Saturday, February 20, 2010

'Pigs' need support from Europe

Lately, the Greek crisis has captured the attention of many analysts, who tend to focus almost exclusively on European deficits and debts on the European periphery. This 'ideological' campaign on the so-called Pigs (Portugal, Italy, Greece, Spain)- or Piigs (if we include Ireland)- conveys a negative message that those governments are irresponsible and that they should cut spending regardless of any deflationary consequences on economic activity.

There is some confusion about the causes and effects of the crisis. Krugman (Nyt Feb.15) is right to assert that the lack of fiscal discipline is not the source - and probably not the main factor- of Europe's problems. Most southern European countries have lost competitiveness over the past decade with rising costs in the manufacturing sector and growth was largely fueled by the construction sector which caused the house bubble.

P. Krugman, like many American economists, do not have much sympathy for the euro. The economic arguments are well known: lack for labour mobility, no optimum currency area and no federal budget to absorb external shocks. But the euro is also a political project to strengthen European integration after the collapse of the Soviet Union and the disintegration of the Eastern bloc.

As N. Roubini and A. Das (FT Feb.3) put it, Greece highlights 'an uncomfortable truth, that no currency union has survived without a fiscal and political union'. Unlike the United States, Europe lacks burden sharing mechanisms to provide assistance to its member States when they are faced with critical budgetary situations.

All southern countries (Pigs) will need to change their growth model based on residential construction driven by a boom in house prices. Spain like Ireland have a fragile banking sector due to massive mortgage debt, which is a key source of financial contagion. . Spain has to engage in fiscal consolidation to restore debt sustainability and to achieve higher growth to face mass unemployment. Ireland has made deep budget cuts; Portugal is struggling with a painful deflation; Italy has also introduced fiscal austerity but has still to restore its external competitiveness. In comparison, Greece has a high debt (but lower than Italy), a high budget deficit ( comparable to many countries and has lost structural competitiveness (but less than Spain). The main concern is that Greece has huge liquidity problems as it will have to find around 30 billion to refinance its public debt, but this is something that the IMF can deal with (but this is now ruled out) or eventually by a consortium of banks or non traditional creditors like China.

In fact, Greece has become the front line of a wider battle between the federalists, who seek further political integration and the eurosceptics - which in fact include the US and countries which did not join the euro area for domestic reasons as well as the Czech republic for ideological reasons. The latter expect a failure of the euro area to advance their pro-free market agenda and undermine the whole European integration process. In this regard, they expect that Greece would leave the euro area in order to devalue and re-denominate its liabilities into a 'new dracma' like in Argentina. But no serious economist can defend such a position as this would trigger, as B. Eichengreen puts it, the 'mother of all financial crises'.

Making the euro work needs a political union, but this is probably a long term endeavor as many countries will oppose it. For the time being, the question is whether Europe will intervene or if it will leave the case in the hands of the IMF. If Europe decides to act, there will be a need to design formal rules for fiscal burden sharing such as debt restructuring mechanisms for eurozone sovereigns to restore the credibility of the euro. But there is a more fundamental question: which Europe do we want, a cohesive or a fragmented one? Without any doubt we should opt for the first model albeit it entails high social costs but in the long term appears to be more sustainable both on efficiency and equity grounds. This means reinvigorating EU solidarity with countries most in-need. Pigs unite !

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