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The sovereign debt crisis has cast doubt over the future of the European project.
This is where things went wrong. Enforcement of deficit limits has been farcical, market reforms limited, and in the case of Greece outright fraud perpetrated (the previous government cooked the books). All of these factors undermined investor confidence. Greece, Spain and Portugal face higher costs when raising cash from investors demanding greater return for their risk. For weeks European policymakers sought to contain the crisis to Greece. But the financial turmoil spilled over to wider European markets with the potential to unhinge the nascent global economy recovery. As investors seek to compensate for losses in one market they sell in others, leading to financial contagion where even the fiscally prudent can suffer.
Even if the recent aid package calms markets, Europe faces more serious, enduring systemic challenges. Where the EU had failed to impose long overdue reforms, the IMF is now doing the job. European leaders were reluctant to have the IMF involved precisely because it revealed their inability to get their own house in order. Given the vast literature and policy debates since the creation of the euro — all pointing to the need for competitiveness-enhancing policies among euro member laggards — it’s hard to believe that policymakers were unaware of what was required to be responsible members of the eurozone until now.
The European Central Bank has agreed to buy government bonds of countries in trouble. This puts money into the financial system and eases the flow of credit. Until recently this option was vehemently opposed, especially by Germany which lives with the legacy of hyperinflation from the 1920s. Independence from political influence is the cornerstone of a central bank’s credibility. When monetary policy is driven by the whims of bureaucrats and not clear rules that provide confidence to markets, a central bank becomes ineffective.
Growth will be the biggest challenge. The fiscal austerity, pension cuts, and reforms imposed on Greece will be brutal and arguably will not lead to the deep reforms necessary to purge the country’s Third World-like corruption and nepotism. Even if all goes well, Greece will see its debt reach 140 percent of GDP and economic stagnation over the next three years. Spain and Portugal are looking at spiraling debt and severe economic weakness. In the absence of growth, jobs, and funds for public goods like health and education, social cohesion will be strained.
Europe needs more than an aid package. It needs an aggressive growth agenda coupled with effective tools to manage economic divergence. Only then will the potential gains from a common currency be reaped.
Jonathan White is a senior program officer in the economic policy program of the German Marshall Fund of the United States.