After days of drama-filled meetings, in late October eurozone leaders announced the latest “comprehensive” rescue plan. Although it was an improvement over earlier efforts, this package, too, came up short in that it failed to calm the markets and offer the eurozone a path back to economic growth. And without growth, there will be many more months of crisis.
The stakes are very high. The fate of the US economic recovery rests in part on whether Europe can keep its intertwined banking and debt crises from spiraling into full-fledged financial contagion, which would deal a damaging blow to an already fragile US economy. Yet the United States has little influence over European policy. Not only is Washington’s advice viewed with suspicion in Berlin and Paris (Europeans still rightly complain about the economic shock visited upon their economies by the collapse of Lehman Brothers); with austerity-drunk Republicans in charge of Congress, the United States can’t do much to help rescue Europe.
The most we can do at this point is draw the right lessons from the crisis for our economy and try to nudge policy in the right direction (while encouraging the Federal Reserve to support Europe’s efforts at stabilization). Indeed, there is a danger that we will only compound the problem with bad advice and inappropriate policy. So what are the most essential lessons to draw from the crisis?
First, this is not principally a crisis of runaway social spending or even a government debt crisis, although it has become one for some economies. Contrary to what is often asserted, many of the countries in trouble did not have irresponsible fiscal policies, as Martin Wolf of the Financial Times has noted. Greece did, but Spain and Ireland ran budget surpluses before the crisis and had very low levels of government debt. Ireland’s debt was a mere 12 percent of GDP, while Spain’s was 31 percent, well below Germany’s 53 percent. Italy had a high debt-to-GDP ratio but a very modest budget deficit. As much as anything, these economies were victims of a credit boom and bust born of too cheap interest rates and excessive lending, followed by an especially severe recession and a financial panic. The lesson here is not about the importance of fiscal consolidation but the dangers of credit and asset bubbles that are often the product of weak financial-market regulation and of imbalances, in this case between the core European economies, which ran current-account surpluses, and peripheral deficit countries, which absorbed those surpluses.
The second lesson is that governance matters. Europe’s problem is not too much government but too little. The reason the eurozone has struggled so mightily with the threat of financial contagion—whether it be organizing an orderly Greek default or assembling a stability fund of sufficient size—is that it does not have the government institutions needed to act decisively and quickly enough to calm the markets. If the eurozone had had a common treasury it would have been able to assemble an adequately resourced European Financial Stability Facility much earlier, avoiding the run-up in interest rates. Or if the European Central Bank had been a true lender of last resort, it would have been able to stanch market speculation by buying sovereign bonds more aggressively or by guaranteeing future sovereign debt.
Yet the myth persists that Europe’s problem has been too much government and too much intervention. Ironically, conservatives who complain the most about government are the very ones who want to turn the United States into a eurozone (without the social welfare state) by destroying our fiscal union and by unduly tying the hands of the Federal Reserve (although some democratic reforms may be called for).
The third lesson is that austerity is counterproductive, and that “expansionary austerity” is exactly what it would seem—a dangerous oxymoron [see Ari Berman, “The Austerity Class,” November 7 [1]]. Germany’s view is that the crisis was caused by excessive government debt, built up over the past decade or two, and that market “confidence” and economic growth can be restored only through fiscal consolidation involving steep spending cuts and tax increases. But as common sense would have suggested, imposing austerity measures has killed off growth in much of the peripheral economies while pushing the eurozone economy as a whole closer to recession.
This lesson is, of course, most stark in Greece, where the eurozone austerity program has set in motion a vicious downward cycle of recession and debt, whereby austerity leads to recession, which in turn produces even larger deficits and debt, which in turn prompts calls for more austerity. The IMF expects Greece’s economy to contract by 5.5 percent in 2011; meanwhile, its projected budget deficit has increased to 9.5 percent from 8.6 percent, despite harsh public spending cuts and tax increases. Portugal and Spain are also in danger of being pushed into the debt trap. US advocates of expansionary austerity should take note.
Finally, adjustment must be a two-way process. The euro-zone’s austerity policies are not the only reason European economies are heading toward recession. The monetary union itself is also at fault, because it has put deficit economies in a straitjacket as constraining as the gold standard was during the Great Depression. In order to restore growth and fiscal sustainability, these economies must improve their competitiveness—but they must do so without using an independent exchange rate. And without the ability to devalue their currency, the only way for eurozone economies to regain competitiveness in the short term (structural reforms take longer) is for wages and prices to fall. But that, of course, means an even greater drag on growth, not to mention greater political instability, which can destroy any prospects for recovery.
The best way to offset the contractionary effect of adjustment would be to make it a two-way process: for Germany and other surplus economies to pursue more expansionary policies while the peripheral economies gradually bring down their deficits with more growth-friendly policies. After all, the imbalance between the core surplus economies and the periphery economies was one of the principal causes of the crisis to begin with. But rebalancing runs contrary to Germany’s deeply held philosophy of fiscal rectitude, as well as its export-oriented economy. Without such adjustment by Germany and the other core economies, however, the entire burden falls on the debtor economies, increasing the likelihood that rescue efforts will fail.
If adjustment proves impossible inside the eurozone straitjacket, there are two longer-term alternatives: permanent financing of debtor economies via a fiscal union, which would entail automatic transfer of resources from wealthier parts of the eurozone to poorer regions, or a eurozone breakup. In the meantime, the best we can hope for from Europe is a chronic low-grade crisis with slow growth. This makes it even more important that we heed the lessons of the crisis. We must choose strong government with robust public-investment and growth-oriented Keynesian economics, and avoid the false allure of small government and expansionary austerity.