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Buying time is not enough

    For all the commentary of last week’s EU summit fallout, the key point remains that little discussed or suggested would have helped to eliminate the core problem of the current Eurozone: huge imbalances in competitiveness between nation states – imbalances created by the make-up of the Eurozone itself.

    It’s important to understand the origins of why we are here. When the PIIGS entered monetary union, they benefited from interest rates falling much closer to German levels. This helped to fuel a credit boom and large-scale real estate investments with rising house prices (particularly in Spain and Ireland). Whilst resulting in fast economic growth and increased employment –huge increases in labour costs associated with this made these countries' exports distinctly uncompetitive. Current account deficits financed by capital inflows from external investors in turn led to huge private sector debts. Meanwhile, countries like Germany accumulated large current account surpluses by internally devaluing in addition to benefiting from an undervalued currency given her fundamentals.

    Without the ability to use exchange rate or monetary policy, and with fiscal policy technically constrained by the Stability and Growth Pact, there was little other national governments could do to prevent these imbalances from growing. The ECB continued to target average consumer price inflation across the Eurozone – it had no remit to deal with imbalances, and so showed little concern for what was happening. But the key result of these imbalances was this: the PIIGS were hugely vulnerable to disruptions in international financial markets.

    According to Scharpf’s analysis, the financial crisis then affected the Eurozone in three key ways:

    1. The initial subprime crisis exposed those banks who’d invested in the toxic debts (Germany and Ireland), with bailouts leading to huge budget deficits
    2. The credit crunch choked off growth in credit-dependent economies – further accelerating the gap between government spending and tax revenues for budgets whilst hitting growth and employment
    3. International rating agencies began to worry about how sustainable public-sector indebtedness was, leading to increasing risk premia on sovereign debt

    To understand these varied structural causes grants us an insight into why the current policy solution can’t work – there is no mechanism to cure the imbalances. Thus far the EU has been providing credit for sovereigns via the IMF and the EFSF with conditions attached that significant fiscal retrenchment and supply-side reforms must be undertaken by national governments – essentially, the prescription has been that these countries must make themselves competitive internally because they are unable to devalue their currency.

    This solution is not working and is unlikely to, in part because of huge structural and cultural differences between European states. The short-term results of these contractionary policies has been a continued upward rise in the total debt burden, while the lack of confidence in the solution has seen interest rates on government bonds continue to rise. What’s more, the solution is going to be met with fierce internal resistance. Not only are the conditions being imposed by foreign governments and institutions to prevent what they see as a worse scenario (the break-up of the euro), but the governments will have to adopt and justify policies that will visibly hurt workers and those on welfare.

    So, another way out is needed. And this is where the political considerations come in. In theory, a full fiscal union with a system of transfer payments and the ECB as lender of last resort could work. But Germany appears unwilling to bankroll the southern European states in a system which would lock in their inefficiencies, both for economic and political reasons – and so it seems the current talks are bound to fail.

    Given this, the EU must contemplate a break-up of the euro. To be clear, this will have severely undesirable outcomes in the short-term.

    For the countries that declared bankruptcy and re-adopted national currencies, there would be a large devaluation – which would be very painful. So painful in fact that renowned economists such as Eichengreen have claimed it is not even feasible. But splitting into North and South currency blocs would be somewhat less problematic.

    In fact, splitting and devaluing has huge advantages in terms of the feasibility of the competitiveness goal being achieved. The devaluation would be a one-time shock to the country which would increase import prices and thus reduce domestic real incomes, but it would then be up to policy makers to limit the damage and begin reconstructing the economy. In contrast, the current enforced internal devaluation programmes is more difficult to justify through national Parliaments and the process is incredibly slow.

    The fate of the euro boils down to what Germany decides to do. The sooner she realises that internal devaluations are infeasible, she must decide either to back the currency through transfers or shared debt, or to give it up. The former would require a difficult process of democratic consent. So far the perceived setback to European integration and the heavy potential losses of northern European banks (not to mentioned the negative effect on German exports) have been sufficient for Germany to support efforts to keep the currency on life-support. But without clear signs of progress on fiscal and monetary union in the coming weeks, then it would seem we would have reached the point where a break-up, though difficult, would be the least of all evils.

    Ryan joined the Centre for Policy Studies in January 2011, having previously worked for a year at the economic consultancy firm Frontier Economics.

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