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Last week, the European sovereign debt crisis took a decided turn for the worse. No longer is the crisis confined to relatively small economies like Greece, Ireland, and Portugal. Rather, it has now spread to the systemically more important high-debt countries like Spain and Italy. These developments have attracted the attention of the European Central Bank, which again felt obliged to calm the markets by providing increased liquidity.
As Milton Friedman already foresaw when the euro launched in 1999, the essence of the European periphery’s economic predicament is that these countries have not played by the European Monetary Union’s budget rules. Indeed, over the past decade, Greece, Ireland, Portugal, and Spain all ran up extraordinarily large budget and balance-of-payments deficits that will be extremely difficult to correct without their own separate domestic currencies.
Stuck within the euro straitjacket, these countries cannot resort to currency devaluation to restore their sizeable losses in international competitiveness. Nor can they devalue to boost exports as a cushion to offset the highly negative economic impact from their major fiscal retrenchment. Nor are their European and International Monetary Fund (IMF) masters allowing them to write down their excessive debt burdens. Attempting to adjust under these conditions must be expected to entail many years of painful deflationary and recessionary conditions, as we already witness in both Ireland and Greece.
European policy makers are delaying facing the reality that the euro is presently well on its way to unraveling.
Yet, at a time when markets grasp the solvency problems of the periphery and understand the inevitability of debt restructuring, European policy makers mainly confine themselves to addressing the liquidity aspects of the crisis. European policy makers vainly wrestle with proposals to reform the arrangement’s architecture to prevent the recurrence of budget profligacy. By so doing, they only delay facing the reality that the euro is presently well on its way to unraveling.
European policy makers understand full well that a default in any peripheral country will almost certainly trigger contagion to the rest of the periphery. They are also highly cognizant that a wave of defaults in the periphery would more than likely precipitate a full-blown banking crisis in West Europe. These considerations suggest that European policy makers in the north will not lightly turn off the financing spigot that presently keeps the periphery, and thereby the European banking system, afloat.
Rather, one must expect that European policy makers will continue to kick the can forward in the forlorn hope that something might turn up to rescue the periphery. They might also do so hoping that time will allow the Western European banks to strengthen their balance sheets so that they may as to more easily absorb the shock of a sovereign debt default in the periphery.
The more likely trigger for the euro’s eventual unraveling will be in the periphery itself.
The more likely trigger for the euro’s eventual unraveling will be in the periphery itself. Already, the Greek, Irish, Portuguese, and Spanish governments have tenuous holds on political power. A deepening in their economic and financial crises could very well result in the ascendancy of more populist governments, which might be less willing to hew to the hair-shirt austerity programs dictated by the IMF or to remain within the euro straitjacket. This is essentially what precipitated the demise of Argentina’s Convertibility Plan in 2001.
Another plausible trigger for the euro’s eventual unraveling could be a heightening of the capital flight already underway in Greece and Ireland. Ample experience in earlier fixed-exchange-rate regimes suggests that capital flight can reach such proportions that countries are left with little alternative but to restructure their debt and exit their fixed-exchange-rate arrangements.
There is a very real danger that European policy makers’ denial about the likelihood of a wave of sovereign debt defaults in the periphery will breed a sense of policy complacency. Such a state of complacency could lead them to contemplate too hasty an exit from the stimulus policies put in place over the past two years to support the European economic recovery. It could also induce European policy makers not to fully avail themselves of the breathing room they are being afforded to strengthen their banks in anticipation of the all-too-probable wave of sovereign debt defaults that lies ahead.
This would be the greatest of shames not only for the European economy but also for the global economy as a whole. As we painfully learned from the 2008 Lehman Brothers experience, the world’s financial system is highly interconnected; a major banking crisis in Europe will seriously reverberate throughout the global economy.
Desmond Lachman is a resident fellow at the American Enterprise Institute.
Image by Rob Green/Bergman Group.
The Greek, Irish, Portuguese, and Spanish governments already have tenuous holds on power. A deepening in their economic crises could give rise to populist governments ready to dump the euro.
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