Fiscal Union Cannot Save the Euro

It might have five years ago. Or five years from now. Not right now.

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After a weekend of panic over the fate of the euro, European stocks soared Monday morning. The reason? Leaders are reportedly near a historic bargain to corral the EU's most indebted countries and announce a deal that would bring Europe closer to a true fiscal union.

There's just one problem. Fiscal unity cannot save Europe. It might have five years ago. Or five years from now. Not right now.

Fiscal union means France and Germany exercise control over the budget and taxes of countries like Greece. But it's not as though Greece is one really smart tax-and-spending plan away from solvency. It's a broken economy. "Greece is totally gone," Desmond Lachman of the American Enterprise Institute put it to me. "It's just a matter of time until they have a disorderly default."

The European debt crisis in a nutshell is that poorer peripheral countries have large imbalances that ought to be solved by devaluing their own currency. But these countries don't have their own currencies. They have the euro.

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To understand why the euro has turned into such a disaster, let's revisit why it exists in the first place. The idea was that a European currency would make all of Europe feel richer. The poorer PIIGS (an acronym that stands for the peripheral countries Portugal, Ireland, Italy, Greece, and Spain) wanted to share a currency with Germany so that they could borrow money at affordable rates. Germany wanted a euro, too, because if its neighbors felt richer, they would buy more German products.

And that's basically what happened. Germany thrived off exports sold to peripheral economies that borrowed money at low-risk rates. It was a marriage of convenience. Thrifty Germany got the trade surplus it thought it needed to grow. Profligate PIIGS got the cheap money they thought they needed to get rich.

The euro arrangement either worked out horribly, or a little too well, depending on how you choose to look at it. Investors lent lots of money to peripheral economies, which led to large capital flows from the core to the periphery, and corresponding trade deficits, or "current account imbalances."

As Paul Krugman (who shared this graph) explained, these capital inflows caused a boom in the periphery that raised costs and prices dramatically. Once again, this was somewhat the point. When a country gets richer, costs and prices should go up.

But now the tide is out, and the PIIGS's finances have been revealed as unsustainable. The simplest solution would be to break up the EU and let Greece and other troubled countries go back to their own currencies, devalue like crazy, and trade their way to growth. But the market likes certainty, and you can't very well blow up a ten-year experiment in economic unity without inviting a financial crisis. So we've reached the point of no good choices.

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The standard line is that there are two paths for Europe from here on out. Come together or fall apart. Fiscal union or financial catastrophe.

Analysis thrives in black and white, but the reality is much more gray. Fiscal union might persuade investors of Europe's long-term seriousness. But austerity will shrink the peripheral economies, which will make the road to primary surplus even harder. Higher inflation could raise overall demand, but a cheaper euro won't help Greece and Italy experience a full export recovery because most of the PIIGS' trade is within Europe.

It's much more likely that the next few weeks and months will be just as messy and confusing as the last 18 months. Greece is beyond saving. It might be months from default. Italy and Spain, on the other hand, might be salvageable with lower interest rates. That suggests the ECB should step up and act more like the Federal Reserve by backstopping Spanish and Italian debt. With more affordable borrowing costs, the euro should survive 2011.

"But fiscal unity only matters if countries get rid of their budget deficit," Lachman explained, "because you can't control deficits if everybody cuts at the same time."

"You've got countries moving into a recession and real credit crunch, with Greece moving toward disorderly default," he said. "I can see how the can gets kicked down the road and the crisis gets slowed, but I don't see the endgame."