22 August 2011

Douglas J Elliott: Why can’t Europe get it right the first time… or the second… or the third?

Giving a perspective from the US, Brookings Institution Fellow, Douglas J Elliott, writes that the euro crisis has struck again, hammering not just European markets, but doing real damage to US markets and to economic prospects around the world.

The US could easily be pushed into another recession if the eurozone collapsed. We export well over $300 billion a year to those 17 countries; virtually all of the rest of our exports go to nations that also export to the eurozone and would feel ripple effects; roughly two-fifths of our overseas assets are invested in the eurozone; and our major financial institutions have large credit exposures to eurozone banks and other businesses.

It seems remarkable to many Americans who are following this at a distance that the politicians and Eurocrats cannot find a way to end the crisis, or even to contain it for more than a few weeks or months at a time. The government responses to each phase of the crisis follow the same repeated pattern. First, deny that anything needs to be done beyond what has already been agreed and blame the markets for launching "speculative attacks" out of impatience, misunderstanding, or greed. Second, when these denials just scare the markets further, scurry to convene high-level meetings to work out some step forward that will stop the market disaster that is building. Finally, at the last possible moment, announce a major move towards further economic integration of the eurozone, focused in particular on providing more support from the solid parts of the zone to the weaker ones. However, this major move is never enough to prevent the seemingly inevitable next phase of the crisis, in part because the biggest moves require approval of 17 national parliaments, which takes time and adds uncertainty. Worst of all, each phase of the crisis is more threatening than the last. (Who would have believed two years ago that there would be serious fears expressed about France's creditworthiness?)

Before walking through the detailed analysis of the mistakes that led to the present peril, I feel compelled, as a non-European, to stipulate that America also made grievous fundamental mistakes as it struggled to establish a union and our recent debt ceiling debates likewise show that tough political constraints can make leaders look inept. This is not about European stupidity or blindness. If anything, some of the problems stem from being "too clever by half," in particular by assuming that known weaknesses in the original structure would lead to future problems that would spur greater economic integration at that time.

The eurozone was established, and operated for many years, with a potentially fatal flaw. The nations combined their currencies, and therefore their monetary policy, without doing much effective to insure that their economies operated similarly enough for a single monetary policy to work. In fact, the original Stability and Growth pact that was intended to at least limit national deficit levels was gutted when it started to constrain Germany and France, the two most dominant powers in the eurozone. There are also strong connections between weaknesses in Europe's banking systems and the problems of sovereign debt, which make both sets of issues harder to fix. Banking crises, and the threat of them, have done severe financial damage to the public finances of some weaker countries, particularly Ireland. At the same time, banks hold large quantities of sovereign debt of the weaker countries, putting the financial system in danger from potential sovereign defaults.

Most of the [euro] founders appear to have recognised that there were economic risks in bringing countries together in a currency union when there were still so many differences in their economies, political structures, and cultures. However, the potential gains were large and they thought that they could manage any problems that arose. Frequently, the answer to the problems of Europe came to be "more Europe." In the year and more since the euro crisis erupted in earnest, the eurozone has taken a number of steps towards greater union that would have been virtually unthinkable two years ago.

So, why is there still a problem, and quite a major one? Unfortunately, the governments of the strongest eurozone Member States have shown a great resistance to taking each one of the[se] necessary steps and they continue to strongly resist further steps which have become necessary. Markets understandably feared each time that the latest set of crisis responses might prove to be the limit of what the eurozone could do. This matters because none of the steps to date, big as they are, will be enough if market fears balloon much further.

Sufficiently strong and sensible government responses can put an end to the crisis. The eurozone, taken as a whole, clearly has the economic capacity to pay all of its debt. The market fears are that the weaker members of the eurozone cannot solve their debt problems on their own and that the strong countries may not provide sufficient support to overcome those weaknesses. For the eurozone to avoid the true disaster scenarios, it will almost certainly be necessary for the member countries to provide a common guarantee for much, if not all, of the debt of the other member countries. The markets are too concerned to accept anything less than an ability to rely on the economic strength of the full eurozone (or, realistically, of Germany and the other strong members).

Even if one accepts the economic need for greater fiscal integration, politics may render it impossible. The political leaders can generally see that their countries would be devastated by the collapse of the euro, even if the public cannot. This leaves them with the choice of saving the euro while angering their voters or risking a renewed severe recession that would also make them very unpopular with voters, while doing their country permanent harm. In the end, I believe that the leaders will stare into the abyss, turn back, and take the necessary measures, despite the potential for immense short-term political pain.

Unfortunately, it is likely that quite a number of eurozone countries would default unless the leaders take the kind of bold action that could prevent a collapse of the eurozone. Each country that defaults increases the market pressure on the next weakest, as we have already seen after Greece defaulted. It is also possible that one or more eurozone members would withdraw from the euro. Unfortunately, we do not know how bad the outcome would be even in the short run, in part because the euro was deliberately set up without a mechanism for unwinding it. There are immense legal, political, and economic issues that would have to be resolved in this extreme case. Nor do we know what the net benefits or costs would be in the long run, because of the difficulty of prediction about such a complicated change.

"Europe" has always garnered much more support among the elites of that continent than among the broader publics. It is unlikely that a number of the major steps towards closer union, including the establishment of the euro, would have gone forward if referendums had been required in each of the major countries. German voters, for example, were clearly loath to give up their Deutschmarks, but were not given a chance to veto the move.

Another reason that Europe's leaders may eventually do what is necessary to prevent a collapse is that sovereign defaults by the weaker governments could force a costly set of bank rescues by Germany and the other strong governments. (The weakest ones may not have the resources in that case to rescue their own banks, but may simply have to nationalise them and pick up the pieces and start over, effectively creating a new banking system.)

Returning to the question posed in this paper's title, the core reason that Europe has not yet gotten its response to the Euro Crisis right, despite multiple attempts, is that political constraints make it extremely difficult to do the ultimately necessary things. Even now, we cannot be certain that the key political leaders will be willing or able to take the final bold steps to halt the crisis. One can only hope that staring over a cliff at a very steep drop may produce the necessary resolve. One unfortunate corollary is that we will probably have to live through a couple more escalating phases of the crisis before the drop looks terrifying enough to persuade the leaders to put in place the ultimate solution.

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