Setting the stage lights for Europe’s second crisis

Published in Business Spectator (Melbourne), 3 July 2014

Last week, I wrote about Angela Merkel’s declining influence in Europe. For a number of domestic and international reasons, the German Chancellor can no longer enforce austerity and economic reforms in the eurozone. She is already past the peak of her power, I concluded.

What I did not say explicitly was what all of this meant for the euro crisis. This triggered Robert Gottliebsen later to send me an email asking me what would happen if austerity is out and big spending in. Does the euro fall? Does that solve the Greek and Italian problem? And what about the German courts? Would they allow all of this to happen?

To Robert and other readers asking similar questions, I cannot offer any precise answers. Not just because predictions are inherently difficult as far as they concern the future. The added complication about predictions in the euro crisis is that we are not dealing with purely economic problems but political decisions.

Whenever I am asked to predict the future of the euro, I usually reply that you should not ask an economist about it. Had it been up to (the majority of) my profession, the euro would have never seen the light of day. However, being a bad economic idea did not stop it from happening politically. Similarly, even though most economists would still conclude that the euro area is far from an optimum currency area and the currency is poorly designed, there is no guarantee that the euro could not be kept alive for a long time provided there is political will to do so.

In short, if you want to know the future of the euro, you might want to skip the economists and consult with an astrologist of your choice. It is not because economists would not understand what is going on but only because we do not make the decisions. Politicians do. Having said that, there are a few developments we can predict with some confidence if indeed, as I observed last week, austerity is losing its main political proponent in Angela Merkel.

There were many factors that together triggered the original euro crisis in late 2009 and early 2010. Chief among them was growing doubt that European economies and their governments would be able to service their enormous debts. Added complications were the lack of enforced (or even enforceable) fiscal rules for the eurozone, a severe banking crisis, huge differentials in productivity across the continent and the resulting balance of payments and trade imbalances – all of this coupled with a palpable absence of political leadership, both at the national and the EU levels.

Looking at the eurozone today, it is obvious that many of these original conditions are still present. Not much has changed over the past five years and yet the panic, which accompanied the initial phase of the euro crisis, has disappeared. That is not least due to various stopgap measures of a fiscal or a monetary nature.

By now, you would need a dictionary for all the various programs that have been introduced to contain the euro crisis: EFSF, ESM, LTRO, TLTRO, OMT, SMP, ELA, SSM, to just name the most important. What they all had in common was that they were in effect buying time to get the euro crisis under control. The idea was to give Europe’s economies a chance to reform, lift their competitiveness, and reduce their indebtedness.

What none of these programs did was address the underlying issues of Europe’s economies. That was supposed to happen through reform and austerity. Financial assistance was only supposed to help countries through this process. It certainly was not meant to be an indefinite, open-ended policy.

Unfortunately, the stopgap measures have been too successful for their own good. By taking the heat out of the euro crisis, they have reduced yields on periphery bonds which made it easier for eurozone countries, even the most indebted ones, to refinance. This also reduced the pressure on them to implement any meaningful economic reforms, which had been unpopular in any case. The backlash against reform and austerity, therefore, is unsurprising. Why continue taking the bitter medicine once the symptoms of the disease are gone?

We should not forget, however, that the symptoms of the euro disease have only been supressed but the diseases has not been cured. Quite on the contrary, one could argue that the problems are worse today than they were in 2009 when everybody was in a panic about the euro’s imminent collapse.

The best indication is the naked data on Europe’s indebtedness. After five years of supposed austerity, debt levels in Europe have gone up, not down. According to European Commission data, in six eurozone countries (Greece, Italy, Portugal, Ireland, Cyprus and Belgium), debt to GDP levels were above 100 per cent in 2013. On their current trajectories, Spain and France could join this club in a couple of years.

A relaxation of austerity rules, as it is now proposed, will only accelerate Europe’s march into the debt trap — a trap from which there is no escape but inflation or default. Is this unavoidable? Maybe not technically but for a country like Italy on 132 per cent debt-to-GDP with no growth and an adverse demographic profile, it is hard to see a more plausible option.

The end of Europe’s short-lived era of reform and austerity will therefore lay the foundations for the next stage of the euro crisis. We are likely to see renewed doubts about Europe’s fiscal viability and speculation on euro periphery debt. This would then also trigger questions about the future of the euro as a currency.

Of course, the European Central Bank can (and will) try everything to stop a new crisis from escalating, just as it has done so far. It can create more money to pass on to banks which lend it to governments. Similarly, fiscal policy can also invent new bailout schemes or extend existing ones. Such policies can continue as long as there is political will to do so. But the required interventions to keep a dead currency alive and bankrupt banks and governments solvent will need to become more extreme over time.

Which leaves Robert’s final question about whether the courts, in particular the German Constitutional Court, would let this happen. Unfortunately, even seasoned observers of the courts cannot forecast this with any certainty either.

Where are the qualified and reliable euro astrologists when you need one? Don’t count on me. I am just an economist.

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