Illiquid Europe

ROME – Crisis management in the eurozone has clearly failed to restore confidence. Indeed, following each of the six rounds of emergency measures implemented between May 2010 and December 2011, matters took a turn for the worse. Without fail, markets signaled growing doubt: interest-rate spreads over German Bunds increased in Portugal, Ireland, Italy, Spain, and Greece. Even Germany experienced a partial Bund auction failure in November 2011, while France lost its AAA rating from Standard & Poor’s in January 2012.

Germany and other Northern European countries maintain that the culprit is lax fiscal policy and excessive debt accumulation by other eurozone members. Their solution has been to strong-arm European Union countries into adopting strict fiscal governance and enforcement procedures.

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As a result, fiscal consolidation and structural reform seem well under way in all of the “sinning” countries. Indeed, the International Monetary Fund now forecasts sovereign-debt stabilization by 2016 throughout the eurozone, except Greece.

Why, then, does every announcement of harsher governance rules merely fuel another round of financial turmoil?

One need look no further than the mechanics of liquidity. When a country with higher inflation and structural rigidities joins a monetary union, it initially finds itself awash with liquidity: exchange-rate risk disappears, real interest rates turn negative, and borrowing becomes an irresistible bargain. And, while real exchange rates appreciate and competitiveness suffers, leading to rising unemployment, the abundant credit postpones the adjustment. With the inflow of cheap money, public spending rises, and politicians thrive on distributing subsidies and preserving inefficient jobs to broaden their electoral appeal. The public-sector deficit widens.

Lax financing conditions may prevail for quite a long time, but, sooner or later, growing external and fiscal deficits become unsustainable; confidence evaporates and investors flee, taking their liquidity with them. The country finds itself unable to refinance its debts in private markets at an affordable cost – as happened to Greece and Portugal. Fear of default in distressed countries is then transformed into doubts about the sustainability of core countries’ banks, as their lending to the weaker economies comes under scrutiny. The crisis then spills over borders: investors overreact and withdraw their money from the entire region.

The contagion could be stopped by a liquidity injection, but fear of encouraging deficit spending has impeded these efforts. As a result, fear could become a self-fulfilling prophecy: following a run by investors on all other sovereign debtors in the union, fiscal transfers would become inevitable in order to rescue overextended – for example, German – banks that have highly risky loan portfolios. On the other hand, simply restoring adequate liquidity would stop the run, reduce the risk of insolvency, and thus preempt the need for fiscal transfers.

Policymakers must understand that the eurozone has turned into a straightjacket: tight budgets restrict growth in the peripheral countries that need it the most. These countries must now engineer substantial real wage and price deflation in order to regain competitiveness and reduce their trade deficits. Meanwhile, the core countries, already running trade surpluses (in some cases as high as 6% of GDP), have no incentive to strengthen the aggregate demand that would relieve pressure on their partners.

Thus, if reform on the eurozone’s periphery succeeds, both these economies and core countries will suffer from decreasing aggregate demand; if reform fails, either the deficits will continue to be financed, leading to further accumulation of external debt, or the entire eurozone will fall into depression, with sovereign debtors eventually defaulting on their liabilities.

Neither of these alternatives is palatable, which may help to explain why the crisis of confidence gripping the eurozone lingers on. If so, a lasting solution will have to include credible measures to raise eurozone growth rates. Otherwise, the new fiscal compact will lack credibility and eventually flounder. The promise of never-ending and self-defeating austerity cannot provide solid foundations to the monetary union.

The eurozone has proven itself unable to develop a convincing economic strategy to revive economic growth, reduce public debt to normal levels, and raise credible liquidity walls around its distressed sovereigns. Meanwhile, the adjustment costs in troubled countries have ballooned in response to rising interest rates and falling economic activity. Both herald further budget cuts and a downward deflationary spiral.

Europe’s leaders must go back to the drawing board and agree on a more balanced combination of discipline, liquidity support, and pro-growth policies. If this cannot be accomplished, the eurozone, and most likely the EU itself, will break up – with enormous economic and other implications for us all.