments to service, let alone repay, their debt. In my mind, rightly so.

Greece is by any account bankrupt. Its debt to GDP ratio is so high that it will never be able to restore it to a sustainable level. The Greek economy is shrinking; unemployment is rising; and bar a 20% internal devaluation, the country will not be able to compete with its European neighbours. A Greek default is inevitable.

Ireland has made progress but is still unable to finance itself in international markets at reasonable interest rates. The situation is even worse for Portugal, which has not seen any productivity growth for more than a decade.

These small countries could, of course, be kept alive by other Eurozone countries. But the crisis has now spread to the heavyweights of Italy and Spain. The European Central Bank has been purchasing Spanish and Italian bonds to drive down yields. This has had the desired effect but at great cost. And despite this, yields are rising again because markets sense that the European Central Bank is bluffing.

In order to permanently save Italy and Spain, a massive extension of the bond buying activities would be necessary. However, this ‘nuclear’ option by which the European Central Bank intervenes to the tune of a few trillion euros would not only be monetary madness—it would be politically impossible to communicate this to stability concerned Germans, Dutch and Austrians.

So what will happen once Italian and Spanish yields reach danger levels yet again?

I think there will come a point when the Germans will cut the cord. They will not allow their currency to be destroyed by continued quantitative easing (because that’s what it is), nor will they be willing to give in to a transfer union and eurobonds. This leaves only one way out: pulling the plug on monetary union. Besides, the political differences in Europe are so enormous that there can be no consensus for the alternative—a fiscal and political union.

It is difficult to forecast what will happen once the Germans pull out of the union, but it is plausible, perhaps even probable, that they will establish a new bloc of countries that share their commitment to monetary stability and greater fiscal discipline. This could be the new North Euro, consisting of countries like the Netherlands, Austria, Finland, Luxembourg, Estonia and Slovakia.

This solution would be painful to German manufacturers: it would require a recapitalisation of some banks holding Southern European bonds and may lead to greater tensions within the European Union.

On the positive side, this is the only solution that avoids the creation of a giant redistribution mechanism in Europe. It makes it possible for countries like Greece to regain competitiveness through default and devaluation, and it would be a way for Europe to dig itself out of its current mess.

This is the only plausible way Europe could deal with debt, monetary union and competitiveness differentials. It’s a shame they are going to exhaust all possible alternatives before taking this only workable solution to their three crises.