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As the European debt crisis now knocks on the Italy and Spain’s door, it is well to recall that the Euro was a flawed idea from its very inception. It is also well to recall that over the past decade countries in Europe’s periphery did not play by the European Monetary Union’s rules. Instead, they built up the largest of public finance and external account imbalances that are now proving extraordinarily difficult to correct within the Euro straightjacket. These considerations make it highly improbable that the Euro will survive in its present form by end-2012.
“Compounding the periphery’s adjustment problems is the fact that the European core economies are already slowing abruptly.”–Desmond Lachman
At the launch of the Euro in January 1999, Milton Friedman famously expressed the gravest of misgivings about the Euro surviving its first major recession. He based these misgivings on the fact that European countries lacked the labor market flexibility and labor mobility that was required for a country to manage without its own currency. He also thought that it was a singularly bad idea for Europe to move towards an economic union before it had a true political union in place that would facilitate a system of fiscal transfers.
Skeptical as Friedman was about the viability of the Euro at its launch, it is highly improbable that, even in his darkest moments, he would have anticipated how poorly the Eurozone’s internal policing of member countries’ economic policies would have worked. He would also have been taken aback by how miserably the markets would have failed to exert discipline over wayward fiscal behavior that allowed peripheral countries’ budget deficits to increase to as high as 15 percent of GDP.
The essence of the European periphery’s present economic predicament is that it is proving extraordinarily difficult to reduce these countries’ still outsized budget deficits without the benefit of having their own separate domestic currencies. Stuck within the Euro-zone straightjacket, these countries cannot devalue their currencies to boost exports as a cushion to offset the highly negative impact on their economies from the major fiscal retrenchment that the IMF and the EU are requiring as a condition for their financial support.
As Greece and Ireland have found out, attempting to adjust under these conditions must be expected to entail many years of painful deflationary and recessionary conditions that will only compound their indebtedness problems. Over the past two years, both the Greek and the Irish economies have contracted by over 12 percent, while unemployment in these two countries is already over 18 percent and 15 percent, respectively. Little wonder then that governments have now fallen in Greece, Ireland, Italy, Portugal, and Spain or that “bailout fatigue” is all too much in evidence in all of these countries.
Compounding the periphery’s adjustment problems is the fact that the European core economies are already slowing abruptly. In addition, European banks are already cutting back on lending in an effort to shore up their balance sheet positions, which are threatened by large loan losses on their peripheral lending. This makes it all too likely that Europe as a whole will move into a meaningful and prolonged recession, which will make it even more difficult for the peripheral countries to meet their budget deficit targets.
With countries in Europe’s periphery highly unlikely to be able to reduce their large imbalances, the only thing that could realistically hold the Euro together over the longer-run would be for countries in Europe’s North to willingly write large checks year-in-year out to finance the deficits of the countries in Europe’s South. One cannot rule out that this in the end will happen. However, judging by Mrs. Merkel’s most recent strictures about the need to tie further financial support to the peripheral countries to their agreeing to sign up to long-term IMF fiscal retrenchment, I would not bet the ranch that the Euro will long survive in its present form.
Desmond Lachman is a resident fellow at AEI
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