By John Ballard
It didn't take long this afternoon to come across a couple of gloomy commentaries on the state of the European economy. This makes for a fascinating backdrop to the president's hosting of APEC in Honolulu. In one of Saturday's links Roubini predicted Europe would implode first, then China, with the US being last man standing.
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.
Unfortunately, Germany and the ECB oppose this option, owing to the prospect of a temporary dose of modestly higher inflation in the core relative to the periphery.
The bitter medicine that Germany and the ECB want to impose on the periphery � the second option � is recessionary deflation: fiscal austerity, structural reforms to boost productivity growth and reduce unit labor costs, and real depreciation via price adjustment, as opposed to nominal exchange-rate adjustment.
The problems with this option are many. Fiscal austerity, while necessary, means a deeper recession in the short term. Even structural reform reduces output in the short run, because it requires firing workers, shutting down money-losing firms, and gradually reallocating labor and capital to emerging new industries. So, to prevent a spiral of ever-deepening recession, the periphery needs real depreciation to improve its external deficit. But even if prices and wages were to fall by 30% over the next few years (which would most likely be socially and politically unsustainable), the real value of debt would increase sharply, worsening the insolvency of governments and private debtors.
In short, the eurozone's periphery is now subject to the paradox of thrift: increasing savings too much, too fast leads to renewed recession and makes debts even more unsustainable. And that paradox is now affecting even the core.
If the peripheral countries remain mired in a deflationary trap of high debt, falling output, weak competitiveness, and structural external deficits, eventually they will be tempted by a third option: default and exit from the eurozone. This would enable them to revive economic growth and competitiveness through a depreciation of new national currencies.
Of course, such a disorderly eurozone break-up would be as severe a shock as the collapse of Lehman Brothers in 2008, if not worse. Avoiding it would compel the eurozone's core economies to embrace the fourth and final option: bribing the periphery to remain in a low-growth uncompetitive state. This would require accepting massive losses on public and private debt, as well as enormous transfer payments that boost the periphery�s income while its output stagnates.
Italy has done something similar for decades, with its northern regions subsidizing the poorer Mezzogiorno. But such permanent fiscal transfers are politically impossible in the eurozone, where Germans are Germans and Greeks are Greeks.
That also means that Germany and the ECB have less power than they seem to believe. Unless they abandon asymmetric adjustment (recessionary deflation), which concentrates all of the pain in the periphery, in favor of a more symmetrical approach (austerity and structural reforms on the periphery, combined with eurozone-wide reflation), the monetary union's slow-developing train wreck will accelerate as peripheral countries default and exit.
The recent chaos in Greece and Italy may be the first step in this process. Clearly, the eurozone�s muddle-through approach no longer works. Unless the eurozone moves toward greater economic, fiscal, and political integration (on a path consistent with short-term restoration of growth, competitiveness, and debt sustainability, which are needed to resolve unsustainable debt and reduce chronic fiscal and external deficits), recessionary deflation will certainly lead to a disorderly break-up.
With Italy too big to fail, too big to save, and now at the point of no return, the endgame for the eurozone has begun. Sequential, coercive restructurings of debt will come first, and then exits from the monetary union that will eventually lead to the eurozone�s disintegration.
What more is there to say? Europe is on a precipice, political as well as economic. Eurozone leaders think they have time to slowly habituate their constituencies to incrementally greater commitments, as if we didn�t know from centuries of experience that financial crises descend with terrifying speed in the form of bank runs, panicked asset dumps, and other spasms of runaway positive feedback. Greece, Portugal, Spain and Italy will not edge gently toward insolvency; one or more of them will undergo a sudden phase change, and the game will be up as soon as it has started.
And incantations of austerity and reform are pointless. Simple arithmetic demonstrates that the peripheral countries cannot pay their way out of debt through primary fiscal surpluses: at current real interest rates and debt loads it just can�t be done. Moreover, fiscal tightening throughout the zone can only lead to a severe recession, and as indicators of the slump materialize the panic dynamics will intensify.
Worse, the �reform� imperative�the demand that deficit countries privatize and deregulate�is punitive nonsense. Politics in the surplus countries seems to demand that there be a story about wayward prodigals to the south who must be stripped of their comforts and put to the yoke. Put aside this morality tale and there is no economic logic whatsoever. There is no theoretical or empirical reason to believe that Greece, Italy and the rest are in deficit because they have too much public employment or their workers have too many rights. (Where there is corruption and clientelism, any sort of employment, public or private, can be uneconomic.) In fact, those who want to force-feed these reforms, with public displays of abject political submission to them, have never even tried to make this case. There is no argument to critique, no evidence to rebut. �Reform� is not a rational economic program for restoring trade balances; it is about exacting a cruel price on entire populations so that bailouts come with a quid pro quo. Receive a transfer and you must sacrifice.
Of course, the bailout funds go directly to the creditors, mainly private banks, so even this attempt at moral equivalence is beside the point.
Eurozone policy, and most journalistic coverage of it, is in a parallel universe of virtue and vice, benefactors and supplicants, industrious and indolent, modern and honest versus traditional and corrupt. It satisfies a craving for moral order. Unfortunately, the real universe is about to crash into it and smash it to pieces.
Fasten your seatbelts and pass the popcorn.