Today’s financial headlines show the crumbling of the edifice of the Euro zone. Greece is in full blown depression; Spain is nearly there, as the shrinkage of its economy is accelerating and the country plans a fiscal tightening of 10 percent over the next two years. The Euro has fallen under $1.21, below its long-term average; European markets have fallen today by almost 3%.
The futility of current policy in the EU is manifest. Every policy measure hailed as a way out has failed to stem the decline in confidence. The grand summit at the end of June seemed to promise a 100 billion Euro recapitalization of Spain’s banks without requiring harsh new austerity or piling new debt onto the Spanish government. In fact, as German chancellor Merkel revealed when she submitted the plans for approval to the Bundestadt, what she meant (apparently she had her fingers crossed behind her back at the summit) was that Spain’s government would initially be responsible for the full amount of any assistance, and would have to submit to harsher austerity measures than ever before to qualify for a new stability mechanism that would (at some unknown time in the future) take responsibility for both supervising European and Spanish banks and shifting responsibility for the bailout from the shoulders of Spain’s government to a Eurostability fund. The result — three weeks after measures designed to hold down Spain’s costs of borrowing the yields on Spanish 10-yr bonds have soared to over 7.5% Meanwhile, the flight to safety has driven yields on 10yr US treasuries to 1.4%, and German bonds even lower.
Why has every measure failed so badly? Sadly, this was all predictable (as indeed we have been predicting). The logic is elementary: Germany and northern Eurozone countries have insisted that weak Eurozone countries pay off their state debts, instead of defaulting or reducing them. How to do so? Lower state spending and raise taxes, and that will provide a greater margin to pay off the debt. Right? Wrong! That is a static analysis — if an economy is stable and growing, then raising taxes and lowering state spending will yield increased state revenues. But in a dynamic analysis, one has to take account of both the direction of the economy and the impact of the fiscal measures being taken. Weak economies have been shrinking due to private deleveraging and other structural factors creating a long-term slowdown (see my analysis in TheAtlantic.com). Under those conditions, there is a built-in tendency for state revenues to fall and required social spending to grow; thus any hypothetical gains from cutting spending and raising taxes may be offset by the dynamic of the economy. In addition, if the state spending cuts and tax increases are large enough, they themselves will have a further contractionary impact on the economy, further driving down the eliminating the gains in state revenues hoped for.
What has been the response of European policy-makers to this dilemma? Fantastically and tragically, they have tried to get ahead of this dynamic by pushing weak economies to cut spending and raise taxes ever more harshly, hoping that at some point a magical rebound will occur and lead to debt benefits. But the world is not magical. The combination of deleveraging and structural adjustments plus harsh austerity measures has pushed recessions into depressions (shades of the 1930s!) and the resultant fall in government revenues and increases in required spending for social support has led to increases in states’ debts and a rise in their borrowing costs — the opposite of what was desired.
How long before policy makers realize the folly of their past actions? Extending the days before reality is recognized has simply led to piling up more and more debts to draw things out, with Germany itself (the rock on which the Euro stands) becoming ever more liable for the emergency measures and debt extensions (no wonder that Germany’s equity market is down 3.4% today; if the jig is up Germany will be damaged too).
In the days of monarchies, it was common to sacrifice the interest of people to the interests of the state. “L’etat est moi” (the state is ME) Louis XVI proclaimed; his glory was the glory of France, and if the peasants and workers had to pay for the glory, that was life. The democratic and constitutions revolutions of the 18th and 19th centuries were supposed to reverse all that — and make the interests of the people primary. At some point in Europe, the welfare of the people has to start taking priority over the debt of states. that means state debt must be reduced (whether written off by default or shrunken by inflation or currency revaluation, the latter two of which would require breaking the Euro).
The European single market is, in population and GDP, the largest rich country market in the world, bigger than the U.S. Until Europe faces its reality, writes off its weaker nations’ debts, and starts to grow again, the entire world economy will struggle to return to normal growth.