Fiddling while the euro burns

If you’re confused about where Europe is headed, join the club. Last week at a seminar a colleague with considerable knowledge of European affairs confidently told me "Don’t sell your euros … the Germans will eventually step in and rescue the whole thing." He may be right, but the head of the Bundesbank isn’t stepping up yet and there are significant political obstacles to the level of integration that would be necessary to make the European Central Bank a true "lender of last resort."

My concern is more long-term. It’s possible that Germany is bluffing, and that Europe’s leaders will find a way to stagger through the current crisis. But as I’ve noted before, the underlying issue isn’t just the rickety structure of the euro itself. In addition, it is whether economies like Greece and especially Italy can generate enough economic growth to make it plausible that they will ultimately repay their debts. An all-European guarantee (funded largely by Germany) might help in the near-term, because holders of Greek and Italian debt are less likely to panic if they think a bailout is available if needed and reduced fears of default will lower spreads on Italian and Greek bonds and thus allow them to continue to finance the debts they already have.

Unfortunately, economic growth in the entire eurozone is sluggish, and troubled economies like Italy aren’t likely to see sharp increases in growth, especially if they are being forced to adopt austerity budgets that shrink public sector spending and/or throw more people out of work. Plus, over the longer term most of Europe –including Greece and Italy — are going to decline in population, while the median age will rise sharply. For example, Italy’s population will decline by about 1 million by 2035 and its median age will rise from 43 today to nearly 50. A growing population of retirees and a shrinking number of active workers is not exactly a formula for robust economic growth, even in the best of circumstances.

Even if my friend is right and the Germans eventually go "all-in" to save the euro, isn’t there likely to be a point where the more prosperous European countries are no longer willing to finance bailouts in perpetuity? And what if a situation arises where they aren’t in such great shape themselves and aren’t able to fund a bailout? This is where nationalism will really kick in: it is one thing for wealthy New Yorkers or Californians to subsidize poorer U.S. states more-or-less forever, because the subsidies are mostly hidden from public view and in the end we all think of ourselves as part of the same country. But I don’t think the existing sense of common European identity is powerful enough to neutralize stubborn local nationalisms, even when the bond market is pushing in that direction. I continue to hope that Europe’s leaders will find a way out, but I’ve yet to hear a convincing story that tells me how.