Too Bad about the Euro…

The big summit has come and gone — and Italian interest rates are already back over 6%.  So much for a dramatic rescue.  Moreover, Britain has essentially withdrawn from the EU as regards fiscal policy, in order to protect the prerogatives of the The City from the grasp of EU commissioners.    The hope that a united Europe would team up to rescue the Euro with a dramatic plan to rescue insolvent states has been dashed.

Some time was bought with a clever measure by the ECB.  While making it clear that the bank will not buy up sovereign debt, it lowered the costs and requirements for European banks to obtain funds from the ECB.  So if European banks can obtain unlimited funds at 2% or less, maybe they will use some of that money to buy Italian and Spanish bonds that yield 5-6%, and lock in profits that will help their bottom line.  That strengthens banks and helps maintain the market for soveriegn debt at reasonable levels.

Unfortunately, that only works as long as banks have confidence that Italy and Spain — not to mention Greece and Portugal — will in fact pay their debts.  Otherwise those bonds are worthless at any nominal interest rate.

And here is the biggest failure of nerve by European leaders.  They simply failed to address that problem as a whole, leaving it to individual states to figure out how to manage their debts and return to solvency.

The fiscal union pact is a promise to keep future promises, without clarity on how those promises will be made credible.  In effect, Germany extracted a promise from all European countries that they would ‘behave’ in the future, by keeping their fiscal deficits within manageable boundaries.  So what Germany got is a promise that it will not have to bail out its Euro partners in the future, because they will get their houses in order and manage their finances with German discipline.  How very nice!

But I have to ask two questions — what are the Euro partners getting in return for this promise?  Eurobonds backed by Germany — no!  Unlimited ECB purchase of their bonds — no!  Cash infusions to their governments to relieve their own fiscal stress — no!  As far as I can see, all they got is Germany’s seal of approval for their future behavior; but I do not see how that will convince the markets that anything has really changed today.  And since the Euro partners are getting so little, what is the reason their peoples and legislatures will accept the harsh austerity programs being asked of them in order to win German approbation?

There seems to be the old hope that if other states promise to match German discipline in the future, the confidence fairy will visit all the capitals of Europe and sprinkle growth dust on their economies.  This is tired nonsense.  The reality is that in exchange for German approbation that means nothing in hard cash or credit, European leaders have agreed to crush their own economies with harsh austerity measures that will reduce or remove near-term growth and make it harder for them to right their own finances.

Now, austerity might be a formula for financial recovery IF it was combined with some sort of debt-relief or Eurobond or ECB accommodation of existing debts.  But without those measures to manage existing debts, austerity measures will only pile up more debts and make the desired fiscal balancing recede further into the future.

There are two REAL reasons for the current fiscal crisis — first, countries (and banks) have borrowed (or loaned) money that they now cannot expect to repay (or get paid back).  The reason for that is that these funds were mis-invested in unsustainable housing bubbles in the US and southern Europe, or in state spending on non-investment items (pensions, wage support).  Those losses must be written off, or the debts inflated away, or both.  Second, the financial crisis in the US and Europe arrested growth, and their declining work forces and austerity measures will prevent growth from returning.  Without substantial economic growth, the resources needed to balance state finances in the future will not be forthcoming.  So there is a short-term problem (too much debt) and a long-term problem (not enough growth) that together mean countries and banks have unsustainable debts and losses and will, sooner or later, go bust.

The fiscal union pact agreed to in Europe this week is a promise not to engage in these behaviors again, and so to avert these problems in the future.  But there was no agreement on how to respond to these two problems causing the crisis right now!

Very soon, the markets will realize this, and take flight.  Strikes in Italy suggested that the austerity measures will be resisted.  We have yet to see any clear resolution in Greece as well.  European banks are also going to be stressed by their exposure to Italy, Greece, Spain, and Portugal.  In a matter of weeks, the credit structures of Europe are likely to seize up again, and all eyes will turn to Germany to say — you got what you wanted in December; now can we have our Eurobonds?  Or our use of the ECB as the lender of last resort for Euro economies?

Germany has sought and obtained the exact opposite of what is needed.  That is, Europe needs Germany to underwrite a rescue for the Euro zone.  Instead, Germany obtained promises that it would not now or ever in the future be necessary for Germany to use its resources to rescue the Euro.  Isn’t this odd?  The EU was founded in part to ensure that Germany’s interests would be subordinated to those of Europe as a whole.  Now this crisis has created a topsy-turvy situation where Europe’s interests are being subordinated to those of Germany!  And Germany is acting precisely in its own short-term interests, and not in the long-term interest of Europe.

Barring an unlikely and radical change in direction in Germany, the Euro now is doomed.  One can only hope that when the crunch comes, the ECB will — like the U.S. Fed in 2008 — do whatever is necessary to avert a complete meltdown of the global economy and come up with something equivalent to the TARP by acting first and worrying about legality later.  Otherwise, we are looking at the 1930s all over again…

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About jackgoldstone

Hazel Professor of Public Policy at George Mason University
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