THE EURO END GAME

By John H. Makin

Europe has pursued repeated rounds of fiscal austerity and bank deleveraging in exchange for loans that were supposed to save the euro. The result has been a predictable recession with plummeting employment, incomes, and prices. The vicious cycle of contraction—a byproduct of attempts at austerity and deleveraging—has transformed an economic problem into a political dilemma, with leftist governments rising in protest to Germany’s austerity-laced rescue packages. With Greece’s imminent departure from the eurozone, Germany will have to choose between a breakup of the euro system and a movement toward a common fiscal policy that includes issuance of European bonds to replace the country bonds currently in use.

Europe faces a simple but intractable problem. Either price levels have to rise in Germany, or they have to fall in the rest of Europe, especially in Southern Europe. That includes Spain, Italy, Portugal, and the hapless Greece. But the rising burden of deflationary policies that Germany is imposing on Southern Europe has led to a growing antiausterity backlash in recent elections. The economic suffering in Southern Europe and Ireland is clearly demonstrated in the extraordinary rise in overall unemployment and youth unemployment rates in Europe since 2008. (See figures 1 and 2.)

Beyond southern Europe, France is also moving into the camp of countries that are increasingly reluctant to adopt “austerity”—code for deflationary policies—in exchange for low interest rate loans from the European Community (EC), the International Monetary Fund (IMF), and the European Central Bank (ECB). These loans have been made largely on terms dictated by Germany in exchange for footing much of the bailout bill. The May 6 victory of François Hollande in the final round of the French presidential election signals a broadening backlash against the fiscal austerity that has characterized all of Europe’s efforts to preserve the euro.

Even the Netherlands, one of Europe’s most fiscally conservative countries, has been unable to pass into law the austerity measures called for in the March pact to save the euro.

The Dutch government collapsed shortly after the IMF’s pledges of $430 billion to the firewall designed to backstop the shaky finances of non-German Europe’s struggling economies. As is usually the case, the headline number was misleading. About $200 billion of the pledges to the firewall came from Europe, preparing to lend more to itself, that is, to borrow more from Germany while the bulk of the remaining funds were from emerging market stars like China and Brazil that conditioned their support on adjustment by the recipients.

Europe has pursued repeated rounds of fiscal austerity and bank deleveraging in exchange for the promise of loans that will somehow save the euro. However, the result has been a predictable recession with falling employment, incomes, and prices.

With most of Europe imposing austerity simultaneously, reduction in incomes and tax revenues becomes self reinforcing so that even with drastic spending cuts the collapse of the tax base means higher budget deficits and a shrinking economy.
The ratio of government debt to gross domestic product (GDP) arises as a result of efforts to reduce it. Governments appeal for more aid and are required to implement even more austerity in order to receive that aid.

Economic Pain Means Political Unrest

The vicious cycle of contraction, a byproduct of fiscal austerity and bank deleveraging, has transformed an economic problem into a political problem that puts the governments of European nations in impossible positions.

Opposition parties on the Right and the Left pledging to renegotiate or negate austerity-laced rescue packages have gained power through recent elections in France and Greece and are increasing their power elsewhere in Europe.

The Netherlands’s conservative government has collapsed as austerity intensifies an already painful recession. Even German chancellor Angela Merkel’s coalition government has lost support in regional European elections.

Efforts to preserve the euro as a symbol of a cohesive European community are beginning to threaten European unity. How can Spain’s government pursue more fiscal austerity while pressuring its banks to cut leverage (that is, to lend less) if the result is a deepening recession and mass unemployment?

The impossibility of this path has resulted in the Spanish government’s refusal to impose the degree of fiscal austerity called for by the recent agreement between the EC, the IMF, and the ECB to save the euro. Spain cannot reduce its budget deficit from 8.5 percent of GDP in 2011 to 5.3 percent of GDP in 2012 with an unemployment rate of over 50 percent among its younger workers, not to mention that the rest of Europe is in a recession that will be prolonged if full prescribed austerity is implemented across Europe.

In addition to the rise of leftist governments in Europe, the rise of far Right parties (and their opposition to the euro) has been enhanced by the recession and high unemployment that have resulted from the austerity included in recent euro rescue packages.

Marine Le Pen, the leader of France’s right wing movement, surprisingly captured nearly 18 percent of the vote in the first round of the French presidential election on April 22, 2012. Le Pen, who
throughout her campaign alleged that “the euro has been a disaster” declined to support incumbent conservative president Nicolas Sarkozy in the final round of her country’s election.1

Sarkozy was left in the unenviable position of courting anti-euro supporters of Le Pen in order to have a chance at winning the presidency. That was impossible given Sarkozy’s efforts, alongside Merkel’s attempts, to save the euro by agreeing to German-imposed austerity that has pushed Europe back into recession and generated additional support for euro opponents from both the Left and the Right.

Socialist Francois Hollande’s May 6, 2012 win in the French presidential election will weaken the French-German cooperation underlying austerity-laced euro rescue packages like those enacted over the past two years. This is probably a good thing considering the rising political opposition to this approach that is undermining the European unity regional leaders are trying to preserve.

European countries outside of Germany simply will not tolerate more austerity and, as a result, Germany will become increasingly isolated in negotiations over the future of the eurozone.

Until now, when deteriorating European economies have caused tangible erosion of political support for the euro and the currency union it represents, most European commentators have believed that closer political union would prevail in Europe and that the euro would survive as a single currency.

The elections of May 6 and their anti-austerity mandate, however, have called this presumption into question. European elites have touted a single currency as the basis for a more prosperous and harmonious Europe. That outcome seemed assured prior to the 2008 financial crisis when easier credit fueled a consumption boom outside Germany and a production boom inside Germany leaving most Europeans better off. But the resulting surge in government debt, especially in Southern Europe, Ireland, and Belgium (much of it purchased by European banks) left European prosperity highly vulnerable to slower growth and to the attendant inability to service, let alone dream of repaying, such a huge quantity of loans.

Greece’s Likely Exit from the Eurozone

The political chaos that has emerged in Greece constitutes a special case. Its May 6 election underscored the failure of the pro-bailout coalition government that had agreed to austerity terms and that put a left wing coalition headed by Alexis Tsipras in the position to try to form a government. New elections are now scheduled for June, and their outcome is very uncertain.

Tsipras has said that the IMF–European Union bailout agreement of March is now “null.”2 Meanwhile, a prominent German finance official has said that Greece cannot stay in the eurozone if there are changes to the bailout agreement. As John Plender wrote in the Financial Times, it looks like the new question for Europe is not whether Greece will exit the eurozone, but rather how much contagion will result when it does.3

The acute pressure point in the ongoing euro crisis has shifted from Greece to Spain. The overall unemployment rate in Spain is now nearly 25 percent, about two percentage points above that in Greece.

Unemployment rates among those under twenty-five years of age in Spain are above 50 percent. Unfortunately, the persistence of high unemployment is in part due to attractive unemployment benefits in those countries which, of course, add to their high budget deficits. However, when one views these policies, the fact is that it is very difficult for countries that follow them to coexist in a currency union with Germany.

Europe’s Choice

Going forward, Germany will have to choose between a breakup of the eurozone currency area and a movement toward a common fiscal policy that includes issuance of European bonds to replace the country bonds currently in use. Germany will need to share its high credit rating with the rest of less credit worthy Europe. This may not be acceptable to Germany.

Furthermore, the move toward a common fiscal policy will probably have to include, at least in the short term, more inflation than Germany is currently willing to accept, notwithstanding some recent conciliatory comments from the Deutsche Bundesbank described below.

The actual outcome will be the result of a bargaining process between countries calculating the costs and benefits of staying in the euro system or leaving it. Most analyses to date have concluded that the cost of exiting the eurozone is so high that no country would contemplate it. However, the social unrest and virtual economic collapse in Greece have upset those calculations.

Greece, in effect, has little to lose by leaving the euro system. Civil unrest and economic collapse that preserving Greek membership in the eurozone was meant to prevent have already occurred in the country. The next question is whether Spain falls into the same category. This remains to be seen, but a Greek exit from the eurozone will increase the pressure on Spain’s government to further mitigate austerity reducing the likelihood of German support for a Spanish rescue package that will have to be substantially larger than the €130 billion second package provided to Greece in March.

The political disruptions that have emerged this year in Europe mean that whatever happens, the euro, if it survives, will not continue as a deutschemark surrogate. The attempt to achieve this unreachable goal has created more economic pain than politicians outside Germany can manage.

The attempt to prevent Spain from being forced to accept governmentally, economically, and civically impossible bailout conditions will include negotiations that seek to force Germany to accede to less Spanish austerity. At the same time, the ECB will need to signal more accommodation by cutting rates and extending longer term loans to European banks while Germany allows prices and wages to rise faster than they are rising in the rest of Europe.

It is encouraging that on May 9, the head of Germany’s central bank showed some willingness to tolerate faster wage and price increases nationwide while adjustments to slower wage and price increases were underway in the rest of Europe.
It remains to be seen how much Germany will bend on the issue of inflation.

The dilution of the euro as a hard currency store of wealth will, of course, have international implications. Initially, the
dollar may appreciate against the euro. However, too much dollar appreciation in a world of weak demand will no doubt cause the US Federal Reserve to enact further easing to preempt a negative impact on US trade balance and growth.

The upshot will be a new necessary condition for avoiding the collapse of the eurozone: another round of monetary easing and a further delay in addressing the rapid buildup of debt in the global system.

Alternatively, if Germany refuses to follow through and tolerate higher inflation, the eurozone will break apart, much of the European financial system will collapse, and Germany will experience a powerful deflationary shock as funds rush into the world’s last hard currency safe haven. That is a negative sum game we should hope does not happen.

Notes

1. William Horobin and Garbiele Parussini, “Le Pen Picks Up Father’s Mantle in France,” Wall Street Journal, April 24, 2012, http://online.wsj.com/article/SB10001424052702303978104577361950094093204.html (accessed May 14, 2012).

2. “Leftist Leader Says Greece’s Bailout Pledges Are Null,” Reuters, May 8, 2012, www.reuters.com/article/2012/05/08/us-greecetsipras-idUSBRE8470LK20120508 (accessed May 14, 2012).

3. John Plender, “Electorates Cannot Have It Both Ways,” Financial Times, May 8, 2012, www.ft.com/intl/cms/s/0/65c20524-990f-11e1-948a-00144feabdc0.html#axzz1uUk26RsM (accessed May 14, 2012).