The Center Cannot Hold
The EU's newest states want its core members to bail them out. But it's the union itself that's broken.
As Leo Tolstoy might put it, all of Europe's economies are feeling pretty unhappy right now, but each is unhappy in its own unique way. Nowhere have the effects of the crisis been felt more acutely than in the peripheral countries on Europe's southern, northwestern and eastern edges. As the recession worsens, these countries are looking toward Europe's traditional center in hopes of salvation, seemingly unaware that the center itself is struggling to hold, as countries such as Germany and Austria battle with their own version of the meltdown.
As Leo Tolstoy might put it, all of Europe’s economies are feeling pretty unhappy right now, but each is unhappy in its own unique way. Nowhere have the effects of the crisis been felt more acutely than in the peripheral countries on Europe’s southern, northwestern and eastern edges. As the recession worsens, these countries are looking toward Europe’s traditional center in hopes of salvation, seemingly unaware that the center itself is struggling to hold, as countries such as Germany and Austria battle with their own version of the meltdown.
As a consequence, the feeling is growing that the Europe’s problems are not local or national ones, but that it is the eurozone itself — in its conception and its architecture — that is fundamentally flawed, lacking the ability to come to the aid of individual countries in difficulty. Some analysts even worry that we might be witnessing the beginning of the end of the European experiment altogether.
The good news is that Europe can be saved. Rescuing Europe’s problem economies will take much more than a simple bailout, though. It is going to require nothing less than a complete recasting of the continent’s entire political and financial architecture.
We begin our tour in Spain and Ireland, both until recently considered outstanding pupils by the European Central Bank (ECB) and major economic success stories. The two countries are now in serious trouble as they struggle with the unwinding of a property boom that has its roots in the ECB’s ultraexpansive monetary policy. Spain, Europe’s fifth-largest economy, entered its first recession in 15 years at the end of last year and is now suffering from 15 percent unemployment, a figure that might rise to 20 percent or more by 2010. Forecasts for Spanish GDP growth in 2009 range from minus 3 percent to minus 5 percent, but the contraction could easily extend into 2010, 2011, and beyond. The Spanish government is still essentially in denial about the scale of the correction needed and has been busy trying to spend its way out of trouble, with the predictable negative consequence that the country’s once solid fiscal surplus is now spiraling downward into deficit at breathtaking speed. Indeed, the European Commission (EC) has already initiated an excess deficit procedure against Spain.
As for Ireland, it was not so long ago that the country’s economy was experiencing a boom of such proportions that it came to be known as the Celtic Tiger. Now, the tiger is tanking. The EC forecasts a 5 percent contraction in GDP this year; unemployment is widely expected to hit 11 percent; and house prices have plummeted. As a result, the Irish fiscal deficit is expected to rise to 9.4 percent in 2009. Again, the EC has opened an excess deficit procedure, and the country is being threatened with losing its AAA debt rating.
The EU’s most recent members are also feeling the chilly winds of recession. If anything, Eastern European economies and credit ratings are even less capable than their Western counterparts of weathering dramatic increases in debt levels. Thus, in the case of those countries having a significant home-banking presence, such as Latvia and Hungary, the support of external organizations — the EU, the World Bank, the International Monetary Fund (IMF) — becomes rapidly necessary when their banks start having liquidity problems. Then, as a direct result of the consequent bailouts, the countries’ debt-to-GDP ratios start to rise, putting their eurozone membership in jeopardy. If something isn’t done soon, these two countries, and possibly others, are headed for a self-perpetuating process of indebtedness with only one end point: sovereign default.
Latvia and Hungary may be the current worst-case scenarios, but the list of walking wounded is growing by the day. Romania and Bulgaria are now in informal consultations with the IMF, while Slovakia and Slovenia (the two Eastern European countries that actually made it into the Eurozone) hurtle off into deep recessions. What’s more, the chilly wind has now spread even further north, beyond the Baltics and into Scandinavia. Sweden is in the middle of a much more serious recession than previously thought. Official figures for the fourth quarter of last year reveal that GDP contracted 2.4 percent quarter-on-quarter in the final three months of last year, equivalent to an annualized decline of 9.3 percent. Denmark is in the middle of a housing bust, and its economy has contracted as households spend less and the global financial crisis saps demand for the country’s exports. Finnish output also slumped, by 1.3 percent, the most in 17 years, in the fourth quarter of 2008. Certainly the situation is less severe in the north, but in addition to the homegrown recession, Sweden’s troubled banking sector now labors under the growing weight of debt defaults in the Baltics and other parts of Europe.
With the periphery on the ropes, all eyes have been turning to the center for help, particularly to Germany. Peer Steinbrck, Germany’s finance minister, has had to face the cameras on an almost daily basis to answer a barrage of press questions about how equipped the EU is to handle all the looming bailouts, as if reaching for the German checkbook were the magic remedy to cure all ills.
Unfortunately, nothing could be further from the truth. Germany has itself been bruised and battered, first in the U.S. subprime turmoil, then in Ireland, and now in Eastern Europe. Its export-driven economy has suffered the impact of recession after recession among its main customers. The economic slump in the final quarter of 2008 proved worse than feared, with the country posting the sharpest fall in GDP since it was reunified in the early 1990s. And there is evidently worse to come, because the German private sector shrank in February at its fastest rate in more than a decade. Many economists now anticipate a contraction of about 5 percent for 2009.
The Financial Times correspondent Wolfgang Munchau has been complaining bitterly of late — and with good reason — about the extraordinary narrow-mindedness of Europe’s economic and political leadership in the face of the current crisis. But more than narrow-mindedness, what Europeans face is innocence and an inability to react, which frankly, might be worse. I say innocence because it is by now abundantly clear that many of Europe’s leaders simply haven’t yet grasped the severity of the problems the continent faces (especially in Spain, or even Germany, let alone in Eastern Europe), and I say inability to react, because Europe has always and forever been moving too little and too late. The initial response to the banking crisis last October provides just one clear example about how it is one thing to make promises to guarantee the banking sector, and quite another thing to live up to them.
Ten years of bad craftsmanship cannot be put straight in a day, but Europe is going to have to try. The EU now badly needs to remedy its institutional deficiencies to address its crisis overload problem. Fortunately, remedies are available, even if getting Europe’s leaders to talk about them is akin to leading a reluctant father-to-be up to the altar.
First, EU (rather than exclusively national) bonds can be created. These will effectively give Europe a fiscal capacity that is, for all intents and purposes, equivalent to that of the U.S. Treasury. Second, given the deflation problem, the European Central Bank can now follow the Bank of England and the Swiss National Bank by entering the next tier of quantitative easing, expanding its balance sheet and starting to buy those crisp new EU bonds in the primary market.
(Quantitative easing, which is simply a generic way of referring to all the recent attempts to boost money supply when interest rates fall close to zero, becomes in this particular case a euphemism for printing money, with the unusual characteristic that this time, inflation is exactly what we are looking for. And if we don’t get it, well, as Paul Krugman wrote in a recent New York Times op-ed on Spain, we run the risk of ending up with a European economy that is depressed and tending toward deflation for years to come.)
Third, the rules of the Maastricht Treaty should be rewritten to give the eurozone rapid access to the highly vulnerable countries of Eastern Europe. These countries have been suffering, either directly (in the case of countries whose currencies are pegged to the euro — the Baltics and Bulgaria) or indirectly (in the case of countries with floating currencies, but whose economies are tied through exports to Western Europe — Poland, the Czech Republic, Hungary, and Romania) from the gravitational pull of the currency union. They need short-term protection, followed by long-term nurturing, and the Eurozone structure is itself the best incubator we have at hand.
The most important thing to realize is that the arrival of deflation is not only a threat; it is also an opportunity. Having the power (nay the necessity) to print money should give Europe’s central administration one hell of clout should it need to use it, and it will. As Joaqun Almunia, EU commissioner for economic and monetary affairs, said earlier this month, You would have to be crazy to want to leave the eurozone right now, given the economic climate. It’s precisely this fear that should serve as a persuasive stick to accompany that attractive financial carrot. (Assuming Europe’s leaders understand that, in this case at least, sparing the rod would only amount to spoiling not only the child, but all the brothers and sisters and aunts and uncles, too.)
So though the first argument in favor of EU bonds might be an entirely pragmatic one — that it doesn’t make sense for subsidiary components of EU, Inc., to pay more to borrow money when the credit guarantee of the parent entity can get it for them far cheaper — the longer-term argument is that the ability to issue such bonds might well enable the EC to become something it has long dreamed of becoming: an internal credit rating agency for EU national debt.
What Europe badly needs to do at this point is restore confidence — confidence that it is not in denial about the underlying severity of the economic problem, that it has the instruments at its disposal to resolve the problem, and that it is up to the task of implementing them. This restoration of confidence that we have the means, we have the will, and we are going to finish the job is what, more than anything else, is lacking right now. Otherwise, Europe will be back to local, national, piecemeal solutions; to hoping in vain for a German savior (when Germany itself is struggling); and to rising bond spreads and growing economic chaos. As World Bank President Robert Zoellick told the Financial Times recently, It’s 20 years after Europe was united in 1989 — what a tragedy if you allow Europe to split again.
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