Any hope that last Thursday’s debt crisis agreement would finally quell the contagion raging through the euro zone was dashed almost before the ink dried. Only a day later, Italy’s borrowing costs actually rose to a euro-era high in a bond auction, a clear sign that investors were far from certain that the debt deal was a game changer in Europe. The leaders of the euro zone appear to have botched yet another opportunity to convince the global investment community that they could tackle the crisis.
Why do Angela Merkel & Co. consistently disappoint? The reasons are many. They have repeatedly put their own domestic political concerns above the needs of the euro zone overall, leading to “historic” agreement that always fall short. They have shown a bewildering lack of urgency, stepping in too late with too little again and again. If the rich members of the zone are wary of committing their own money to support the euro, why should they expect private investors to do so? The debt burden of Greece, Italy and other euro zone countries is so huge, and the economic weaknesses of these nations so daunting, that it is simply impossible to address the problems in any reasonable period of time. But most of all, I fear the leaders of Europe are simply misunderstanding what is at the root of the crisis, and that faulty diagnosis is the reason why the medicines used are never a cure. Here’s what I mean:
So far, Europe’s approach to the crisis has been primarily a combination of three elements: (1) bailouts to provide liquidity and financing to debt-heavy governments and prevent a sovereign default; (2) austerity measures and, to a lesser extent, structural reform in the troubled economies: and (3) moderate reform to the way the monetary union functions, such as stiffer sanctions on those government that break debt limits and closer coordination of national fiscal policies. None of the measures taken to alleviate these three problems have ever been sufficient – the bailout fund has never been big enough, the reforms never extensive or credible enough, and the changes to the monetary union never strong enough. But beyond that, these issues are only part of the reason Europe is experiencing a debt crisis. The real causes are being ignored.
How’s that? The bailout system is predicated on the belief that the debt crisis is first and foremost a liquidity crisis, that if the euro zone members put up enough cash to show they’ll defend the euro, investors will feel better and the crisis will wind down. The austerity and reform programs have been mainly confined to the PIIGS – the economies in the crosshairs of investors – since the leaders of Europe seem to believe that only the weaker economies actually require reform. And the changes to strengthen the monetary union have mainly entailed the imposition of more rules, as if its flaws can be repaired by improving the way the existing structure functions.
All of these three assumptions are wrong.
The debt crisis in Europe has never been a liquidity crisis. That’s why the bailouts have failed to stop it. Investors are fleeing the bonds of certain European countries because they believe their economies are fundamentally broken, simply uncompetitive compared to either stronger countries in Europe or up-and-coming emerging markets. That means investors don’t have confidence in their long-term outlook, and thus their ability to handle their large debt loads. And the budget cutting and minor structural reform taking place isn’t enough to change their downward course. The problem, in other words, is not concern over these countries’ short-term ability to service their debt, but their long-term ability to prosper within the constraints imposed by the monetary union.
Nor is the difficulty in the euro zone limited to the weakest economies. Yes, Spain, Italy, Portugal, Greece and Ireland need to reform themselves. But that’s only one side of the story. Massive imbalances between its members lie at the heart of the euro zone’s problems. On the one hand, you’ve got uncompetitive economies like Spain and Portugal that have tumbled into large current account deficits; on the other, stronger economies, especially Germany, that gorge on giant current account surpluses. These imbalances are at the center of the debt crisis, but they aren’t being treated that way. The euro zone’s answer has been to force the uncompetitive economies to become more competitive, by reducing their real costs and wages. But that is a painful process, one that is potentially unsustainable either politically or socially. The real solution lies in zone-wide reform. Surplus nations also have to change, to stimulate domestic spending and import more from the rest of the region, which would help the weaker countries grow and stabilize their debt. Or the euro zone has to encourage these surpluses to be recycled into weaker economies – not through bailouts or handouts, but real investment that creates jobs and growth. None of that, however, is taking place in any serious way.
Lastly, the very structure of the euro zone is seriously flawed, and tweaking it isn’t enough. No one believes that new rules and guidelines can be enforced, and no one believes they will be followed by governments will little history of doing so. The problem with the monetary union can be found in its decentralization. With no unified authority controlling fiscal policy overall, investors don’t believe it can be controlled. The euro zone will be continually forced to adjust to the actions of its members, not the other way around, no matter what pacts are signed. And that decentralization presents a political hurdle as well. Though it is remarkable that 17 different nations with different interests can come together and reach agreement on anything – the mere two parties in Washington haven’t been able to achieve the same degree of compromise – the fact remains that any one of the those 17 countries an upend any euro zone policy. We’ve already seen that happen, when Finland halted the process of forging a second bailout of Greece. That’s why many economists believe the only answer to the euro zone debt crisis is more centralization – the often-mentioned fiscal union. But there is little evidence that the individual members of the euro zone will ever sacrifice the degree of sovereignty required to achieve such a union. Thus investors will remain unconvinced that any euro zone policies or programs can actually be effective.
So in the end, the root problem is that investors fear the euro simply can’t survive. The worry is that the debt crisis will bring to its knees the European experiment in integration – not the other way around. To avoid that fate, the doctors of the euro zone have to write up the correct prescriptions. Otherwise, the disease will keep spreading.