It’s astonishing, but everyone is behaving as though the euro crisis were over. Long-term bond yields are bellwethers of investor confidence. And over the past few months, yields on 10-year Spanish bonds have fallen from 7.5% to 6%, while those on similar Italian issues have dropped to 5%. The U.S. stock market seems equally upbeat. The S&P 500 finished the third quarter last week at its highest level in more than four years. Share prices are shrugging off not only the likelihood of an economic slump in 2013, but also the possibility that a crisis in the euro zone could send shock waves throughout the global banking system.
Something seems very wrong with this picture — at least to me. Focus only on the European elite, and everything may appear under control. The May election of Socialist François Hollande to replace Nicolas Sarkozy as President of France has shifted European finances in the direction of easy money. The ruling three weeks ago by Germany’s Constitutional Court removed the biggest remaining stumbling block for future bailouts in the euro zone. And German Chancellor Angela Merkel has also softened on financial questions, declaring last Thursday, “We will continue to do everything necessary to develop the economic and currency union so that it is stabilized permanently.”
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But as soon as you turn from the elites’ self-congratulation to stories about people in the streets, you get a very different impression. Formerly middle-class Spaniards are scrounging for food in dumpsters. Greeks are rioting when they are not engaged in neofascist marches. Rich French people are thinking about leaving their country because of staggering new income tax rates. And former Italian Prime Minister Silvio Berlusconi — the “bunga bunga” man — is mulling a return to office by running against German oppression.
Everything can be straightened out, according to advocates of easy money, if enough cash is handed around by European financial institutions. “If Germany really wants to save the euro, it should let the European Central Bank do what’s necessary to rescue the debtor nations — and it should do so without demanding more pointless pain,” writes Paul Krugman in the New York Times. “The continued survival of the euro is assured,” writes George Soros in the New York Review of Books, although more ominously he adds: “The line of least resistance leads not to the immediate breakup of the euro but to the indefinite extension of the crisis.”
An indefinite extension of the crisis is precisely what appears to be in store. By lowering the cost of borrowing, expansive monetary policies do indeed reduce the short-term financial pressures on heavily indebted countries. But in my view, three long-term problems remain that have no easy solution.
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First, countries can’t easily escape the consequences of past mismanagement. Greece, Italy and Portugal are all projected to run what are called primary budget surpluses next year. That means that their governments will take in more money than they spend, if you don’t count interest payments. In other words, they would now be in great financial shape, thanks to all their belt-tightening, if it weren’t for the burden of the debt they accumulated in the past. By contrast, the U.S. primary deficit is still a whopping 6% of GDP, significantly higher than that of every country in the euro zone. If weak European countries have to pay off all their past debts at the same time that they are running primary budget surpluses, they will face a very long period of austerity indeed.
The second problem is that over the past decade, the euro has created a severe misalignment in labor costs (after adjustment for differences in productivity). Labor costs in weak countries are as much as 20% higher than those in Germany. Part of the reason for the gap is that those countries let wages and benefits rise too fast in past years, and another part is the result of subpar gains in productivity. There are three possible fantasy solutions: everyone could leave the euro and then rejoin it at new exchange rates that equalized costs; everyone in high-cost countries could agree to 20% wage cuts; or a massive wave of new investment could boost productivity. None of those things is particularly likely. More realistically, countries with overpriced labor have a choice between simply leaving the euro zone or preparing for years of austerity that slowly grinds down their labor costs.
The third problem is that perpetual austerity is not only intolerable, it is also ineffective. Occasional protests that result in some broken shop windows are one thing. But current demonstrations in Europe against stringent austerity policies reflect the unraveling of the social fabric itself. What is worse, there is little chance that such policies can solve Europe’s financial problems within a reasonable time frame. There is simply too much debt to pay down and too many accumulated structural problems. Moreover, if austerity pushes countries into recession, their shrinking economies will actually become less capable of hitting financial targets.
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There is, in short, no straightforward solution. At best, a careful balance will have to be maintained between, on one hand, the financial stringency required to chip away at debt while bringing European labor costs into better alignment and, on the other, the basic needs of the people who will suffer in the process. Europe is still immensely wealthy, and there is no reason to believe that today’s problems will necessarily end in catastrophe. However, the current level of complacent optimism seems somewhat naive. There figures to be a lot more mess to wade through before the euro crisis is truly over.