The EU's Cure-All Cured Nothing: Why Germany's Medicine Is Killing Europe
It will be "bankruptcy for our time" unless Europe's leaders dramatically change course.
Europe has many problems. But one problem it doesn't have is too little unemployment. That's apparently news to the continent's lords of finance -- at least based on the policies they are prescribing for Europe's troubled economies. They're acting as though the gravest possible crisis the euro zone could face is inflation. That, in a nutshell, is why this crisis never went away and will only get worse for Europe's unemployed.
The below chart compares (1) unemployment and (2) proposed cuts as a percentage of GDP across the EU. (Figures courtesy of Eurostat and The Economist). Countries with the worst unemployment generally have to make the biggest fiscal adjustments over the next year. This is a particularly perverse case of what economists call pro-cyclical policy -- that is, policies that reinforce the trend in the economy.
The problem with pushing contractionary policies when the economy is already contracting is that you wind up with more contraction. But right now Europe's periphery doesn't have much of a choice "thanks" to the natural constraints of an international currency (the euro) and Germany.
There are three broad ways to counteract a slump. First, the government can run (bigger) deficits. Second, the central bank can lower interest rates. Third, we push down the exchange-rate. It basically amounts to either spending more money, printing more money, or making money worth less. But the euro members in the worst trouble can't do any of these things. They can't afford to borrow, because investors don't think they can grow enough to pay back their loans. They can't lower interest rates, because that's the ECB's job. And they can't devalue their own currencies, because they don't have their own currencies. They have the euro.
The last thing Spain needs right now is austerity. Unfortunately, its government is supposed to close its budget gap by 5.5 percent of GDP this year. Not to get too tautological here, but contractionary fiscal policy is contractionary. It's almost inconceivable, but things are poised to get even worse in Spain -- unless the government ignores the calls for further austerity. They just might. Already, newly elected prime minister Mariano Rajoy has flirted with outright defiance of the EU's deficit target.
This isn't just a Spanish problem. It's bad for all of southern Europe. Governments across the Mediterranean are being asked to narrow deficits at precisely the wrong moment. There's a terrible logic to it. Recessions cause deficits. After all, automatic stabilizers surge and tax revenues collapse as the economy does. It makes sense that the worst-hit countries have the most to cut. But it doesn't make sense to do that cutting now.
Germany disagrees. And since they're the ones writing the bailout checks, their opinion is the only one that matters. The Germans have latched onto a misdiagnosis of the crisis. They think it's a morality tale about profligate governments finally having to live within their means. It's not. If it were, Spain wouldn't be in trouble now. They actually ran budget surpluses during the boom years. (Germany was the one that broke the Maastricht Treaty's deficit limits). What's really going on is a balance-of-payments crisis. Capital gushed into Southern Europe during the bubble years. Then it stopped. Austerity won't solve this. It might even be self-defeating -- tax revenues might fall more than the government saves. The Germans, of course, look at these widening deficits and conclude that the only remedy is ... more austerity! It'd be funny if it weren't so tragic.
TELL ME HOW THIS ENDS
In the short term, the ECB will probably douse the latest panic with a torrent of money. Europe's leaders will go back to pretending that the crisis is over. But that won't bring down unemployment in southern Europe. And that's a political time bomb that could tear the euro apart.
Eventually, too much unemployment will make too much austerity politically untenable. Spain is already near that point. Prime Minister Rajoy has tried to flout the Germans' demands for deeper cuts. Unless Europe comes up with a plan that doesn't require southern Europe to pointlessly suffer through permaslump, this resistance will escalate. In the worst case, Spain's leaders might conclude that leaving the euro zone is both their only political choice and only way to end their depression. A disorderly euro exit would, of course, set off the mother-of-all financial crises.
Which is why Germany needs to radically change course. Even a slight chance of Eurogeddon should terrify them. So what should be done? Germany should promise stimulus for southern Europe, conditional on those governments carrying out fiscal and structural reforms. That could mean Eurobonds to counteract local austerity. It could mean letting the ECB be much more aggressive -- perhaps by putting a ceiling on borrowing costs for southern Europe. It doesn't really matter how Germany does it. It just needs to do something. Eventually you need to stop kicking the can down the road, and actually pick it up.
The longer Germany persists in trying to get Europe to cut its way to prosperity, the worse the problem will get. Today, Spain is on the precipice. Tomorrow, it will be Italy. Even France won't be far behind. Indeed, France has actually has worse unemployment and almost as much to cut as Italy does. The cost of inaction rises each day.
Germany needs to decide whether the half-century European project is worth 4 percent inflation or a bigger deficit. If it's not, then it's time for Europe to start planning for an amicable divorce.