With Ireland voting on the European Fiscal Treaty on Thursday, a primer on the euro crisis might be helpful. The Fiscal Treaty (sometimes referred to as the Fiscal Compact) would create a permanent European bailout fund (the European Stability Mechanism (ESM)) to replace the European Financial Stability Facility that European leaders established at the beginning of the euro crisis to bailout illiquid countries. The ESM is Europe’s most signature response to the sovereign-debt crisis, and as such it suggests the broad themes of European leaders’ thinking on the causes of, and steps needed to resolve the crisis.
The origins of the current crisis lie in the structural problems of the single currency’s design and the contingent features which brought these problems to the fore. As Andrew Moravcsik has explained, the euro always hinged on a gamble: “the deficit-prone countries of southern Europe would adopt German economic standards–lower price inflation and wage growth, more savings, and less spending–and Germany would become a little more like them, by accepting more government and private sector spending and higher wage and price inflation.” In this sense, the very heterogeneous economies that signed the Maastricht Treaty would converge somewhere in the middle. The problem is that this convergence hasn’t happened. Over the past decade, deficit countries like Greece and Spain have become less competitive, as unit labour costs have outpaced average inflation across the eurozone. At the same time, Germany has suppressed wages below inflation. This divergence between excessive wage rises and wage suppression has led to a roughly 25% gap in competitiveness between Greece, Italy, Portugal and Spain, and Germany.
The only things that really converged over the past decade were borrowing rates across European countries. With the single currency, bond yields dropped in Greece and Spain, approaching Germany’s. Lower borrowing costs allowed these countries to cheaply finance expansions in public and private spending, contributing to wage and price inflation in those countries. Larger deficits would normally have led lenders to automatically demand higher interest rates, but investors took the creditworthiness of all eurozone bonds as equal, ignoring the underlying public finances of each particular country. The 2008 financial collapse eviscerated public finances by decreasing receipts and expanding deficits as measures were taken to stimulate economic activity. Shrinking GDP figures made debt-to-GDP and deficit-to-GDP ratios worse. By 2010, bond markets had enough. Concerns about Greece’s liquidity (its ability to finance its short-term debt obligations) turned into a solvency crisis (questioning whether or not Greece would ever be able to pay its debts). Greek bond rates shot up, pricing Greece out of the market, and leading the European Central Bank to buy Greek bonds, violating its “no bailouts” clause. Concerns about Greece quickly spread to Italy, Portugal, Ireland and Spain. Today, in one form or another, these countries all face significant budgetary and financial problems.
Heavily indebted economies have traditionally been able to devalue their currency, through interest rate drops and ensuing inflation, to ease their debt burden. Lowering the value of one’s currency makes exports more competitive and stimulates demand, while simultaneously decreasing the real value of a country’s debt. However, Greece, Ireland, Italy, Portugal and Spain, as members of the single currency, do not have this option since their exchange rate is set independently by the ECB in Frankfurt. As a result, the euro is overvalued for Greek exports outside the eurozone, and Greece’s underlying competitiveness gap with Germany makes its exports uncompetitive throughout the eurozone. Greece must borrow the equivalent of 10% of its GDP to finance its imports on an annual basis (“current account deficit”)–a number which will only grow as GDP contracts.
Responses to this crisis have focused on buying government bonds from countries whose borrowing costs have risen exorbitantly (the EFSF/ESM), on recapitalizing banks–who have taken heavy losses as government debt was written down–and cutting government spending and budget deficits (“austerity”). The Fiscal Compact fits in the third category. Essentially, the Fiscal Compact would grant the European Commission the power to review national budgets and to force European governments to cut spending in order to balance their budgets to reduce their debt levels. In theory, cutting government spending should signal to bond markets that highly indebted countries are on track towards solvency and sustainable debt loads. However, the bond markets have been behaving irrationally, responding to austerity budgets with concerns that by taking so much activity out of the economy, the economy risks contracting, thereby worsening the debt load, and frightening investors all over again. Austerity budgets have already taken their toll on European countries. Greek and French voters have rejected austerity in recent elections; Britain has entered a double-dip recession. The eurozone is expected to contract as a whole this year. ECB head Mario Draghi has raised concerns as well, saying Europe needs a “growth solution” as well as an austerity one. Nouriel Roubini agrees, saying that the eurozone’s austerity strategy and its lack of a growth strategy simply makes for a “recession strategy” which makes austerity self-defeating.
None of this has addressed the underlying lack of convergence among eurozone economies. Until Germany lets labour costs rise and increases government spending and private consumption, and until Greece, Portugal, Italy and Spain bring down their labour costs, loosen labour market restrictions, reduce public spending, and boost their competitiveness, the euro’s problems will not abate. In the meantime, highly indebted countries are expected to shoulder years (possibly over a decade) of painful readjustments, high unemployment, low growth, and falling incomes. These policies will quickly become unacceptable to democratic electorates, if they haven’t become so already. There’s no easy solution; painfully slow growth, high unemployment and popular discontent are, broadly speaking, the “new normal” in Europe.
Irish voters have already endured four years of austerity. Voters across Europe have grown increasingly resentful of austerity, as recent elections in France and Greece and the fall of the government in Netherlands have made clear. It wouldn’t be unrealistic to think Irish voters might follow and reject the treaty (France, Greece and the Netherlands have both already ratified the treaty). Still, polls suggest Irish voters will return a “yes vote” on Thursday. The Prime Minister’s centre-right government and the opposition have both come out in favour of ratifying the Fiscal Treaty. Failure to ratify the treaty would cut Ireland out of future European financing, and would likely mean that Ireland would have to leave the euro. Nonetheless, as Roubini argues, front-loaded austerity is driving economic contraction, and the fiscal compact will enshrine this failing policy. Austerity alone can’t solve the continent’s economic problems, and if the fiscal compact continues to be presented as a magic-bullet, then no progress is going to be made.
“Eurozone in Crisis in Graphics.” BBC. 4 May 2012.
Feldstein, Martin. 2012. “The Failure of the Euro: The Little Currency That Couldn’t.” Foreign Affairs 91: 1, pp. 105-116.
Ferguson, Niall and Laurence J. Kotlikoff. 2000. “The Degeneration of EMU.” Foreign Affairs 79: 2, pp. 110-121.
Lindsay, James and Bob McMahon. “The World Next Week: 24 May 2012.” The Water’s Edge. 24 May 2012.
Moravcsik, Andrew. 2012. “Europe After the Crisis: How to Sustain a Common Currency.” Foreign Affairs 91: 3, pp. 54-68.
Roubini, Nouriel. 2012. “Europe’s Short Vacation.” Project Syndicate. 13 April 2012.