Poking the Eurozone Bear

By Brigitte Granville
Professor of International Economics and Economic Policy at Queen Mary, University of London, and the author of Remembering Inflation.

The conventional wisdom is that, when confronted by a bear, you should lie motionless until it loses interest (or assumes that you are dead) and leaves you alone. But there are different species of bear, with some more likely to be deterred by bold, purposeful action. The question is how to determine the right approach when terror incarnate is staring you in the face.

This scenario is helpful for thinking about the eurozone as it attempts to survive its next round of trials - beginning with the European Parliament election in May. Can it continue simply to "lie still," hoping that no new shocks arise that diminish its economic health, if not threaten its survival?

Some take the sanguine view that the current "lie still" approach is adequate to ensure that the eurozone economy does more than avoid decline. From their perspective, Germany's decision over the last three years to permit actual and prospective transfers just large enough to prevent financial meltdown will somehow be enough to enable the eurozone finally to begin to recover from a half-decade of recession and stagnation.

But the fact is that these transfers - that is, European Stability Mechanism-financed bailout programs and the European Central Bank's prospective "outright monetary transactions" (OMT) bond-buying scheme - can do little more than fend off collapse. They cannot boost economic output, because they are conditional upon recipient countries' continued pursuit of internal devaluation (lowering domestic wages and prices).

Reinvigorating the eurozone economy requires a more radical effort to resolve the interlinked sovereign-debt and banking crises. Specifically, it demands sovereign-debt mutualization through Eurobonds, and thus the elimination of eurozone countries' fiscal sovereignty, and a full-fledged banking union with recapitalization authority and shared deposit insurance - a far cry from the arrangement that has been agreed.

If Europe's leaders continue to choose mild palliatives over bold tactics, the best-case scenario is a lackluster recovery, with GDP growing at a 1-2% annual rate. Unfortunately, this best case probably is not enough to prevent future sovereign-debt defaults in countries like Italy, Spain, and eventually even France. In other words, at some point, lying still will no longer be an option.

In fact, eurozone leaders might be spurred into action even sooner. While the prospect of OMT seems to be keeping financial shocks at bay, at least for now, a political shock seems increasingly likely, with voters reacting against the internal-devaluation policies that are fueling high unemployment and undermining living standards. The upcoming European Parliament election could be just such a shock.

As it stands, Europe's political class is committed to internal devaluation in all of the troubled eurozone economies. The alternative approach - dismantling the eurozone to allow for external devaluations - has thus become the playground of hitherto marginal political parties, which are now surging ahead in opinion polls.

In France, the groups concerned - the National Front and the Union of the Left - represent political extremes. In Italy, a more ideologically neutral anti-establishment force may arise, with a much sharper anti-euro focus than Beppe Grillo's populist Five Star Movement, which emerged last year to become the country's third-largest political force. As these parties gain traction, the euro's chances of survival diminish.

The predicament of Europe's political establishment stems from a combination of irrational fear and vain ambition. This is particularly apparent in France, where the monetary union has often been viewed as a tool for harnessing Germany's economic strength to project power worldwide. Given that dismantling the eurozone would mean the end of the French establishment's European project and would weaken Europe's ability to advance its interests vis-à-vis global powers like the United States and China, "monetary anti-union" is unthinkable.

France's global ambition is apparent whenever its mainstream politicians discuss the euro. For example, in 2011, Edmond Alphandéry, a former economy minister, declared that a eurozone exit by a member country was as likely as a dollar exit by Texas or California. Here, on full display, was the wishful thinking that brought the euro into existence in the first place: its French architects dreamed of a Europe that could equal the US. That was always an illusory ambition, but it continues to cloud European leaders' judgment.

The single currency's advocates are right about one thing: political motives have always underpinned the establishment of monetary unions, from Latin America's in the period from 1865 to 1927 to that between Ireland and Britain from 1922 to 1979. But they are missing a crucial point: politics is also the reason for these unions' dissolution. When the economic costs and divergences become too much of a threat, the political will to do what it takes to ensure the common currency's survival collapses.

Voter reaction against the euro may well force the eurozone to stop lying still and take real action. The question is whether that would mean that some or all eurozone countries must go their separate ways.

Copyright: Project Syndicate


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