My fellow Mint columnist Narayan Ramachandran alerted me to a sincere proposal emanating from Euro-nomics, a group of academics focused on coming up with workable and specific solutions to the problems that Europe faces. Europe faces two problems—one is the historical debt accumulated by borrowers and lenders and the other one is to rediscover structural drivers of economic growth. Most of the solutions in the public domain address the first problem—some carelessly and some sincerely. The second problem is barely touched. That is not a lacuna, nor am I implying a criticism. Had it been easy to come up with a solution for the latter, many would have done so already.
Hence, the circumstances facing the debt-laden European nations—creditors or debtors—are formidable, to say the least. They cannot find new avenues of growth even if, miraculously, a cure is found for their historical debt burden.
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Solutions on the table on the debt problem contain elements of securitization, ring-fencing, collective guarantee with limits, a European debt agency and scope for market signals on debt not guaranteed or ring-fenced. They do not propose a fiscal union (see, for example, http://euro-nomics.com/wp-content/uploads/2011/09/ESBiesWEBsept262011.pdf).
This idea is elegant in theory and plugs many of the limitations of other ideas in play. One is the fiscal union and a common Eurobond. The same moral hazard issues that plagued and still plague European monetary policy would afflict the idea of a fiscal union unless there is a European ministry of finance that has complete power over taxation and spending policies of the member states and sovereign states are stripped of their authority over discretionary fiscal policy. That is not politically feasible at all. But, without that, a common Eurobond transfers the burden on to more prudent states and they lend their credit rating to nations that are lower down the pecking order of prudence.
Hence, the proposal by the Euro-nomics is sensible to the extent that it sidesteps this moral hazard. However, any proposal will eventually run into both the quality and the magnitude of growth issues. Countries can achieve gross domestic product growth by accumulating debt and while they are growing, markets might reward them with low interest rates. The proposed European debt office would then buy more of that country’s bonds in good times. Eventually, when the growth juggernaut grinds to a halt and the quality of growth is revealed, safe bonds acquired by the European debt agency might not be all that safe. That is what happened in 2002-07.
While Spain, Greece, Ireland and Portugal were growing, they were able to borrow at low rates of interest in the market. When growth stopped and their accumulated debt burden was revealed, their borrowing rates skyrocketed. Had this happened under the proposed framework, they would find more of their bonds reclassified as unsafe bonds. To that extent, these countries would have to raise their market borrowing, which would be available at rates of interest that would be too much for them to bear. In other words, what is happening now for the indebted nations would be happening even within this proposed framework.
So, it becomes clear that the debt issue cannot be addressed by separating it from the economic growth issue. The latter is more difficult. Indebted nations need external sources of growth—an ultra-competitive exchange rate and/or a steep decline in real wages.
The former would set off confrontation with the US, Japan, Switzerland, China and Brazil, just to name a few key countries. Confrontation would occur both over loss of trade competitiveness and asset price impacts. Today, the world is united in seeking competitive currencies. Not all can succeed. Europe is poorly placed to succeed compared with others. Renegotiating social contracts are, at best, time-consuming and, at worst, non-starters in the mollycoddled European labour markets.
So, here we are with very few easy options. It is not that the problem started when Greek debt alarmed financial markets since May 2010. It is simply that a bold experiment to politically unite Europe and pose a formidable challenge to the reserve currency status of the dollar has come unstuck. It is now clear that the hope that euro zone would eventually become an optimal currency area, even if it was not one to start with, has been belied due to a combination of factors.
This is in the nature of bold experiments. They can spectacularly succeed and, equally, fail spectacularly. Therefore, whatever is happening in Europe today does not invalidate the bold experiment that took shape over five decades, starting from the end of World War II, culminating in a single currency in 1999.
Now, it appears that a divorce is inevitable. Consequences are hard to tell. The Euro currency—whether it remains or disintegrates—will impose significant costs on the world. Each of us has no choice but to gear up for it in our own ways.
V. Anantha Nageswaran is an independent macroeconomic and investment strategy consultant, based in Singapore. Your comments are welcome at firstname.lastname@example.org.