The only way to fix the euro zone is…

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Late the other night, I was talking about the debt problems in the euro zone with my wife, who is also a journalist. “How can Europe solve the crisis anyway?” she asked me. Leaving aside for a moment how pathetic it is that we still discuss such issues in our evenings at home, it got me musing about what really needs to get done to finally end the crisis in Europe. There are times I think that there is simply no solution, or no politically viable one anyway. The euro zone could be so deeply flawed at its very core that it is doomed to collapse. Or the countries of the euro zone could eventually come to believe the costs of membership far outweigh the benefits, leading to the abandonment of the union.

But perhaps there is a way to resolve the crisis and save the euro. There is certainly no shortage of suggestions. Just open a newspaper almost any day of the week and some expert somewhere will be offering up advice. However, I tend to find many of the proposals to be merely partial solutions. Others I think are simply impossible to execute due to political or economic realities. But I do have one idea that might work, one that often gets ignored in the debates about euro zone policy.

First, let’s take a look at some of the ideas bouncing around recently. The one getting the most attention is the introduction of a “eurobond” – a government bond that would be jointly backed by the governments of the euro zone. The idea is that countries would be able to finance themselves by issuing these bonds based on certain rules. In this way, the creditworthiness of the different countries of the zone would reach some sort of convergence, with weaker governments benefiting from lower borrowing costs due to the stability of the stronger ones. George Soros recently touted the idea:

Europe needs eurobonds. The introduction of the euro was supposed to reinforce convergence; in fact it created divergences, with widely differing levels of indebtedness and competitiveness. If heavily indebted countries have to pay heavy risk premiums, their debt becomes unsustainable. That is now happening. The solution is obvious: deficit countries must be allowed to refinance their debt on the same terms as surplus countries. 

My view on the eurobond is that it could work to stabilize the debt crisis in Europe by relieving the fears investors have about defaults in individual countries. But it is not a real solution. First of all, you get yourself into the problem whereby the debt crisis is supposedly alleviated with debt, so the problem doesn’t really go away. Secondly, I think a eurobond is bordering on politically impossible, at least on a scale that might actually make some difference. The formation of a eurobond effectively means that Germany would be guaranteeing the debt of the euro zone, and I just don’t think that will ever go down well with German voters. Nor should it. Third, there is a chance that the eurobond would have the opposite impact from what its supporters intend – rather than strengthening investor confidence in the weaker economies and the euro overall, it could undercut the credit worthiness of the stronger governments like Germany and heighten the risk perception of the entire zone. It could bring everyone down instead of lift everyone up.

Then there is some thinking out there that the problem of government indebtedness in Europe (and the developed world overall) has become so severe and so threatening to the world economy that fixing it has gone beyond the ability of the individual countries themselves. There has to be some sort of grand, international program in place to resolve the debt crisis. Former IMF Managing Director Hendrikus Johannes Witteveen suggests in an essay in the Financial Times that the IMF should step in with a special debt-financing facility to support troubled governments while they restore their fiscal health:

A new “debt facility” would allow the fund to borrow large amounts from all surplus countries, and so provide temporary financing even for a big country such as Italy. Such a country could apply to the fund for a stand-by arrangement meeting all its financing needs for two years – until its budget deficit could be cut sufficiently. This would reassure markets, reduce interest rates to normal and the SBA would be only partially used, if at all.

International action is now urgent to avert a vicious recessionary cycle, which many governments – bound by their debt problems – would be unable to counter, even becoming a recessionary force themselves.

As in the case of the eurobond, I see the merit here, but again, this plan puts us in the position of solving a debt crisis with debt. It also has the same flaw inherent in the current bailout system used by the euro zone to tackle the crisis – the success hinges on the political will and ability of individual governments in Rome, Madrid, Lisbon and elsewhere to implement the reforms necessary to fix their finances within the time frame of the support package. Investor doubts on that very point is one big reason why the existing bailouts of Greece, Ireland and Portugal have failed to stem the contagion. If the bailout is coming from the EU or IMF, that confidence problem remains the same. So at best, Witteveen’s suggestion is just another way of buying time, no more.

Another notion that has been bouncing around for some time is that the euro zone needs greater political integration if the euro is to survive. Specifically, critics of the euro zone have believed from the euro’s inception that it was destined to fail since it lacked a fiscal union to match its monetary union. The idea here is that greater coordination of national budgets is necessary to ensure the fiscal policies of individual members don’t undermine the stability of the monetary union – which is exactly what has happened. Here’s Stephen King, HSBC’s chief economist, on this point, from a recent report:

We have argued on plenty of previous occasions that, ultimately, the survival of the euro depends on the creation of some kind of fiscal union…Creating a fiscal union cannot take place overnight but a useful first step might be to agree on a timetable for the creation of such a union…Armed with a timetable, countries could be given a choice of two alternatives: either closer fiscal integration with reduced national sovereignty or banishment from the ECB and effective “euro-isation”. The choice would allow countries to show they either took their fiscal responsibilities seriously…or that they could not seriously expect to rely on the help of their European partners. Only then would there be a lasting resolution to the crisis. Otherwise, the fault lines will only re-open at a later date, no matter what kind of short-term fix – or failure –materialises. This is ultimately an issue about political cooperation and, unfortunately, its current absence.

We’ve already seen some movement in this direction. The leaders of the euro zone agreed last year to better coordinate their fiscal policies by submitting their national budgets to the EU at an earlier stage than in the past. Eventually, some proponents of fiscal union imagine the euro zone having a central finance ministry as a counterpart to the European Central Bank. These ideas are all very nice on paper but I think they are impractical. First of all, I can’t see the individual nations of the euro zone giving up the degree of sovereignty necessary to make a fiscal union work. I feel that they would more likely head towards dissolution of the euro zone before full fiscal union. Secondly, the euro zone has always had rules about debt and deficit levels, which have been routinely ignored by its members. Why would that change? So I think a fiscal union is a fictional one, and therefore not a viable solution to the current debt crisis.

So now that I’ve trashed other suggestions for solving the euro crisis, what’s left? The only way I see out of the crisis can be summed up in one word: Growth.

Yes, it sounds very simple, but the fact is the importance of economic growth simply does not get enough attention from the leaders of the euro zone. The debates are all about budget cutting, bailouts, rules and sanctions. There has been a recognition that the euro zone needs to become more competitive – thus the “competitiveness pact” built into a euro zone agreement earlier this year – but again that was merely an exercise in suggesting new guidelines, with no real teeth to it. What we really need to see in the euro zone is real reform aimed at generating real growth. A dearth of growth is what got Europe into debt trouble in the first place, and enhancing growth prospects would get Europe out of it.

The sad fact is that the euro has not brought the grand economic benefits envisioned by its proponents. Since the inception of the euro, the euro zone averaged an annual GDP growth rate of 1.5%, compared to over 2.1% for the U.S. Since the financial crisis, the zone’s growth has been held up almost entirely by Germany. In 2010, Germany accounted for 60% of the euro area’s GDP growth, even though it represents only 27% of its GDP. As Germany’s growth has sagged, so has the entire zone’s. GDP in the euro zone edged up a mere 0.2% in the second quarter. Yuck.

Without getting growth up, the debt crisis cannot be solved. Though there has been some effort to erase growth bottlenecks in debt-stricken countries – such as labor reform in Spain to make the market more flexible – bailouts and austerity programs for the PIIGS haven’t thought at all about how to sustain growth while state finances are being fixed, condemning the region’s weakest economies to years of miserable economic prospects. More importantly, the level of change has to be much broader, reaching well beyond the PIIGS to the euro zone overall, weak and strong economies alike. There is much lip service given to breaking down the final barriers to cross-border business in the euro zone, but hardly any action. Surplus countries like Germany need to liberalize their domestically oriented sectors to spur incomes and thus consumption, to help support growth throughout the entire zone. And let’s think outside of the box. Along with bailout loans for Greece, why not offer EU-backed tax incentives for European companies to invest in the country, creating jobs and easing the pain of fiscal adjustment?

This sort of reform won’t happen immediately. But even progress towards it would bolster investor sentiment by bolstering hope in the region’s future performance. Yet we seem to be moving in the opposite direction. Germany and France have floated the idea of a tax on all EU financial transactions – just the kind of pointless growth killer the zone doesn’t need at this moment. In the end, the leaders of the euro zone can agree on all sorts of new rules, bailouts, austerity programs and sanctions; they can form all sorts of new committees and bureaucracies. But in the final analysis, unless the euro can bring real economic benefits in terms of growth, jobs, investment and higher incomes, than the debt crisis will stay a crisis. And the survival of the euro will remain in doubt.