Can The Euro Be Saved?

Includes: ERO, EU, EZU, FXE, IEV
by: Carnegie Endowment

With the global economic recovery sputtering, fingers are pointing at the stagnating European economies and their spreading sovereign debt crisis. In a new Q&A, Uri Dadush warns that Europe has little time left to address the underlying weaknesses in the monetary union in order to prevent collapse. But even if changes are made, a sudden stop of funding and a bailout remains a possibility for Italy and Spain, and the necessary structural reforms in the periphery will take a long time to be implemented.

Is the European Union on the brink of a major economic catastrophe?

Unless the European Union takes important and convincing remedial measures in the next few weeks, its problems will escalate dramatically—and the eurozone could even collapse.

Initially, the euro crisis affected relatively small economies like Greece, Ireland, and Portugal. The Greek situation is far from resolution, but now Italy and Spain are at risk, and they are much more important economic players—Italy is even part of the G7, the group of major world economies.

Italy, which has the third largest debt in the world behind the United States and Japan, already faces very high costs on new borrowing. If the costs go much higher, Italy will effectively find itself shut out of financial markets. This would have catastrophic effects on the country’s economy, but also on its ability to repay and refinance its debts. The value of its government bonds, many of which are held by international banks, has already declined and would plummet, triggering major repercussions throughout the eurozone and the international banking system. Credit ratings for individual euro countries would plummet and other governments would be unable to meet their debt obligations.

The starting point is also inauspicious—many governments have little policy room left to engage in fiscal or monetary stimulus, or to bail out the banking system. Countries could drop out of the eurozone. This would be the perfect storm—and has the potential to repeat the Great Depression of the 1930s.

Should the euro be saved?

It is clear now that the euro was built on a shaky foundation. It is a monetary union that does not have adequate underpinnings in terms of political union and in a fiscal pooling of resources. Moreover, in several member states, labor markets and product markets are inflexible, making it difficult for prices and wages to adjust. Without the ability to devalue currency, these weaknesses have led to large imbalances that created the problems we see now. For the first time in memory, very large economies are tied down by an arrangement where they have lost all policy room to react to slowing growth and rising debt levels, creating the real possibility of a sudden stop in their financing.

But we can’t go back, and if the euro was to collapse now, there would be chaos. This means the underlying problems must be addressed to save the common currency.

It is entirely possible that one or more countries—particularly Greece—may not be able to make the political and economic changes necessary. A way must be found that reduces their debt in an orderly fashion. Even that may not be enough, and Greece may have to drop out of the zone to regain its competitiveness and reestablish conditions so it can grow again. But it isn’t possible the save the euro as we know it if one of the larger countries like Italy or Spain is forced out.

Has Europe done enough to save its economies?

No. At every stage, Europe has reacted with too little and too late, and has failed to adequately focus on the long-term solutions. While European Central Bank interventions and use of the European Financial Stability Facility bailout fund are important and necessary in the short term, and both types of operations need to be greatly expanded, they won’t fix the euro’s real problems.

To do that, European policymakers must take three steps. The first is to make the necessary structural and fiscal adjustments in the periphery countries—like Ireland and Portugal—that will put their finances on a sustainable path and allow them to regain competitiveness.

Second, countries unable to make the necessary adjustments—because their debts are too high, it’s not realistic politically, or their economies are too weak—need a mechanism for relief, including forgiving a part of their debts and, if necessary, assisting in their exit from the eurozone.

And finally, the eurozone needs to create a much larger common fiscal pool. Calling it a fiscal union might be a bit extreme, but there needs to be capacity at the center to issue bonds jointly and to implicitly guarantee all of the countries in the eurozone, at least to cover a large part of new financing requirements over many years. There also needs to be the capability to address shocks that affect members in different ways (such as the burst of the banking and housing bubble in Ireland) through, for example, a common unemployment insurance program and a facility to recapitalize banks.

But creating greater fiscal unity is a huge challenge. The recent debates have made it clear that countries in Europe are far from sharing a European identity.

Is Germany responsible for saving the euro?

All of the countries in the eurozone are responsible for saving it, particularly the ones whose economies are troubled. But at the same time, Germany is the largest economy in the eurozone by a large margin, and also is among the healthiest, placing it in the best position to help others make adjustments.

Germany also carries some responsibility for the problems we see at present. Germany—and France—have flouted the 1997 fiscal stability pact, designed to prevent some of the problems we see today, which set a poor example for the other countries. Germany has benefited from a euro that is weaker than the Deutsche Mark would have been. Its decade-old effort to contain wages and demand have led it to run larger trade surpluses than China, placing even more pressure on its eurozone partners.

Germany’s political and economic choices today will determine the future of Europe. If Germans were to say today that they wanted a tighter political and fiscal union, the other countries would follow.

What can other major economies do to help Europe? Should China bail out Europe?

It will take many years to fix the eurozone. These types of structural changes do not happen overnight. If the crisis spreads to Italy and Spain, they will need a bailout. And it is unlikely that Europe alone can afford it—the cost would likely be in the neighborhood of $2.1 trillion. Regardless of the political will in Europe to come up with that large sum, it’s just not economically conceivable without affecting the credit ratings of the countries at the core of Europe.

So while the G20 has distanced itself from the euro crisis in recent weeks, there is little question in my mind that if Italy and Spain were on the brink of collapse, the rest of the G20 would have to step in—at a minimum through expanding the resources of the International Monetary Fund (IMF). The IMF is already providing a third of the bailout money for Ireland, Portugal, and Greece. But that share will not be enough to support Spain and Italy, if it comes to that. The IMF will likely need to provide half of any bailout, which is where the G20 will have to play a role to support that type of funding.

The announcement by the U.S. Federal Reserve that it is willing to use its swap lines to help Europe in an emergency is significant and helpful. The United States Treasury is also clearly paying close attention, just as it should. And the emerging economies of the so-called BRICS—Brazil, Russia, India, China, and South Africa—have put Europe on their agenda, though at the moment there is little buy-in for a coordinated response.

China can and should help Europe, and I expect it will. China is now the largest exporter in the world and has large exchange rate reserves. The Chinese have a vital interest in the health of the global and European economies. So they would have to be part of the solution. But there is a limit to what China can do. A G20 intervention through the IMF could only occur if the United States and Japan made a big contribution.