Why Optimists Are Wrong About The Euro Zone

I don’t there’s much disagreement on that the euro zone needs is a consolidation strategy based on growth, a credible fiscal adjustment plan and and a new and functioning system of economic governance. In face of the worst economic crisis in Europe since WW II, the most optimistic politicians believe that austerity programmes coupled with a weak euro will solve the problems. Well, they’re wrong.

“The Europeans are choking off the recovery before it has even started.

Wolfgang Münchau

The consensus argument among European leaders at the moment is that fiscal indiscipline has caused the crisis. Austerity must therefore solve it. A weak euro and a global recovery would cushion the impact of austerity. In addition, the financial guarantees and the bans on short sales would see off the speculators. Voila! End of crisis.

Sounds pretty straight forward, right? Almost too good to be true.

And it probably is.

The optimists have not had a good crisis so far. According to Financial Times commentator, Wolfgang Münchau, this will not change.

Here’s why:

“First, fiscal adjustment programmes will be necessary eventually but European governments are currently repeating their age-old mistake of cutting spending and raising taxes well before the economy has recovered. In the US there is a debate about another stimulus package to ensure the recovery does not prematurely run of out steam. The Europeans are choking off the recovery before it has even started. The premature austerity programmes will ultimately impede debt reduction, as nominal growth remains very weak,” Münchau points out.

Furthermore, Italy and Spain will both need to accompany fiscal adjustment with structural reforms.

There are no such reforms on the horizon in Italy. Spain is about to decide a labor reform package.

But it will almost certainly not deal with the fundamental problem of a divided and extremely inflexible labor market.

Even in Germany, where domestic spending remains anemic, the government coalition is discussing a tax increase.

How Low Can You Go?

“Second, the euro’s exchange rate has indeed weakened, and may weaken further. But it will probably not do so sufficiently to solve southern Europe’s competitiveness problems. In Greece, for example, tourism is the main export industry. A slump of the euro against the dollar is not going to change the country’s relative competitive position against the euro zone nations of the Mediterranean Sea. It could improve competitiveness against Turkey and Croatia, for example, but only to the extent that the lira and kuna also revalue. For the euro exchange rate alone to do the heavy lifting in restoring southern European competitiveness, it would take a massive further depreciation – to about 60 or 80 US cents to the euro,” the FT Deutschland commentator writes.

Assume this were to happen, and then consider the overall effects:

The Organisation for Economic Co-operation and Development last week forecast that Germany’s current account surplus, which fell to 5 per cent of gross domestic product in 2009, would rise again to 7.2 per cent in 2011.

That forecast is based on current exchange rates. An extreme further fall in the euro would have two effects: it would increase Germany’s surplus even further, probably to well over 10 per cent of GDP, and thus increase internal imbalances within the euro zone.

It would also contribute to a deterioration of global imbalances, as the euro zone as a whole would turn a small current account deficit into a large surplus. Relying on the exchange rate would be the ultimate beggar-thy-neighbor policy.

Rescue Package Might Be Illegal

“Third, lingering doubts remain about the €750bn financial rescue package to help weaker euro zone countries. The German constitutional court has still to rule on the package and, while its rulings are difficult to predict, there are some legitimate reasons for concern,” Münchau says.

The Council invoked Article 122 of the treaty on the functioning of the European Union, under which financial assistance is allowed “where a Member State is in difficulties or is seriously threatened with severe difficulties caused by natural disasters or exceptional occurrences beyond its control.”

But it is not sure the court will accept the force majeure argument invoked by the European Council in deciding to permit the rescue package.

“I think there are legitimate doubts about whether the multiple policy failures that led to this crisis constitute an event beyond one’s control. I also fear the German justices will express misgivings about the European Central Bank’s decision this month to buy bonds,” Münchau writes.

Chasing Ghosts

“Fourth, the assumption that the crisis was caused, or triggered, by speculation, is not just legally dubious. It may also deflect from the overriding need to reform the euro zone governance framework. If you blame speculators, it may be an obvious policy response to ban short sales and penalize hedge funds rather than reform the framework. I therefore expect little substantive reform. At most there will be a souped-up stability pact, to be announced in another pompous press conference at the next European summit in June. Governments are already watering down the European Commission’s sensible, though not very ambitious, proposals. This means European governments are very likely to miss the opportunity to fix the problems in the long run,” Wolfgang Münchau concludes.

What the euro zone really needs is a consolidation strategy based on growth and a credible fiscal adjustment plan.

It needs to encourage domestic demand in northern Europe to facilitate the adjustment in the south. And it needs a new and functioning system of economic governance.

But instead, governments have chosen to chase speculators and to impress each other with austerity packages. They are thus contributing further to the euro zone’s increasingly probable though still distant disintegration.

Related by the Econotwist:

Bundesbank Suspects A French Conspiracy

Goodbye Keynes – Hello Ricardo!

Transantlantic Bailout Buddys Agree To Disagree

Proposal For New Single European Bond

Albert Edwards: Europe On The Edge Of A Deflationary Precipice

Merkel: The Euro Is At Risk, Could Have Global Consequences

E.U. Prepared To Set Up Own Rating Agency

Europe To Fight Speculators With “Secret Plan”


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