Sunday, November 20, 2011

Two (or three) speed Europe

As the crisis has reached its peak,  the division between the core and the periphery of Europe becomes more acute. Neither the European councils nor the G-20 summit have triggered confidence in the economic governance system that was put in place with great difficulties. Tensions over Italy and Spain have in fact led to the idea of a two speed Europe with a hardcore around France and Germany while tensions between the euro area and the UK are revived. The prospect of a deep recession, as warned by the ECB, feeds the economic pessimism over the current possibility to deal with the crisis within the confines of the Lisbon treaty.

P. Krugman  argues that the euro crisis is about 'original sin' (in the economic sense), meaning that countries like Italy, by joining the euro, converted its status of economic power, as a country issuing its debt in its own currency into a situation with debts in euro, which makes it more vulnerable to financial crises. This principle was inherent in the European monetary union, but no governance rules were  introduced to help address possible financial crisis due to the financial orthodoxy imposed by Germany. 

Beyond this apparent contradiction,  N.Roubini explains that the structural causes of the eurozone crisis are much deeper and do not lie in a fiscal crisis. The divergence in real exchange rates and the strength of the euro - which introduces a competitive shock on weaker economies- largely explain the current crisis. Over the past ten years, the southern economies , which include Cyprus, Greece, Italy, Ireland, Portugal and Spain- were essentially consumers ' of first and last resort', with budget gaps exceeding their respective incomes. In addition, the private sector had also accrued considerable debts, fueled by the housing bubbles, especially in Spain and Ireland. On the other hand, the other countries- Germany, France, Austria and the Netherlands- were producers 'of first and last resort'  resulting in a growing surplus in current account balances, which was exacerbated by the strength of the euro. So, the large current account deficits, due to excessive consumption, led to loss of competitiveness and economic stagnation.

N. Roubini's argument points to the following option:  "Symmetrical reflation is the best option for restoring growth and competitiveness on the eurozone's periphery while undertaking necessary austerity measures and structural reforms. This implies significant easing of monetary policy by the European Central Bank; provision of unlimited lender-of-last-resort support to illiquid but potentially solvent economies; a sharp depreciation of the euro, which would turn current-account deficits into surpluses; and fiscal stimulus in the core if the periphery is forced into austerity". 

This solution is vigorously opposed by Germany and the ECB as it would have (modest) inflationary effects in core countries relative to the periphery. The bitter medicine that they are imposing on the 'peripheral' countries is deflation with recessionary effects: fiscal austerity, structural reforms and real depreciation. Austerity policies reduce output in the short term, due to lower demand and productivity effects linked to structural reforms and reduction of nominal wages and prices. This will become socially unsustainable, and if peripheral countries remain caught in a deflationary debt trap, they might be tempted to default and exit the euro area. In this scenario, "coercive restructurings of debt will come first, and then exits from the monetary union that will eventually lead to the eurozone’s disintegration".

Alternatively, the possibility of a break up of Europe, especially with Italy too big to fail or to save - and the contagion of the debt crisis to France, could lead to a closer political Union, which would require new forms of economic governance. The Netherlands Bureau for Economic Policy Analysis pointed out in a recent report that the debt burden of southern countries is not only the consequence of lax fiscal policies, but that  banks from the northern euro area have lent too much money to Greece and other troubled countries without any effective supervision in the banking system. It also believes all euro area countries should give up some national sovereignty when it comes to bank supervision, the EFSF, the deposit-guarantee scheme and budget supervision.

The German-French 'Directoire' no longer works and may be extended now to Italy - with the Monti government close to European affairs - with a view to build  more effective supranational institutions, in particular more economic powers to the ECB as a functioning lender of last resort, fiscal integration (with permanent fiscal transfers from the core to the periphery) and a common sovereign debt with the emission of euro-bonds. This project seemed unrealistic only a few weeks ago, now, with the opening of a strong divide with the UK and non euro-countries, it may even sound plausible in a few years time with a revised EU treaty.

P.S: Last week, José Manuel Barroso, President of the European Commission, warned that the collapse of the euro area would destroy half of the value of European economy, which would swamp the region to depression similar in scale to that of 1930. 

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