2012 was meant to be the year of reckoning for the eurozone. The Spanish banking system lay in tatters, the long-term interest rate on Italian debt was unsustainable, and the prospect of a Greek exit seemed frightengly plausible. Yet the doomsayers, of whom there were many, have had to think again as the euro is still completely intact, mainly due to Mario Draghi, the head of the European Central Bank. In July 2012, he remarked that he would do “whatever it takes” to save the euro and subsequently pledged to buy an unlimited amount of government bonds. His remarks set off a flurry of investor optimism and long-term interest rates on Italian and Spanish debt fell to more manageable levels. Some have suggested that Draghi’s actions might just prove to be the turning point in the crisis. Few contemplate the horrifying thought of a break-up. Yet the tragic irony of this newfound optimism is that European politicians might just be lulled into a false sense of smug complacency. Throughout the crisis, they have only acted when absolutely necessary, coming up with half-baked stopgaps and avoiding the question that should be at the forefront of their minds: How does Europe move to a full-fledged federal republic? The indisputable fact is that a monetary union with independent fiscal policies will inevitably be chronically unstable and prone to crises and possible break up. Draghi’s actions might have given Europe some much needed respite and breathing space but it certainly is no time to celebrate. That would be downright dangerous.
Once the focal point of Western civilization, Greece is now sadly the centerpiece of the European tragedy. It enters its sixth year of recession with youth unemployment at a staggering 53%. A walk through the streets of Athens will quickly make you lose any urge to celebrate the calming of the bond markets. The streets are punctuated with jobless queues, beggars and violent protests, reminding us of images of the Great Depression we encounter in history textbooks. The mass suffering not only in Greece but also in Spain, Portugal, Ireland and Italy is evidence of the failure of the economic policies being forced upon them, primarily by Germany. The two central tenants of economic policy—intended not only to ensure the survival of the monetary union but also to bring it back to prosperity—have been government austerity and supply side reform to boost competitiveness. Measures to improve competitiveness like reforming unsustainable pension systems and cutting labor costs work only if other countries in the monetary union are not doing the same thing. However, every country in the southern periphery has been ordered to reduce labor unit costs relative to Germany, but it would be absurd to think Germany would not attempt to do the same. Trying to increase competitiveness at the same time is a zero-sum game. A fixation on solely increasing competitiveness will not guarantee a return to prosperity because the basic problem holding back prospects of recovery is a huge lack of aggregate demand in the eurozone as a whole.
This lack of aggregate demand has been severely exacerbated by the government austerity undertaken by the governments in the southern periphery. The incessant obsession with nominal deficit targets means that Greece and Spain have been sucked into a self-defeating dynamic. If the economy misses the deficit target, more severe austerity measures are implemented, which only leads to another failure to meet the target. Although most governments in Europe need to reduce their debt-to-GDP ratios, it needs be done over a long time period, complemented by policies to boost economic growth. This obsession with fiscal austerity has not only caused immense damage in the short run but also represents a fundamental misunderstanding of the root causes of the crisis.
A common consensus shared amongst the media, academics and politicians is that the eurozone crisis has primarily been a sovereign debt crisis. Governments have been fiscally profligate, spending beyond their means for a decade and now they can borrow no more. If fiscal recklessness was the root cause, then austerity has to be the solution. Austerity certainly has not been the solution and has in fact worsened the crisis. Apart from Greece, who did spend recklessly for a decade, the economic woes of the eurozone cannot be attributed to fiscal irresponsibility but instead to fundamental flaws in the institutional framework of the monetary union. These flaws are ever so apparent in the case of Spain. Before joining the euro, Spain’s interest rate was significantly higher compared to Germany. However, when it joined the euro and lost independence over monetary policy, interest rates fell dramatically, fuelling a housing boom which in turn led to higher wages and inflation. Consequently, Spanish exports became uncompetitive relative to Europe’s core. If Spain still had the lira, it would just fall in value, making it easy to regain competiveness. With a single currency though, the exchange rate is no longer an escape route. Instead, Spain has had to undergo what is know as an “internal devaluation.’’ To be more competitive, it has to endure an extended period of high unemployment, until wages fall. This is very hard to achieve because wages are sticky downwards, even with massive unemployment.
To compound its unemployment crisis, Spain has to deal with unsustainable public debt. However, debt is a symptom of the crisis and not the cause. The Spanish government, until recently, had a lower debt- to- GDP ratio than Britain and the USA but was forced to borrow at much higher interest rates. The key difference is that Britain and the USA have their own currencies and central banks. Therefore, they cannot default on their debt because the central bank would step in and buy up government bonds by printing money. The European Central Bank on the other hand does not have a mandate to do that. Therefore, investors buying Spanish debt demanded higher interest rates because of the fear that the Spanish government might default. The higher interest rates actually increase the prospect of default, leading to even higher interest rates, resulting in a self-fulfilling crisis. This self-fulfilling panic was finally ended when the ECB pledged to intervene in the bond market. However, this promises to be a one-off emergency measure since the ECB is not permitted to buy government debt.
Given these institutional shortcomings, it might be tempting to conclude that Europe simply was not ready for a common currency and Europeans should abandon the idea and return to their independent currencies. That however, is not an option. A break up would be an economic, political and social calamity; what the eurozone needs is fiscal federalism. Having created the monetary union, the Europeans have to take the next logical step towards a fully functional federal republic like Germany or the USA. The absence of a federal system is the major institutional drawback that has led to the instability of the last few years. When unemployment soared in certain states in America following the crisis of 2008, the shocks were absorbed to a certain extent by the federal government. People in those states still received Social Security benefits while the Federal Deposit Insurance Cooperation, a federal agency, backstopped the state’s banks. Federal aid to state and local governments increased too. In the eurozone however, individual member states had to bailout its own banks and pay for unemployment and health benefits in the face of decreased tax revenue. The United States provides the perfect model of the conditions required for a monetary union to work. What the eurozone needs is a common Eurobond (bonds issued by the European Federation backed by all governments), a significantly bigger central budget to which individual states contribute, and fiscal transfers for the northern core to the southern periphery.
Of course, tax and spending policy is always a hotly debated topic. The task of calibrating the tax and social security systems of all members of the eurozone seems a Herculean one. The fact is, in a federal republic, resources usually get distributed from the more productive sectors of the federation to the less productive ones. This means the northern countries transferring resources to the southern periphery. According to financial historian Niall Ferguson, a federation would entail transfers from Germany to the southern periphery worth 8% of Germany’s GDP every single year. Since Germany is a key payer in deciding the future of Europe, it seems implausible that they would entertain thoughts of forming a “United States of Europe.” However, Germans need to be reminded of the benefits that joining the euro has given them. The euro is significantly weaker than the German Deutschmark and has enabled Germany to run current account surpluses year after year. Moreover, the only other alternative, if it may be called one, is a break up of the monetary union that would be catastrophic from a German point of view. The Economist magazine predicts that the cost of a break up to Germany would be about €500 billion or 20% of GDP.
Forming a federation would take several years, probably a decade or so. The process would be complex and frustrating, highlighted with major disagreements. To further complicate matters, Britain has openly declared its hostility towards the idea of a federal Europe. Its future in the EU hangs in the balance. However, there must be a signal of intent from policymakers in Europe. They must signal a willingness to talk about and discuss a long- term move towards a fiscal federation. Unfortunately, moving towards a federation has not dominated the public discourse, to say the least. European politicians still talk and behave as if the eurozone in its current form can survive and a mix of austerity and supply-side reform can return it back to health. This option does not exist; there is no middle ground. Either the eurozone moves to a federation or it eventually breaks up, bringing the world economy to its knees in the process. The choice is clear and the consequences of that choice could define our generation.