Can Europe’s economic system survive its debt crisis?

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As contagion spreads in Europe, political and economic leaders continue to struggle to find a real solution. There is hope that the European Central Bank will announce Thursday that it will expand its purchases of government debt to appease jittery markets. And Spain’s government announced a wide-ranging privatization plan to raise fresh funds. Perhaps such steps may calm investors for a while, but the underlying problems remain firmly in place. Portugal simply may not be able to avoid a European Union-led bailout; the next dominoes to fall could be much bigger Spain and Italy. The bailout mechanism in place has done nothing to resolve investor concerns about the future solvency of weak Eurozone economies, and the leaders of Europe are still muddling through, their indecision, sloth and poorly timed initiatives have only further fueled the contagion.

In my opinion, the mess is threatening the sustainability of Europe’s entire economic system. Here’s my list of the four fundamental questions facing Europe right now:

1. Can the euro survive? In The Financial Times the other day, Martin Wolf wrote an excellent explanation of how the introduction of the euro made the kind of credit crises we’re seeing today almost inevitable. To sum up, the meshing of economies at very different levels of competitiveness into the monetary union set the stage for future problems, while the low interest rates brought about by the euro in many countries fed the dangerous asset bubbles that eventually exploded in placed like Spain. The issue now is: What can be done about it? The Eurozone is planning to introduce stricter controls over the public finances of its member states, but this effort probably doesn’t go far enough towards the sort of “fiscal union” that could preserve stability in the Eurozone in the future. Almost nothing is being done to actively address the weak competitiveness of some Eurozone economies. In other words, solving the problems inherent in the euro hasn’t gone much beyond the formulation of a bailout system. And we all see where that’s gotten us. Not very far.

The question is: At what point will the leaders of one or more Eurozone countries deem the costs of being in the union outweigh the benefits? On my two reporting trips to Europe this year, the general attitude I found on the euro is that (1) the euro is still a good idea, (2) that there is a commitment within Europe to make it work and (3) there is nevertheless serious doubt about the euro’s ability to survive. In its favor is the fact that the euro is as much a political mission as an economic tool. The euro is part of Europe’s drive for peace through integration, and that will make politicians across the zone reluctant to ditch it. However, the fact is it would be easier for the Greeces, Irelands and Spains of the Eurozone to achieve the painful adjustments needed within their economies if they had their own currencies. Those currencies would depreciation, bringing instant competitiveness to their economies. Without that, they have to endure the much more painful process of suppressing costs and wages to become more competitive. We can also argue that these countries may not have gotten themselves into the mess they’re in if they weren’t euro nations. On the other side of the equation, is it politically viable to expect the citizens of better-off Eurozone countries, such as Germany, to spend their tax money supporting weaker neighbors to preserve the euro? The deeper the debt crisis digs into the Eurozone, and the more expensive the bailouts become, the more likely it is that Europe’s governments will start asking themselves if the euro is worth all of this cost and effort.

2. What do the weaker economies of Europe do now? One of the grim realities facing the weaklings of the Eurozone – especially Greece, Ireland, Portugal and Spain – is their poor prospects for growth going forward. Some, such as Portugal, are suffering today because they already have low growth. Others, such as Spain, have to find new sources of growth and employment after their credit busts destroyed the economic engines of the last decade. But what are those new sources? It’s not an easy question to answer. One CEO I interviewed in Spain said that the economy should just give up on manufacturing altogether, that Spain simply had no comparative advantages in it. And what about Ireland? What makes the Ireland case especially scary is that for years it had been heralded as a paragon of free-market genius, with a low-tax, pro-business environment and an aggressive financial industry. Now that’s gone. In theory, as mentioned above, these economies will become more competitive as a result of the debt crisis. But there are still real questions about what these countries become competitive in to create jobs and sustainable growth over the long term. If they don’t find a way forward, they could become feeble wards of the EU, living off the largesse of more productive economies. And that puts even more pressure on the monetary union.

3. Will European integration continue? One way in which these weaker economies could be helped along is through greater European integration. Yet despite the introduction of the euro and common market, the reality is that Europe is far from one great market. Nationalistic hurdles to cross-border business remain. Countries have been unwilling to alter domestic trade and economic policy in ways that could help the economic development of the zone overall. This has been a long-standing problem, the subject of endless EU studies and warnings. Now add on top of that the debt crisis. The current mess has further exacerbated divisions in Europe. Taxpayers in better-off economies like Germany resent having to bail out neighbors perceived as profligate and irresponsible. The weaker economies feel ill-treated by the leaders of the Eurozone, especially Germany (expect a post on that problem soon). This all makes me wonder how much further the experiment in European integration can go. How many more sacrifices will Europe’s citizens and governments be willing to make for the idea of an integrated Europe?  This issue goes beyond the survival of the monetary union into the future course of the European Union itself.

4. Can Europe’s welfare states survive? The citizens of many European countries have for decades had a social contract with their governments: The people pay absurd levels of taxes and the government takes care of them from cradle to grave. Nationalized healthcare, Ample pensions. Hefty labor rights. Early retirement. Generous unemployment benefits. But can this contract survive the euro crisis? The heavy obligations imposed on European government budgets by the welfare system were already set to become even heavier as Europe’s population ages. That means fewer working age and taxpaying Europeans will have to support a greater number of retired old timers. Now here comes the euro crisis, in which the stability of the national finances of European states have come into focus. That’s going to put extra pressure on European governments to keep their debt and deficits under control. The fact is that many European countries have high levels of debt. Look at how the yields on Belgian government bonds have recently jumped. The question is: can post-crisis Europe sustain the government spending necessary to keep their welfare states going?

France’s Nicolas Sarkozy has come to realize the answer might be no. That’s why he’s acted to increase the retirement age in France. Europe is going to be seeing more and more of these types of decisions, eating away at the welfare state and the social contract at its heart. And rightfully, Europe’s taxpayers will be angry about it, as we’ve seen in the protests against Sarkozy’s reform. This is very likely a window into Europe’s future.