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 !

Saturday, February 6, 2010

Why the Euro needs governance

The recent events which caused a turmoil in the euro area are not temporary shocks. They are the symptom of major imbalances in the world economy. After the housing and banking crisis speculative attacks are now directed to the huge deficits accumulated in the United States and Europe. Their significance is clear: 2010 (and years ahead) might be as bad or even worse than 2009.

The economic outlook is gloomy, to put it bluntly. In 2010 Europe will show a modest growth of less than 1% due to the effect of fiscal stimulus plans. As a result, deficits went on soaring to unsustainable levels close or higher than 10%; unemployment will rise to 8% but with considerable variation between countries (20% in Spain!). Should we care about a potential Greek default and of other EU countries? Greek GDP is about 2,5% of total EU GDP, Portugal slightly less and Spain around 10%; Baltic States and Hungary are also in a bad state. But, in theory, we are not talking in the Greek case of magnitudes that could cause a collapse of European economy. Therefore, we should not worry in theory about defaults of these economies.

In fact speculation takes advantage of that situation to push the euro down in respect of the dollar. Potentially, central banks of G7 economies could intervene to stop that speculative movement. Why don't they do so?

In practice, there are other more fundamental reasons. Germany is reluctant to rescue the default economies; the United States have a huge public debt, and the measures taken by the Obama administration are ridiculously insufficient to curb the rising trend. Under these conditions, it is unlikely that they would get involved in any operation to resolve the financial crisis in other countries, especially in Europe. The major risk actually stems from the US debt which to bring it to sustainable levels by 2012 would require around 3.000 billion dollars !

This is the real danger which threatens the world economy, opening catastrophic scenarios with inflation coupled with economic recession and further contraction of global trade and employment.

The Spanish Presidency is set to reinforce economic governance with the introduction of targets and sanctions as for the Stability Pact. But this is likely to be opposed by Germany and other countries which refuse any transfer of sovereignty in economic policy matters. The economic pessimism about the Greek situation has extended to other countries as the ability of single governments to aid the recovery of their national economies is put in question.

G. Verhofstadt, the leader of the Liberal group of the European Parliament keeps a very critical stance on the EU reaction to the crisis. He advocates for more integration and unity of Europe to restore sound economic conditions in European economies. If Germany and France would listen to the alarm bell, maybe Europe could still hope in its recovery.