Resuscitating the Euro

Resuscitating the Euro

The eurozone is down, but not out. There may yet be hope for the euro's survival.

For almost two years, the eurozone has been stricken with a potentially fatal malaise. Three crises have intermingled and reinforced each other: Greece, Ireland, Italy, Portugal and Spain face crises of excessive debt (public and private); those same countries suffer from anemic economic growth; and much of the European Union is afflicted with a banking crisis. The EU’s cumbersome decision-making procedures and poor political leadership have worsened all three. Every time EU leaders try to tackle them, they come up with solutions that prove to be too little, too late. The result of all this is that the euro’s survival seems at risk.

Over the past few weeks, however, the chances of the euro holding together may have grown. This is because Angela Merkel, the German chancellor, has said she wants a new treaty to enforce closer coordination of economic policy making.

In general, new treaties are a bad idea. They take years to negotiate and cannot take effect unless ratified by every member state through a parliamentary vote or referendum. There is always the risk that one country or another will block a new agreement. In any case, the current treaties contain provisions that would allow the euro countries (seventeen of the twenty-seven EU member states) to introduce stricter rules on economic governance, if they wish.

But on this occasion, the news that the Germans want a new treaty is welcome. This is because the new treaty only makes sense as part of a grand bargain. Merkel will be able to say to the German people that, thanks to the new treaty, tough new rules will keep profligate southern Europeans under firm discipline. In return, she will say, Germany should be ready to support more generous bailout mechanisms. The new treaty would probably be for the seventeen eurozone countries, rather than the twenty-seven, so that euroskeptical Britain—in the EU but not the euro—would have no opportunity to block it.

The promise of more generous German financial support could save the euro, at least in the short term. The EU’s existing bailout fund, the European Financial Stability Facility (EFSF), has €440 billion at its disposal (on September 29 th the German parliament voted to give the fund more powers). The EFSF is already aiding Greece, Ireland and Portugal. It could, if necessary, give limited support to Spain but would have no spare capacity to help Italy as well. In recent months, financial markets have started to doubt the willingness and ability of EU leaders to stand behind Italy and Spain, two countries with mountainous debt and insufficient economic growth. Their cost of borrowing has therefore risen sharply.

In order to reassure the markets and bring down these borrowing costs, Germany needs to indicate support for one of three options. First, the European Central Bank (ECB) could step up purchases of government bonds. But though the ECB is already buying the southern Europeans’ bonds, to a modest degree, the practice is—arguably—illegal, and the Germans do not like it. Second, the EU could set up a scheme for “Eurobonds,” with euro members raising money collectively to ease the cost of borrowing for those with too much debt. Merkel opposes this scheme, lest it encourage the southerners to spend too much. But Wolfgang Schäuble, the German finance minister, says Eurobonds could be a long-term solution. The third and most plausible option is to boost the firepower of the EFSF, possibly through mechanisms that would link it to the ECB. A war chest of around €2 trillion likely would convince the markets that the EU is serious about keeping Spain and Italy in the eurozone.

But more financial assistance is only part of what is required to save the euro. Much of the debt owed by Greece, Portugal and perhaps others will have to be written off, and that in turn will require a massive recapitalization of European banks (by €200-300 billion, IMF figures suggest). And, crucially, the problem countries need to adopt intelligent policies. They need to keep public spending under control and introduce structural economic reforms that will facilitate growth (such as opening up closed professions and labor markets). Of the countries in difficulty, Ireland has begun to perform better. Its problem is mainly one of insolvent banks, but its economy is flexible, and rising exports are bringing some economic growth. The Spanish government has begun to enact some of the right reforms. Italy’s government, worryingly, seems incapable of undertaking reforms that would boost productivity. Portugal’s new government says it will do what it takes to stay in the eurozone, but it is too early to tell whether words will lead to actions.

Greece is in a dire state. Like Spain, Italy and Portugal, it suffers from poor productivity, many restrictive practices, too much low-tech industry and an inefficient state—but these problems are more acute in Greece than in the other southern countries. Greece’s unit labor costs have diverged from those of Germany by 30-40 percent since the launch of the euro. In order to restore competitiveness, the country would have to cut wages by that amount. But that could lead to unacceptable levels of social and political instability.

Greece is likely to default on its debt, and in the long run it may wish to leave the euro. Staying in would mean year upon year of unremitting austerity. Leaving, though economically traumatic, would allow the devaluation of a new currency and the prospect of export-led growth.

EU governments should create an orderly exit mechanism for Greece or any other country that may wish to leave. The more that EU governments plan in advance, for example by agreeing to a legal framework and financial aid for departing countries, the less disruptive any departure would be. The biggest argument against Greece leaving is the fear of contagion spreading through panicky financial markets. But the EU would be able to ring-fence Greece from other problem countries if it pledged sufficient financial support and if these countries adopted credible policies.

In the long run, a stable euro requires more balanced trade and growth among its members. The financial markets worry not only about the southern countries’ budget deficits but also their inability to grow. The Germanic medicine that the EU has imposed on Greece and Portugal—austerity and structural reform—was necessary but not sufficient. Unaccompanied by measures to promote growth, it has led to shrinking economies and government debt rising as a percentage of GDP.

Furthermore, structural imbalances in the eurozone stifle growth in the south: Germany, the Netherlands and other north European countries have big trade surpluses, mirrored by the deficits in southern Europe. Germany, particularly, has a strange economic structure, dependent on exports rather than consumption and investment for growth. If northern Europe did more to stimulate consumption, the extra demand would make it easier for southern Europe to grow.

However, the German government dislikes being told it is part of the problem. It has insisted that new EU rules on economic governance, including an “excessive imbalances procedure,” focus on criticizing and, as a last resort, punishing deficit countries, rather than those with surpluses. The people running Germany are much more hostile to John Maynard Keynes and his ideas on demand management than many leading figures in Britain, France or the United States. Germany’s leaders tend to believe that sufficiently tough austerity and structural reform will ultimately lead to growth. The last two years of European economic history suggest that they are wrong.