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As the euro zone’s crises escalate, what’s the end game?
The euro zone debt crisis took another dramatic turn Tuesday as thousands of Italians hit the streets in a general strike, protesting a new round of austerity measures.
Europe's woes continue to rile global investors. The Swiss National Bank surprised the markets by setting an exchange rate cap on the soaring franc, which investors have been flocking to as a safe-haven currency.
European stock markets, meanwhile, hit their lowest point in two years Tuesday.
While Europeans take their August vacations and leaders prevaricate, investors are growing increasingly concerned that the continent’s common currency could collapse, and that one or more countries could default on their debt, leading to another global economic crisis.
More from GlobalPost: German court rejects challenge to eurozone rescue deals
For insights on the current state of the crisis, GlobalPost turned to economist Yannis M. Ioannides, the Max and Herta Neubauer Chair at Tufts University. Ioannides is an authority on Greece's economy. He has served as a research associate at the National Bureau of Economic Research in Athens, and is currently on the academic board of trustees at the Athens Institute of Economic Policy Studies in Athens. He also co-chairs the Greek Study Group at the Center for European Studies at Harvard University.
GlobalPost: In mid-August, German Chancellor Angela Merkel and French President Nicolas Sarkozy proposed initiatives to deal with the euro zone crisis, but investors viewed these as weak. Global equities plummeted. One of the Merkel-Sarkozy ideas was to bolster euro zone governance, which is a step toward greater fiscal union for Europe — essentially, toward a common budget and government-spending policy. Some people have compared this to a United States of Europe. Would this work, and is it needed?
Yannis Ioannides: There's no doubt that better governance would help solve the crisis, but the real issue is whether the European Union is ready to move closer to the kind of political union that has to undergird a fiscal union. I think that both Sarkozy and Merkel were motivated by a desire to appease the markets by making a political statement. But I think that their ideas are really ideas of the past.
We know very well that what is needed now is growth. Yes, it is important to have surpluses in order for lenders to be prepared to lend to different countries. At the same time, everybody understands that there are times when deficits are inevitable, just as there are times when surpluses appear because of growth. The key thing is growth, and the markets did not see any growth ideas in the meeting last Tuesday. The markets went down basically because of a lack of ideas from Merkel and Sarkozy's summit. It's a political failure of the European Union.
Jacques Attali, the former head of Europe’s development bank, told the Council on Foreign Relations recently that Europe needs to create a federation — with a central budget, central “euro bonds” and strict restrictions on national budget. If they don’t do this soon, he warned, the euro will disappear. Would you agree?
He’s right. The idea that you could have a common currency without a fiscal union is patently failing, and people can't come to terms with that. The question is, how do you construct the United States of Europe? There is no way, because of low labor mobility, the lack of political uniformity across the euro zone and many other factors.
European leaders are currently doing the minimum necessary to get by, as opposed to putting on the table bold proposals about things that are going to appeal to the public throughout the 17th member euro zone or the 27-member European Union. They keep talking, but at the end of the day, the market is unconvinced, and the public is unconvinced.
If you can't have a currency union without a fiscal union, and we don't have a fiscal union now, how likely is it that they will be able to put together a fiscal union in the necessary amount of time?
The problem is, leaders in major countries — Germany, France, Italy — won't tolerate subsidizing other countries, especially when those other countries are not behaving in a like manner.
Compare that to the U.S. Massachusetts, for example, subsidizes people in Arizona on a regular basis, and people in Arizona subsidize Massachusetts. That happens automatically, through our tax money, our social-security contributions, our contributions to the federal unemployment fund and the like. When fewer people draw from those funds in Massachusetts, the surplus is available for people in Arizona to draw from. This cross-subsidization goes on without you or I debating it. It's part of the U.S. fiscal union.
In Europe, people keep talking about the European Union, but they forget the simple fact that the entire E.U. budget is less than 2 percent of E.U. gross domestic product. In the U.S., it's much higher, (as high as 40 percent, by some estimates.) There is little scope for stabilization-type activities with a 2 percent budget. A fiscal union would mean having a budget of 20 percent of GDP, ten times larger. Is the European public ready for that? I don't think so.
There's been a lot of talk about whether the European Central Bank should issue euro bonds — essentially, debt that would pool the credit of euro zone member countries, thereby making it more difficult for credit-worthy countries to borrow. Would this help, and what would the risks be?
The problem with the euro bond idea is that it won't solve the more difficult problem, namely, fiscal discipline. Countries that are not doing well fiscally, like Greece, could no longer be forced to stand by their promise to be more prudent _the way the European Financial Stability Facility requires them to be, before freeing up bailout funds). There's nothing in the euro bond mechanism that allows you to do that. In the U.S., we don't have this problem because the states are allowed to issue bonds for investment projects, but not to cover deficits. Only the federal authorities can do that, because they have control of the money supply.
The euro bond would allow the European Central Bank to be more like United States Federal Reserve Bank. But at the same time, the issuing entities would still be looked upon with suspicion by the markets. Why would Greece have an incentive to be prudent? That is not addressed in all of these discussions. In principle, the Eurobond is a good idea, and it would make the European Central Bank a more standard central bank, but I haven't heard anything about the moral hazard problem.
On the other hand, the euro bond would help Europe take action quickly, without convening a summit (and dealing with the complex politics).
If the euro zone is unlikely to adopt one of these policies that brings countries’ budgets together — such as issuing euro bonds or creating a fiscal union — is it inevitable that some countries will default? And will we see countries leaving the euro zone as a result?
Whether the obvious inescapable outcome of a failure to introduce euro bonds is that countries will default, I don't see that link. I think countries run a risk of defaulting if their economies fail to grow, rather than if leaders fail to issue euro bonds. We see that Portugal is picking up, Portugal is doing much better, already in a few months of its rescue phase.
Are defaults inevitable? I think the issue is growth. If they can implement pro-growth policies, then we will see the end of the tunnel, and more importantly, the markets will see the end of the tunnel.
Right now, governments are pursuing an approach which appears to restrict growth. They're pursuing austerity, which promotes deflation, slows growth, and increases unemployment. Is this the right strategy?
Austerity is needed to reduce budget deficits, but they need to cut the senseless stuff that they spend money on, and move some of the spending on infrastructure investment, job creation, and subsidies to certain businesses.
By senseless stuff, what do you mean? Salaries for too many bureaucrats?
Yes. I’m very familiar with the Greek public sector. It’s staggering what the Greek state pays, and gets nothing in return. It's just pure waste.
And what would they invest in?
They basically have to slash the state sector by discontinuing activities that do nothing except eat up tax revenue, and have a system where they can screen people, and reallocate them to different activities that are more productive. That's not happening. They keep talking about it, but it's not happening.
If Greece, Ireland, or Portugal were to default, what impact do you think that would have on Spain and Italy? Would it increase their borrowing costs and would they be able to handle the result?
Whether or not there is contagion, strictly speaking, it's an empirical question that has not been addressed fully. I would want to see a serious study that establishes cause and effect, that Greece, Portugal, and Ireland are impacting Italy and Spain. For me, contagion is a lot of talk.
What I believe is the issue, especially as it pertains to Italy, is the political crisis. Yes, early in the summer the Italian government very quickly passed measures controlling its budget. But traders believe that a clown is running Italy, and that Finance Minister Giulio Tremonti is the person who needs to take the lead. I think this is a very important factor regarding Italy.
As for Spain, the prime minister decided to call early elections in November instead of next spring. So it's natural that the public and the markets perceive political instability.
Finally, what about inflation? Debts are denominated in nominal amounts, and inflation tends to erode them by making it easier to come up with cash to make payments. Some in the French media have suggested that inflation could help the situation, more or less the way houses purchased in the U.S. in the 1960s became very easy to afford for the people who held mortgages once the inflation of the 1970s came along.
There's no doubt that inflation would erode the real value of the debt, (making it easier to afford). But that's tricky business. It seems to me that nobody is going to go for inflation. The parties that argue in favor of fiscal prudency: Germany, the Netherlands, the Scandinavian countries, Austria and those people, will not go for inflation. The most frightening thing to the German public is inflation.
Because it helped fuel the rise of Hitler?
Yes. They have not forgotten that.