A permanent state of depression could hit the Euro
The euro is heading for a permanent state of depression
If the euro survives in its current form, then Mario Draghi, president of the European Central Bank, will surely have earned his place in the history books as one of the chiefs of its salvation.
By Jeremy Warner
8:42PM GMT 31 Oct 2012
A year ago, monetary union looked as if it was heading for certain death, with the European banking system in apparent meltdown and extreme divergence in monetary conditions across the single currency area. In all but name, monetary union had already ceased to exist.
Action by the ECB, first with the cash-for-debt Long Term Refinancing Operation and, more recently, the promise of unlimited bond purchases, has succeeded in stilling the waters, at least to some degree. Even a Greek exit seems, for the time being, to be off the table. With more austerity, Berlin seems minded to give Greeks another chance – until the next bail-out, in any case.
But, though the single currency may have been saved from imminent death on the operating table, it seems now to be heading for a scarcely more appetising alternative – a condition of chronic, long-term illness where still very tight monetary conditions in many parts of the eurozone in combination with lockstep austerity threaten to induce a virtually permanent state of depression. Even Germany shows every sign of slipping back into economic contraction.
For Britain, still reliant as it is on some sort of a recovery in European trade to see it through its own austerity programme, there could scarcely be a set of circumstances less conducive to long-term recovery than this.
New research by Dawn Holland and Jonathan Portes of the National Institute of Economic and Social Research has confirmed what has long been suspected – that co-ordinated fiscal consolidation across many EU countries has not only had a substantially larger negative impact on growth than expected, but has also had the very reverse consequence to the one intended by raising rather than lowering debt-to-GDP ratios.
You need to be a little bit careful with these findings, which are somewhat self-serving. Under Jonathan Portes, the National Institute has positioned itself very much on the stimulus side of the austerity-versus-stimulus debate. This is a paper that sets out to prove that the poor growth performance of most EU countries, including the UK, is primarily down to fiscal austerity.
Nonetheless, the number crunching seems to be robust enough, and it’s hard to disagree with the paper’s central finding that fiscal multipliers are much larger than in more normal times when consolidation is conducted collectively and into conditions of an already depressed economy.
Even so, the paper suffers from one, rather glaring, omission. Whether you are on the big or small state side of the argument, there is no doubt that fiscal consolidation is urgently needed in much of the eurozone periphery, and some parts of the core as well.
Without bail-outs at least three eurozone countries would already be completely bust, and several others would fast be heading in the same direction. Deprived of access to the capital markets, these countries would be forced into a degree of fiscal austerity that would make present programmes look like a stroll in the park. Fiscal stimulus, or even the normal operation of automatic stabilisers, is not an option for some eurozone countries.
In any case, the growth problem in Europe is not so much one of too much austerity as the straitjacket of the euro itself. This has prevented both the natural corrective of exchange-rate adjustment and the application of appropriate monetary policy to counteract the fiscal contraction. It has also prevented the sort of burden sharing between creditor and debtor nations that has to take place if the crisis is ever to be resolved.
The old system of free-floating sovereign exchange rates wouldn’t have prevented austerity, all other things being equal. But what it would have done is allowed the periphery to mitigate the damage through quantitative easing and through the very rapid restoration of competitiveness that devaluation would have brought about.
Devaluation would also have greatly reduced external indebtedness. The creditor would have been made to take the bad debt writedown through the exchange rate.
As it is, creditor and debtor nations remain locked in unresolved conflict, with the debtor nations forced to make the necessary adjustment in competitiveness through the long and painful process of internal devaluation. In layman’s terms, that means punishing levels of unemployment and, for those still lucky enough to be in a job, hard-to-accept cuts to nominal wages.
Conversely, the currency appreciation that would have taken place in surplus nations such as Germany would have forced those countries into reflationary policies to counter the collapse in exports and stop the currency going through the roof. A virtuous circle of growth would soon establish itself.
There is a sense, then, in which the National Institute paper is addressing the wrong issue. It’s not the austerity, stupid, it’s the euro.
In any case, the focus is again back on Greece, which is being forced to implement a further €13.5bn (£10.8bn) of austerity measures in return for the next tranche of bail-out money. Is this the fifth, tenth or twelfth Greek austerity package since the crisis began? It’s so hard to keep up.
Antonis Samaras, the Greek prime minister, reckons the latest package will allow Greece finally to exit the crisis. He’d be so lucky. The poor Greeks have been put through the mangle so many times that there will be nothing left by the time the troika has finished.
Once Spain and Italy have joined the others in sovereign bail-outs, the process of debt mutualisation will be as good as complete, with large parts of the eurozone funded pretty much exclusively by a combination of the European Central Bank, the eurozone sovereign rescue fund, and the European Stability Mechanism.
Yet the underlying problem is not really addressed until there is much broader recognition of the bad debt problem. The International Monetary Fund, part of the troika, has already conceded the point by making the provision of further bail-out money to Greece dependent on the writedown of Greek sovereign debt to a more sustainable level.
Since there is now very little privately-held debt left to be written down, the burden from here on in falls largely on officially provided sources of finance. The bail-out funds and ECB will have to take haircuts, too.
This is the point at which the situation becomes politically highly toxic. Euro troubles are already weighing heavily on Angela Merkel’s parliamentary majority. German disenchantment with the euro will harden further once the losses from bailing out Greece and others become real, as opposed to the current situation of contingent, and therefore have to be paid for with tax rises and spending cuts at home.
Mario Draghi may have saved the euro, but perhaps only for a worse fate – years of further economic and political turmoil.