Monday, November 24, 2014

Europe’s Perpetual Crisis

ATHENS – The Cyprus bailout deal is a watershed in the unfolding eurozone crisis, because responsibility for resolving banks’ problems has been shifted from taxpayers to private investors and depositors. But imposing major losses on Cypriot banks’ depositors violates the deposit-insurance guarantee that forms part of the proposed European banking union, while the imposition of capital controls further erodes the monetary union’s foundations. So, is Europe chasing its tail?

Germany and the other countries of the eurozone core are signaling that debt mutualization within the monetary union is out of the question, and that bailouts of countries or financial institutions will be balanced by “bail-ins” of their creditors. Increased uncertainty concerning the safety of deposits will push up interest rates and deepen Europe’s recession, and may also trigger capital outflows from the eurozone’s weaker peripheral economies to the core.

The implications of this shift may be far-reaching. The German model for resolving the debt crisis and returning to internal or external balance relies on fiscal consolidation and structural reforms for the deficit countries. But, if all countries simultaneously attempt to improve their fiscal or external balances by cutting spending and raising taxes, all will fail, because each country’s austerity implies less demand for other countries’ output, in turn perpetuating both domestic and external imbalances. “Bailing in” creditors will exacerbate these trends.

Moreover, a deep and prolonged recession implies vanishing support for reforms, as governments fail to convince citizens that current sacrifice will ensure a better future. Privatization, market liberalization, the opening of closed professions, and government downsizing involve conflicts with powerful vested interests, such as businesses in protected industries, public-sector unions, or influential lobbies. Resolving such conflicts requires social alliances, which are invariably undermined by discontent, civil disorder, and political instability.

The recent Italian election has shown how toxic the association of austerity policies with the pursuit of reform has become. Anti-austerity anger swept away the reform agenda of Mario Monti’s previous technocratic government, leaving Italy, its future uncertain, to continue muddling through. The same scenario seems to be emerging in Greece, where the depth of the austerity-induced recession, with output down by 25% over five years and unemployment at 27%, is paralyzing a reform-minded center-right government.

The gaps in the strategy are clear. First, the eurozone authorities misread the real causes of the debt crisis, which stemmed mainly from a growing competitiveness gap between the core and periphery countries. The resulting private-sector imbalances culminated in banking problems that were eventually transferred to sovereigns. Greece’s fiscal profligacy was the exception rather than the rule.

Indeed, in contrast to the United States, eurozone authorities were slow to consolidate the banking system after the global financial crisis erupted in 2008, and failed to sever the ties between sovereigns’ and banks’ balance sheets. Nor did they push strongly for structural reforms. Instead, they emphasized harsh austerity, which was to be pursued everywhere.

Second, the effects of austerity were exacerbated by the choice to pursue nominal, rather than structural, fiscal-deficit targets. Countries with a stronger fiscal position (that is, smaller structural deficits) should be encouraged to adopt more expansionary policies in order to contribute to lifting overall demand. Moreover, the European Investment Bank’s lending capacity could be increased substantially, and European Union structural funds mobilized, to finance investment projects in the peripheral economies.

Third, the European Central Bank’s announcement last August of its “outright monetary transactions” program – through which it guarantees eurozone members’ sovereign debt, subject to policy conditionality – has contributed significantly to subduing financial turbulence in the eurozone. But the OMT scheme has not been reinforced by a reduction in key interest rates, which would boost inflation in core countries with external surpluses and thus help to close the competitiveness gap with the periphery. Crucially, monetary-policy measures do not address the underlying problem of lack of demand.

Last, but not least, the eurozone authorities misread the confidence factor. In theory, simultaneous fiscal consolidation and supply-side reform facilitates economic recovery, because it increases confidence among consumers and investors, thereby inducing higher spending and production. But this does not necessarily work in an imperfectly functioning monetary union, such as the eurozone, where the continual appearance of systemic flaws erodes confidence; in such circumstances, the result may be hoarding and capital outflows, rather than increased spending.

The eurozone’s flaws reflect its conceptual distance from the US, which is the only model of a well-functioning monetary union. Europe’s history rules out emulating the US model. But, to make the eurozone work, monetary unification should extend to the fiscal and financial fields, thereby creating an integrated economic union.

The longer that European authorities postpone the introduction of Eurobonds, an effective banking and fiscal union, and lender-of-last-resort status for the ECB, the longer the crisis will last. By effectively defaulting on a deposit-insurance guarantee through its actions in Cyprus, the eurozone backtracked on the planned banking union.

Pursuing a strategy that simultaneously deepens recession and weakens confidence will not resolve the debt crisis. As funding problems recur in the recession-hit economies, governments may resist “bailing in” and the associated losses. Civil unrest and political destabilization could erupt into financial and social crises that ultimately threaten the monetary union’s survival.

In short, the “solution” to the Cyprus crisis is no solution at all for the eurozone. Unless the authorities embrace a growth strategy – and do so quickly – the eurozone’s prospects will become increasingly bleak.

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    1. CommentedCarol Maczinsky

      The problem is that the persons responsible for the state finance fraud did not follow in the footsteps of Hans Langsdorff but annoy us with their "growth strategy" fantasies. I never heard any apology for the misconduct.

    2. CommentedTomas Kurian

      The problems of Europe are stemming from fact, that some countries are persuing predatory, export led growth model and this is not replicable by all. Simply, not everybody can have trade surplus against everybody.

      Countries with trade surpluses are on the winning side, they truly are and their inflow of money gained that way enables them to lower their deficits and even maybe balance their budgets completly. But to say that everybody should achieve balanced budget as fiscal compact requires is at best ignorant arrogance. Those with trade deficits have no chance to do it, money is not growing on the trees.

      My theory ( ) is proving, that without expansionary monetary policy, permanent budget deficits or trade surplus the economic system is going into automatic depression.

      So even by cancelling the trade imbalances the problem would not be solved, as further debt or monetary easing would be always necessary. This is the fact that surplus countries are ignoring ( or are not avare of at all) and by requesting "structural reforms" are just ruining internal demand.

    3. CommentedZsolt Hermann

      Comments on certain parts of the article:
      1. "...First, the eurozone authorities misread the real causes of the debt crisis, which stemmed mainly from a growing competitiveness gap between the core and periphery countries..."
      The misreading goes deeper. Even the growing competitiveness gap, or growing social inequality, or growing unemployment are simply signs of the unsustainable socio-economic system we are pursuing.
      The constant quantitative growth economic model is impossible to maintain since it has no natural foundations. And since we exist in a natural system with very strict, unbreakable laws such unnatural models break, collapse after a while as the natural system has to return to balance.
      This is the reason why the previously seemingly working tools, methods suddenly turned against us, and with every attempt to solve the crisis within the previous framework we just make it worse.
      Only a complete thinking, attitude and system change can return humanity to a postively developing path.

      2. "...The eurozone’s flaws reflect its conceptual distance from the US, which is the only model of a well-functioning monetary union. Europe’s history rules out emulating the US model. But, to make the eurozone work, monetary unification should extend to the fiscal and financial fields, thereby creating an integrated economic union..."
      Well I am not sure how good of an example the US is showing, simply at present their method of cosmetic surgery is covering the same cracks that are visible elsewhere, although under the surface the social inequality, unemployment, loss of competitiveness, unsolvable debt burden is brewing.
      But if Europe wants to take one example from the US is that if people want economical, financial unity, integration, that can only happen if the whole structure is integrated, the whole area of integration functions as a single, united whole.
      Again since we exist in a natural system, that is interconnected and integral, in such system no partial unity or connection can exist, be viable. An integration, unity is either full, permeating the whole depth, or none.
      This is why the European experiment is falling apart because from the founders to the present leaders they always stop short of full integration fearing political suicide.
      Which is a mistake as with their present "kicking the can" attitude they simply make their own job much more difficult as in difficult times the extremeist political forces gain advantage.
      Everything depends on the success of motivating people in a positive way, and such positive motivation can only be achieved by transparent, honest, selfless, scientific education, information sharing.