How Can Europe Possibly Save Itself?
Well, things are getting a little gnarly in Europe. When you're down to the point of celebrating that Italy managed to place some debt at the low, low price of 7.6% . . . well, it's two for one drinks specials at the first class bar on the Titanic!
But don't worry: they have a plan! Ladies and Gentlemen, I give you, Plan #9,784:
"Under the partial risk protection, EFSF would provide a partial protection certificate to a newly issued bond of a member state.
"The certificate could be detached after initial issue and could be traded separately. It would give the holder an amount of fixed credit protection of 20-30 percent of the principal amount of the sovereign bond.
"The partial risk protection is to be used primarily under precautionary programmes and is aimed at increasing demand for new issues of Member States and lowering funding costs.
"Under option two, the creation of one or more Co-Investment Funds (CIF) would allow the combination of public and private funding. A CIF would purchase bonds in the primary and/or secondary markets.
"Where the CIF would provide funding directly to member states through the purchase of primary bonds, this funding could, inter alia, be used by member states for bank recapitalisation. The CIF would comprise a first loss tranche which would be financed by EFSF.
At first, I thought this was the kind of big move that we'd been waiting for. Then I noticed that it was being done through the EFSF, and that the The EFSF has not gotten noticeably bigger. This is basically just another variation on levering up the funds--and that has so far not proven to be a winning strategy for reassuring markets.
I remain skeptical, in the end, that Germany is going to agree to substantially deeper fiscal integration with Greece and Italy. You hear a lot of people saying that "We know what will work" and lamenting the fact that policymakers won't do it, but if the last four years should have taught us anything, it's that we don't actually know that anything will work.
Don't get me wrong--I think that either an ECB intervention or a eurobond are the only things that are likely to work. But I can also see scenarios where they don't, or where they work for only a short period of time.
The current plan on the table, as I understand it, is for the PIIGS to get bailouts in exchange for letting the more solvent countries step in and run their budgets if they violate budget rules. I can see how this could work, but I can also see how that might be the last straw, and that if the central countries actually tried to execute on this authority, they might find that it doesn't actually exist . . . while their guarantees of that debt very much do. The EU, in fact, has a rather long history of creating toothless institutions that everyone ends up ignoring. If I were German, I'd be thinking really, really hard about that . . . even if I believed (as I do!) that letting the PIIGS go would be vastly more expensive in the short term.
Why might this be unstable? Leaving aside perjoratives about Mediterranean nations (though really--if the Greeks can't collect taxes, how are the Germans going to manage?), there are big problems that bailouts don't fix, as Austan Goolsbee just ably explained in the Wall Street Journal:
Northern Europe has fueled its growth through exports. It has run huge trade imbalances, the most extreme of which with these same Southern European countries now in peril. Productivity rose dramatically compared to the South, but the currency did not.Keeping the euro together requires much more than fiscal integration--all fiscal integration does is turn the peripheral countries into something like those Algerian ghettos ringing Paris. Actually correcting these imbalances is going to require a lot of people in the periphery to get up and move. That's a really tall order. Despite the fabled European multi-lingualism, in my experience, the majority of workers speak English about like I spoke high-school French and college Spanish; well enough to go on vacation, but not well enough to enjoy living in another country. I'm told that this is about standard. And that's just one of the many barriers to movement between countries.
This explains at least part of the German export and manufacturing miracle of the last 12 years. In 1999, exports were 29% of German gross domestic product. By 2008, they were 47%--an increase vastly larger than in Italy, Spain and Greece, where the ratios increased modestly or even fell. Germany's net export contribution to GDP (exports minus imports as a share of the economy) rose by nearly a factor of eight. Unlike almost every other high-income country, where manufacturing's share of the economy fell significantly, in Germany it actually rose as the price of German goods grew more and more attractive compared to those of other countries. In a key sense, Germany's currency has been to Southern Europe what China's has been to the U.S.
If you don't think this dynamic has profound implications for Southern Europe, consider the case of East Germany. At the time of unification in 1990, it joined West Germany at an overvalued exchange rate, with its currency at parity with the Deutsche Mark. Suddenly East German factory workers were being paid West German-style wages but working at East European productivity levels.
The number of people employed in the former East Germany fell to about five million today from around 10 million in 1990. Its unemployment rate compared to the rest of Germany remains elevated more than 20 years later. Yet in some senses the East Germans had it easy. They received more than $1 trillion in subsidies. They also spoke the same language, and massive numbers of them simply packed up and moved west.
What would have happened without these escape valves? Something awful. Something like what Southern Europe now faces.
It's not just the Germans who have to ask themselves whether the PIIGS won't eventually say "Enough!" and renege. The bond buyers have to ask the same thing. At this point, it's not entirely clear to me that any solution is credible enough to kick the can more than a very short distance down the road.
On the other hand, I certainly hope I'm wrong.