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Europe’s Darkness at Noon

Barry Eichengreen

2011-11-08

BERKELEY – It may be hard to imagine that Europe’s crisis could worsen, but it just has. European Union leaders failed at their summit two weeks ago to produce anything of substance. China and Brazil are clearly reluctant to come to the rescue by providing a large injection of foreign cash. And the recent G-20 summit in Cannes produced no agreement on steps that might have helped to resolve the crisis.

Now there is the collapse of the Greek government. The trigger may have been outgoing Prime Minister George Papandreou’s ill-advised decision to call for a referendum on the EU’s rescue package (which implies further severe austerity measures); but the fundamental problem is that a brutal recession made the government’s demise all but inevitable.

The formation of a new national unity government does not mean that the Greek problem is behind Europe or the world. On the contrary, the new government’s position will be no more tenable than that of its predecessor. Until there is hope, however remote, that Greece can begin to grow again, the problem will not go away.

Even worse for financial stability, Papandreou’s announcement of a referendum provoked German Chancellor Angela Merkel and French President Nicolas Sarkozy to break an important taboo. Previously, European leaders had averred that the euro was forever, repeating at every turn that they would do whatever it took to hold the monetary union together. Last week, in a dangerous departure, Merkel and Sarkozy bluntly told the Greeks that it was up to them to decide whether they wanted to keep the euro.

Their statements were designed to beat Greek politicians into submission, and may have succeeded, at least for now. But they also opened the door to destabilizing speculation. The temptation to bet against continued Greek participation in the euro is now greater than ever. As investors place their bets, the balance sheets of Greek banks and the Greek government will deteriorate further, which could cause bearish expectations to become self-fulfilling.

The greater danger is that where Greece leads, Portugal and Italy will be forced to follow. Anyone who doubts this need only think back to 1992, when the European Monetary System fell apart.

In September of that year, Bundesbank President Helmut Schlesinger made some reckless comments about how deval‎uations within Europe’s system of supposed stable exchange rates “cannot be ruled out.” Schlesinger’s unguarded remarks signaled that the Bundesbank was not willing to do whatever it took to preserve the system – a signal that encouraged investors to place massive bets against the British pound and Italian lira. The result was the collapse of Europe’s exchange-rate mechanism.

If Merkel and Sarkozy are serious about preserving the euro, they will have to repair the damage caused by their reckless remarks. They should acknowledge that the only entity with the capacity to stabilize the situation is the European Central Bank. And they must give the ECB the political cover that it needs to do what is required to preserve the system.

Specifically, the ECB must do much more to support economic growth. Its decision to cut rates by 25 basis points at the first policy meeting under its new president, Mario Draghi, is the one ray of light in an otherwise darkening sky. But 25 basis points are a drop in the bucket. With Europe headed for recession, the danger of rising inflation is nil. Still, given German sensitivities, Merkel should use her bully pulpit to reassure her public.

More controversially, the ECB needs to increase its purchases of Italian bonds. Unless yields on those bonds fall to German levels, there is no way that Italy’s debt arithmetic can be made to add up. But Draghi has indicated that he is reluctant to see the ECB become a lender to governments. Reassuring the markets by adopting structural reforms, he has observed, is properly the responsibility of those governments, not of the central bank.

But structural reforms cannot be accomplished overnight. Italy needs time to put its pro-growth reforms in place. Not providing that time would sound the death knell for the euro.

Here’s where the political cover comes into play. Merkel and Sarkozy need to make the case that if the euro is to become a normal currency, Europe needs a normal central bank – one that does not merely target inflation like an automaton, but that also understands its responsibilities as a lender of last resort.

Meanwhile, Italy, now under the watchful eye of the International Monetary Fund, needs to move ahead with those pro-growth reforms in order to reassure the ECB’s shareholders that the central bank’s bond purchases are not money losers.

If it does, maybe – just maybe – there will be reason to hope that the European project’s darkest hour is just before the dawn.

Barry Eichengreen is Professor of Economics and Political Science at the University of California, Berkeley. His most recent book is Exorbitant Privilege: The Rise and Fall of the Dollar.

Europe’s Next Nightmare

Dani Rodrik

2011-11-09

CAMBRIDGE – As if the economic ramifications of a full-blown Greek default were not terrifying enough, the political consequences could be far worse. A chaotic eurozone breakup would cause irreparable damage to the European integration project, the central pillar of Europe’s political stability since World War II. It would destabilize not only the highly-indebted European periphery, but also core countries like France and Germany, which have been the architects of that project.

The nightmare scenario would also be a 1930’s-style victory for political extremism. Fascism, Nazism, and communism were children of a backlash against globalization that had been building since the end of the nineteenth century, feeding on the anxieties of groups that felt disenfranchised and threatened by expanding market forces and cosmopolitan elites.

Free trade and the gold standard had required downplaying domestic priorities such as social reform, nation-building, and cultural reassertion. Economic crisis and the failure of international cooperation undermined not only globalization, but also the elites that upheld the existing order.

As my Harvard colleague Jeff Frieden has written, this paved the path for two distinct forms of extremism. Faced with the choice between equity and economic integration, communists chose radical social reform and economic self-sufficiency. Faced with the choice between national assertion and globalism, fascists, Nazis, and nationalists chose nation-building.

Fortunately, fascism, communism, and other forms of dictatorships are passé today. But similar tensions between economic integration and local politics have long been simmering. Europe’s single market has taken shape much faster than Europe’s political community has; economic integration has leaped ahead of political integration.

The result is that mounting concerns about the erosion of economic security, social stability, and cultural identity could not be handled through mainstream political channels. National political structures became too constrained to offer effective remedies, while European institutions still remain too weak to command allegiance.

It is the extreme right that has benefited most from the centrists’ failure. In Finland, the heretofore unknown True Finn party capitalized on the resentment around eurozone bailouts to finish a close third in April’s general election. In the Netherlands, Geert Wilders’ Party for Freedom wields enough power to play kingmaker; without its support, the minority liberal government would collapse. In France, the National Front, which finished second in the 2002 presidential election, has been revitalized under Marine Le Pen.

Nor is the backlash confined to eurozone members. Elsewhere in Scandinavia, the Sweden Democrats, a party with neo-Nazi roots, entered parliament last year with nearly 6% of the popular vote. In Britain, one recent poll indicated that as many as two-thirds of Conservatives want Britain to leave the European Union.

Political movements of the extreme right have traditionally fed on anti-immigration sentiment. But the Greek, Irish, Portuguese, and other bailouts, together with the euro’s troubles, have given them fresh ammunition. Their Euro-skepticism certainly appears to be vindicated by events. When Marine Le Pen was recently asked if she would unilaterally withdraw from the euro, she replied confidently: “When I am president, in a few months’ time, the eurozone probably won't exist.”

As in the 1930’s, the failure of international cooperation has compounded centrist politicians’ inability to respond adequately to their domestic constituents’ economic, social, and cultural demands. The European project and the eurozone have set the terms of debate to such an extent that, with the eurozone in tatters, these elites’ legitimacy will receive an even more serious blow.

Europe’s centrist politicians have committed themselves to a strategy of “more Europe” that is too rapid to ease local anxieties, yet not rapid enough to create a real Europe-wide political community. They have stuck for far too long to an intermediate path that is unstable and beset by tensions. By holding on to a vision of Europe that has proven unviable, Europe’s centrist elites are endangering the idea of a unified Europe itself.

Economically, the least bad option is to ensure that the inevitable defaults and departures from the eurozone are carried out in as orderly and coordinated a fashion as possible. Politically, too, a similar reality check is needed. What the current crisis demands is an explicit reorientation away from external financial obligations and austerity to domestic preoccupations and aspirations. Just as healthy domestic economies are the best guarantor of an open world economy, healthy domestic polities are the best guarantor of a stable international order.

The challenge is to develop a new political narrative emphasizing national interests and values without overtones of nativism and xenophobia. If centrist elites do not prove themselves up to the task, those of the far right will gladly fill the vacuum, minus the moderation.

That is why outgoing Greek Prime Minister George Papandreou had the right idea with his aborted call for a referendum. That move was a belated attempt to recognize the primacy of domestic politics, even if investors viewed it, in the words of a Financial Times editor, as “playing with fire.” Scrapping the referendum simply postpones the day of reckoning and raises the ultimate costs to be paid by Greece’s new leadership.

Today, the question is no longer whether politics will become more populist and less internationalist; it is whether the consequences of that shift can be managed without turning ugly. In Europe’s politics, as in its economics, it seems there are no good options – only less bad ones.

Dani Rodrik, Professor of International Political Economy at Harvard University, is the author of The Globalization Paradox: Democracy and the Future of the World Economy.

 Down with the Eurozone

Nouriel Roubini

2011-11-11

NEW YORK – The eurozone crisis seems to be reaching its climax, with Greece on the verge of default and an inglorious exit from the monetary union, and now Italy on the verge of losing market access. But the eurozone's problems are much deeper. They are structural, and they severely affect at least four other economies: Ireland, Portugal, Cyprus, and Spain.

For the last decade, the PIIGS (Portugal, Ireland, Italy, Greece, and Spain) were the eurozone's consumers of first and last resort, spending more than their income and running ever-larger current-account deficits. Meanwhile, the eurozone core (Germany, the Netherlands, Austria, and France) comprised the producers of first and last resort, spending below their incomes and running ever-larger current-account surpluses.

These external imbalances were also driven by the euro’s strength since 2002, and by the divergence in real exchange rates and competitiveness within the eurozone. Unit labor costs fell in Germany and other parts of the core (as wage growth lagged that of productivity), leading to a real depreciation and rising current-account surpluses, while the reverse occurred in the PIIGS (and Cyprus), leading to real appreciation and widening current-account deficits. In Ireland and Spain, private savings collapsed, and a housing bubble fueled excessive consumption, while in Greece, Portugal, Cyprus, and Italy, it was excessive fiscal deficits that exacerbated external imbalances.

The resulting build-up of private and public debt in over-spending countries became unmanageable when housing bubbles burst (Ireland and Spain) and current-account deficits, fiscal gaps, or both became unsustainable throughout the eurozone's periphery. Moreover, the peripheral countries’ large current-account deficits, fueled as they were by excessive consumption, were accompanied by economic stagnation and loss of competitiveness.

So, now what?

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.

Nouriel Roubini is Chairman of Roubini Global Economics, Professor of Economics at the Stern School of Business, New York University, and co-author of the book Crisis Economics.

Striking Euro Gold (and Silver)

Harold James

2011-11-01

PRINCETON – The alternatives for Europe’s currency, the euro, seem increasingly limited to a desperate muddling through or a chaotic collapse. But there is a bolder and more productive approach that relies on past experience with multiple currencies.

The threat posed by Europe’s current policy impasse can hardly be overestimated. In the early 1930’s, monetary-policy incoherence paralyzed US policy, with the Federal Reserve Bank of New York locked in insurmountable conflict with the Chicago Fed over monetary easing (at that time through open-market securities purchases). Today’s chronic policy disputes between Germany and France are producing a level of uncertainty that is potentially even more destructive.

Every few months, European governments launch a new and ever more ingenious initiative to resolve the eurozone’s debt crisis. For a day (and sometimes only for a few hours), financial markets rally euphorically. But soon doubt sweeps back in. There is no sense of a realistic endgame. And there is no longer-term vision of how the fiscal integration needed for the effective operation of a monetary union could be achieved in a practical timeframe.

Europeans should look to the past, when previous crises produced innovative solutions. The extended crisis of the European Monetary System (EMS) between September 1992 and July 1993 looked as if it would derail European integration. What was initially seen as a problem in one country (Italy) toppled other currency regimes like dominos: Britain, Spain, and Portugal – and, by July 1993, even France was vulnerable. Then, as now, Europe’s future was at stake.

The solution adopted in frantic late-night negotiations in Brussels initially looked counterproductive. The massive widening of the EMS bands to 15% on either side of a central parity initially made a single currency appear more remote. But it also took away the one-way-bet character of speculative attacks on vulnerable currencies, and thus removed the fundamental driver of instability.

The modern equivalent of the band widening of 1993 would be to maintain the euro for all members of the eurozone, but also allow some of them (in principle, all of them) to issue – if necessary – national currencies. The countries that did would probably find that their new currencies immediately traded at a heavy discount. California recently adopted a similar approach, issuing IOUs when faced with the impossibility of access to funding.

The success of stabilization efforts could then be assessed according to the price of the new currency. If the objectives were met – fiscal stabilization and renewed growth – the discount would disappear. In the same way, after 1993, the French franc initially diverged from its old level, but, in a good policy setting, it then returned within the exchange-rate band.

This approach has an important advantage: it would not require the redenomination of bank assets or liabilities. As a result, it would not be subject to the multiple legal challenges that a more radical alternative would run into.

Of course, there would also be the possibility that no convergence would occur, and that the two parallel currencies would coexist for a much longer period. This is not a novel thought. One of the possibilities raised in the discussions on monetary union in the early 1990’s was that a common currency might not mean a single currency. That possibility is not just a theoretical construct in fringe debates two decades ago; it is a real historical alternative.

In fact, there is a rather surprising parallel for stable coexistence of two currencies over a long period of time. Before the victory of the gold standard in the 1870’s, Europe had operated with a bimetallic standard for centuries, using silver as well as gold. Each metal had its different coinage. This regime was so successful in part because the coins were used for different purposes. High-value gold coins were used as a reference for large-value transactions and international business. Low-value silver coins were used for small day-to-day transactions, including payment of modest wages and rents. Silver was what Shakespeare termed the “pale and common drudge ‘tween man and man.”

A depreciation of silver relative to gold in this system would bring down real wages and improve competitiveness. Early modern Italian textile workers would find their pay in silver reduced, while their products still commanded a gold price on the international market for luxuries. This is one of the reasons why theorists such as Milton Friedman considered a bimetallic standard inherently more stable than a monometallic (gold-based) regime.

Nowadays, the equivalent of the adjustment mechanism in the early modern world of bimetallism would be a fall in, say, Greek wage costs paid in the national currency, as long as it was traded at a discount. These would be the silver currencies.

Meanwhile, the euro would be the equivalent of the gold standard. It would be kept stable by the institutions that already exist today, the European Central Bank and those national central banks that have no new alternative. In this sense, the core countries would be the equivalent of eighteenth- and early nineteenth-century Britain, which had only a gold-standard regime.

Maintaining a choice of currencies in a national as well as an international setting seems odd and counterintuitive. But it can – and has – been done, and it can be remarkably successful at satisfying peak demand for stability.

Harold James is Professor of History and International Affairs at Princeton University and Professor of History at the European University Institute, Florence. He is the author of The Creation and Destruction of Value: The Globalization Cycle.