Friday, November 28, 2014

Europe’s Options

STANFORD – Many Europeans have come to believe that they have weathered the economic and financial storm. In the last two years, deficits and debt have stabilized. Yields on the sovereign debt of the eurozone periphery’s weak economies have fallen sharply. Portugal and Ireland have exited their bailout programs. Talk of Greece leaving the euro has subsided.

All of that is true, but there is a big catch: economic growth in the European Union remains anemic. GDP in Holland and Italy shrank in the last quarter, and France’s barely budged. Forecasters are revising down their estimates for 2014 eurozone growth to just 1% year on year. Unemployment remains at a staggering 11.6% in the eurozone as a whole, compared to 10% in the United States at the worst of America’s Great Recession. It is above 25% in Greece and Spain – and even higher among the young.

Europe’s economy remains shackled by three problems – sovereign debt, the euro, and wobbly banks – despite several new policy backstops: the European Stability Mechanism (ESM); the European Central Bank’s easy-money policies and holdings of sovereign debt; and the ECB’s takeover in November of supervision of the 130 or so largest pan-eurozone banks. None of these reforms has been sufficient to restore the stronger growth that Europe desperately needs.

Widespread economic discontent is reflected in recent political instability. The European Parliament election in May shocked Europe’s elites, as parties of the far right, assorted euroskeptics, and even leftists made strong gains in many countries, fueled in part by popular frustration with the European Commission’s concentration of power. Great Britain may be headed for a referendum on EU membership in 2017 unless certain terms of its membership are revised.

Elected leaders face a daunting task: enacting difficult structural reforms of labor markets, pension systems, and taxes. All were long overdue prior to the crisis, and they remain in the very early stages, at best, in most countries, while the high-debt countries’ fiscal condition has improved only modestly. And Italy and France demand relief from the eurozone’s budget deficit and debt rules.

Economists are not certain whether there are short-run costs or benefits to rapid fiscal consolidation. My view is that it depends on facts and circumstances, such as the size, credibility, and timing of the consolidation; the mix of spending and tax cuts; whether consolidation is mostly permanent and structural (for example, a change in pension formulas); and, of course, the stance of monetary policy.

Given most European countries’ increasingly daunting demographic outlook, the current pace of structural reform is woefully insufficient. Italy and Germany are headed toward a ratio of one retiree per worker; without more rapid GDP growth, new immigration policies, higher retirement ages, and efforts to stem the increase in welfare spending, taxes will inexorably rise from already damaging levels.

Europe has three broad options. The first is the status quo – which would entail cobbling together responses to future mini-crises as they arise, following the pattern of the past few years. Given the divergent interests and problems facing different countries within the eurozone and the EU, together with cumbersome governance structures and the difficulty of treaty changes, this is the path of least resistance for elected leaders – and thus the one most likely to be followed.

The second option is serious, concerted structural reform. This would include, at a minimum, reforms of labor rules, pension systems, and anti-growth provisions of tax codes. It would also include an aggressive attempt to reduce the sovereign-debt overhang that remains a major impediment to growth and continues to threaten some European banks.

Existing debt agreements are not sufficient without a decade of strong growth, which appears unlikely, to say the least. European governments and banks ultimately will need a solution similar to Brady bonds, which worked quite well in overcoming the 1990s Latin American debt crisis and the threat that it posed to highly exposed US money-center banks. As was true then, a menu of exit options and credit extensions will have to be negotiated.

The politics of this approach will be difficult, particularly in the rich countries; but, structured properly, concerted structural reform could help to restore growth, which would feed back into healthier budgets, more jobs, better balance sheets, and less financial risk.

The third option is rethinking and reworking the EU itself, from the euro to its basic institutions. As a free-trade arrangement, the EU has been a major success. But the euro makes economic sense only for a subset of its current members, not for countries such as Greece in its current situation. Some economists have proposed a two-track euro, with “problem” countries using a “euro-B” that floats against the “euro-A” until they abide by the economic and financial rules and earn re-entry.

Enhanced labor mobility has been another great benefit brought about by the EU. But the European Commission’s rigid bureaucratic diktats have taken some regulation too far, and efforts to force lower-tax countries to “harmonize” their rates would be devastating to their citizens and firms.

While it is unlikely that much progress will be made along the lines of the second or third options in the near future, Europe’s elected leaders should constantly test what makes sense and what needs to be reformed. The recent election was a wake-up call; Europe’s leaders need to open their eyes.

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    1. CommentedÖmer Aytaç

      Given the choice between entering the EU or the Shanghai 5, I'd choose the latter 9 times out of 10. EU just does not have the prospects for a future. Only two generations of Europeans have lived a life without worry of war or fiscal deficiency in the last 10 generations. That says something..

    2. CommentedAndré Fonteyne

      The most startling thing in all this is that nobody is talking about the most natural way to rebalance demography: births ! We should encourage people to have kids, and these encouragements should be targeted at middle class people with work, otherwise it will only make social problems worse. Immigration is not the solution, as we can already see it has changed our societies for the worse, and beyond recognition, and has sown the seeds of potential future civil war.

        CommentedTomas Kurian

        You are right, but the obstacle to this obvious solution is firmly build in the system itself: Without additional resources to buying power constituted from wages (AD) the businesses are not able to realize in full their production priced at wages + profit (AS).

        Therefore the constant downward pressure on wages in order to try to balance this unbalancable equation, which eventually kills off the middle class and leads to importing slaves ( or outsourcing)

        It can be avoided by productivity subvencing, be means of lets say family subsidies.

        Read more @
        Genom of Capitalism
        Ways of productivity subvencing instead of outsourcing

    3. CommentedJoshua Ioji Konov

      Following the Budgetary Economics as it has been done the EU will not be able to restart the economy to a point of substantially lowering their Debt and Unemployment, without using unorthodox economic tools such as the Quantitative Easing, and more important stopping the practiced wealth trickle-down policies of taking from the have not and giving it to the have...

    4. Commentedpieter jongejan

      French non-financial companies have the lowest Debt to total assets ratio of all Euro-members (28) and the highest Debt to GDP ratio (118). Doesn't that imply that the valuation of their assets are too high? Which accountants do they use? How can we have a banking union on the basis of overvaluated assets? Why is nobody complaining. Because it is in the interest of bankers, politicians and criminals to keep their mouth shut? Who are supposed to pay the bill? The pensionistas in Europe? Is that why Christine Lagarde is promoting inflation together with the Americans? Read Kemmener of Princeton 1919 if you want to know the outcome of expropriating the middle class. Hitler rose to power in 1923 four years after the writings of Kemmener on increased debt and high inflation.

    5. Commentedde Lafayette

      Prof. Boskin makes some very good arguments regarding EU restructuring, particularly as regards its antiquated Labor Regulations. Let's not forget that Chancellor Schoeder, just before leaving office, undertook some widespread measures (as regards Labor) to make Germany more competitive. Germany underwent two years of hardship, but ultimately as a result became Europe's Strong Man.

      I don't think the EU is totally oblivious to the challenges it is facing. Upon signature of the Maastricht, the countries were to undergo a convergence process that would align the Euro amongst the participating nations. Part of that agreement was a Stability & Growth Pact that outlined a stringent process of debt-containment. Which did not work as planned.

      Since, however, the EU has renewed its efforts at diminishing debt. And, a good many countries have been successful. This info-graphic shows the current status of fiscal-compliance that will lead to national debt containment:

      Evidently, the largest burden is upon the larger countries. But, this effort is presently undergoing and we can hope that it will succeed. The only problem is that it will take time.

      I for one think the EU-countries were too confidant about the Europe, resulting in fiscal profligacy. That attitude, however, is very definitely past.

    6. Portrait of Michael Heller

      CommentedMichael Heller

      Very welcome oped from Michael Boksin, which I read as advocating activist structural reform, intelligent debt restructuring, and a common currency conditionality program.
      Heller Economic History Entertainments