The euro zone 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 euro zone’s problems are much deeper. They are structural, and they affect at least four other economies: Ireland, Portugal, Cyprus, and Spain.
For the last decade, PIIGS (Portugal, Ireland, Italy, Greece, and Spain) were the euro zone’s consumers of first and last resort, spending more than their income and running ever-larger current-account deficits. Meanwhile, the euro zone 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 euro zone. Unit labour costs fell in Germany and other parts of the core leading to a real depreciation and rising current-account surpluses, while the reverse occurred in PIIGS (and Cyprus), leading to real appreciation and widening current-account deficits. In Ireland and Spain, private savings collapsed, and a housing bubble fuelled 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 and current-account deficits, fiscal gaps, or both became unsustainable throughout the euro zone’s periphery. Moreover, the peripheral countries’ large current-account deficits, fuelled 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 euro zone’s periphery while undertaking necessary austerity measures and structural reforms. This implies significant easing of monetary policy by the European Central Bank (ECB); 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 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 ECB want to impose on the periphery—the second option—is recessionary deflation: fiscal austerity, structural reforms to boost productivity growth and reduce unit labour costs, and real depreciation through 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 reallocating labour 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% in 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 euro zone’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 euro zone. This would enable them to revive economic growth and competitiveness through a depreciation of new national currencies.
Of course, such a disorderly euro zone break-up would be as severe a shock as the collapse of Lehman Brothers in 2008, if not worse. Avoiding it would compel the euro zone’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.
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 euro zone, where Germans are Germans and Greeks are Greeks. That also means that Germany and 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 favour of a more symmetrical approach (austerity and structural reforms on the periphery, combined with euro zone-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 euro zone’s muddle-through approach no longer works. Unless the euro zone moves towards greater economic, fiscal, and political integration, recessionary deflation will 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 euro zone has begun. Sequential, coercive restructurings of debt will come first, and then exits from the monetary union that will eventually lead to the euro zone’s disintegration.
Nouriel Roubini is chairman of Roubini Global Economics and professor of economics at the Stern School of Business, New York University
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