I just landed in Rome for some on-the-ground reporting on the latest twists and turns in the euro-zone debt crisis, and I immediately got some sound insights from our reporter here, Stephan Faris. Faris watches the situation in Italy more closely than I do, and he makes the point that Rome simply would not pursue any meaningful economic reform if Italy got bailed out or received more help from the European Union. The pressure of the crisis, he contends, is necessary to force Italy’s politicians to implement progrowth reforms and reduce debt. Without it, Italy would simply continue on as usual, no matter what poor growth the economy may suffer or how many young people are unable to find jobs. The entrenched interests are simply too powerful, the politicians too wary of taking unpopular measures. What most people don’t understand about the euro zone, Faris explained, is that reform is impossible without the crisis.
My guess is that German Chancellor Angela Merkel agrees with Faris. Of course, Merkel would never say outright that she wants the crisis to persist so that she can press forward on European integration and reform. But, effectively, that what’s going on. Yes, Merkel insists again and again that the steps she’s taking are aimed at rebuilding confidence in the monetary union. But her actions have always spoken otherwise. Throughout the debt crisis, Merkel has been reluctant to take the steps many in financial markets think might help end the debt crisis – whether a bigger bailout fund, or eurobonds jointly backed by all euro-zone governments. Instead, she’s demanded reform and kept the heat on those nations that need it. Thus the crisis continues. And, despite my high regard for Faris’ opinion, that’s where the danger in Merkel’s euro-zone strategy can be found.
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We can clearly see that danger in the European Union’s latest effort to tackle the euro crisis – an important agreement reached during a Jan. 30 summit of Europe’s leaders. A new fiscal compact – which has Merkel’s fingerprints all over it – tightens the controls on fiscal policy in euro-zone countries in an attempt to prevent profligate politicians from undercutting the viability of the monetary union. Deficits (adjusted for economic cycles) must be no more than 0.5% of GDP, and governments have to enshrine a pledge to maintain balanced budgets into their laws or constitutions. Violators can now be sanctioned by the European Court of Justice. The idea is to put teeth into rules on fiscal policy that have often been ignored. In many ways, this is a positive step – one toward fiscal union, in which national budgets would be subject to control at a European level. The new fiscal pact will definitely keep the pressure on Italy, Spain, Greece and the other troubled sovereigns to get their national finances fixed.
So that’s the good news. The problem with this effort is that the struggling nations of Europe are getting zilch in return for signing on to the harsh, new pact. Yes, Europe’s leaders did a lot of blabbering about spurring growth and creating jobs, but no firm measures were taken. And even though European leaders also agreed to bring the E.U.’s permanent bailout fund into action ahead of schedule, it was not increased in size, as many market players believe is necessary to create a proper fire wall against defaults. This is an “austerity union,” not a fiscal union. And though it may force reform in Rome, Madrid and Athens, Merkel’s strategy is also heightening the risk of the euro crisis spiraling out of control.
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Why is that? Three reasons:
First, the fiscal pact does nothing to resolve the problems facing the euro zone today. These tough rules would have been great 10 years ago; maybe they could have prevented the crisis we have today. And perhaps they could improve the stability of the monetary union down the road. But now? The countries saddled with too much debt still have too much debt, whatever the rules say.
Second, the focus on austerity in the euro zone is causing what George Soros called a “deflationary debt spiral.” Here’s how it works. Austerity measures – tax hikes, cuts in budget spending – dampen growth. That, in turn, makes it harder to meet deficit and debt targets, forcing governments to implement more austerity measures, which further hit growth, and so on and so on. We can see the terrible toll Europe’s drive for austerity is having on the region’s economies by taking a look at unemployment in the euro zone – the rate is at a euro-era high. Yet Merkel keeps pressing for more austerity, despite the consequences. Athens is being pressured to slice the country’s minimum wage, even though the government estimates that step would shave another 1.5 percentage points off national output, which is already contracting.
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Third, and most important, the evidence is mounting that the austerity-led reform programs are not working to help countries exit the crisis. Take a look at Portugal. Worries are growing that Portugal, like Greece, might be faced with default and could require a second bailout. What makes this especially disconcerting is that Portugal has been a relatively good reform citizen. Unlike Greece, its leaders have been praised for their efforts to cut the deficit and implement reform. And where has that gotten them? Not very far. The economy is contracting and bond yields have hit fresh euro-era highs – a sign that investors are increasingly worried about a default. Fears are spreading that bondholders might have to incur losses in a Portuguese debt restructuring, as they are facing with Greece. Here’s what research firm Capital Economics said on the matter in a recent report:
Although the government in Portugal is not as indebted as it is in Greece, we think it is also likely to default before too long. Portugal’s existing bail-out package should ensure that is fully funded until the end of 2012. But with the 10-year government bond yield now above 16%, it may have to seek a second rescue deal well before that deadline expires. With little chance of the debt burden being eased by strong growth – we expect GDP to contract sharply this year and next as fiscal austerity bites – a debt restructuring may be a quid pro quo for further official sector support … What’s more, we also think uncompetitive Portugal (with a large current account deficit) may choose to leave EMU at some point in 2013. Indeed, this outcome now forms part of our central scenario, in which we expect Greece to be first to leave EMU this year.
So what the case of Portugal tells us is that abiding by the demands made by Merkel doesn’t necessarily help alleviate the risk of default. So even though I can understand Faris’ logic – that continued pressure on weak euro-zone nations is necessary for political reasons – that logic falls apart for economic reasons. That is what Merkel & Co. are missing in their approach to the euro debt crisis. Whatever political motivations make sense in fighting the crisis, the fate of the euro will depend on economic realities. Europe doesn’t get that.