Coverage of the crisis in the Eurozone is astonishingly poor. Commentators scarcely try to analyse the situation properly; instead they revert to one of two unsatisfactory critiques. First, the Eurosceptic one, is that the Eurozone was always an unworkable idea and the best thing to do is abandon the whole thing. The alternative, the Europhile critique, is that a currency union without political integration was a major mistake, and the best thing to do is move further towards the political integration of the union.
These positions are both unhelpful. The Eurosceptics fail to see the benefits of the currency union, the awful logistics involved in unpicking it, or the unsatisfactory nature of floating currencies for most countries. The Europhiles want to drag European peoples down a road they do not want to go. There is a third way: that Eurozone governments change their countries’ economic arrangements so that they can live within the currency zone, more or less as it is currently configured. This crisis is a learning experience.
The more far-sighted of the Eurozone’s designers did not want full political integration. It was never to be a currency zone like the USA, with a federal government able to make massive fiscal transfers across the union to help balance out asymmetric crises. Instead the single currency, alongside the single market, was meant to act as a discipline on national governments. This would address the widespread failure of floating currencies, which allowed governments to buy time through currency depreciation rather than addressing economic inefficiency. This was a process leading inexorably to hyperinflation and economic collapse – which was very clearly beckoning for Portugal in particular before the Euro project was taken on board.
Discipline was required in two particular areas: government finances and labour markets. In the former case discipline is to be provided by the threat of default; in the zone it was impossible to evade default by debauching the currency. The consquences of a sovereign default are very severe, and European leaders sought to prevent it through the muddled Growth & Stability Pact, which sought to restrict deficits and levels of government debt. For labour markets the discipline was that without flexible labour markets, economies would become uncompetitive, creating unemployment.
But things went badly wrong almost immediately. Bond markets did not seem to believe the default story, as spreads between the more creditworthy governments (like Germany) and the less so (Italy and Greece) were impossibly narrow. Governments in the shakier countries (especially Italy, Portugal and Greece) found it much too easy to borrow cheaply and used this as an excuse for not proceeding with reform.
Labour markets were largely untouched by reform, as were other economic inflexibilities. This caused major problems in Spain, Portugal, Italy and Greece whose economies became increasingly uncompetitive. Only one country (apart from Ireland perhaps) really grasped the implications of living inside the Euro, and that was Germany. After unification the German economy lost competitiveness and unemployment became a real problem. But through its system of corporate deal-making between employers and unions, pay was restrained and other reforms instituted. Competitiveness was duly restored, as was employment. Unfortunately that made things worse for the laggards.
While the Eurozone had proved a failure in these two areas it proved a bit too successful in another: capital flows. There was a lot of reckless lending, with quasi-public banks in Germany in prominence. Capital flowed freely to countries, like Spain and Ireland, that didn’t really deserve it, allowing problems to be hidden in a property bubble. And then Pop! The Eurozone has lurched from one crisis to the next.
But the basic idea remains intact. Markets now fully appreciate the risks of default and are pricing debt accordingly. This is applying pressure on governments like Italy’s that the Growth & Stability Pact simply could not. And the pressure to make market reforms is likewise proving unbearable. It’s been a horrible experience for many, but this is not a structural failure: it’s a learning curve.
So what next? The Greek government must default, and default properly (i.e. the principal must be cut rather than repayment simply deferred). Maybe it will be forced out of the Euro. If so, it will be a terrible example. Some eurosceptics make it all sound rather easy (“decouple, default, devalue”), but it involves the utter collapse of the Greek economy with private savings being wiped out. The hope would be that it would be easier to rebuild from the ashes than interminable limping along inside the zone. Portugal and Ireland (whose crime was not to manage its banking system properly) may also go through some form of de-facto default. But they will stay in the zone. Portugal must go through a painful period of reforms, but at least for them this path is clearly better than being outside the Euro.
Meanwhile the Euro governments need to keep “kicking the can down the road”. This is not as short-sighted as it sounds, since with each kick the various parties invovled understand the situation better and what needs to be done. The default word is now openly talked of. German bluster over not bailing out the profligate is gradually having to come to terms with the role German banks played in the disaster. There is learning for the Germans too. Bold decisive action can be disastrous – it didn’t help the Irish. This way things are properly thought through.
Reforms? Fiscal reforms are unnecessary. But the banking system does need serious attention. The regulatory system is badly coordinated. There are too many cosy quasi-public banks who have been allowed to make silly investments. Banks remain largely national affairs, with only a limited number of transnationals. There is strong case for a centralised banking regulator. And cross-border banking mergers need to be encouraged.
But the Eurozone is not dead; and neither are we on the verge of a more centralised European government.