Back to the Brink for the Eurozone?

When European Central Bank President Mario Draghi announced in late July that the ECB would “do whatever it takes” to prevent so-called “re-denomination risk” (the threat that some countries might be forced to give up the euro and reintroduce their own currencies), Spanish and Italian sovereign-bond yields fell immediately. Then, in early September, the ECB’s Council of Governors endorsed Draghi’s vow, further calming markets.

The tide of crisis, it seemed, had begun to turn, particularly after the German Constitutional Court upheld the European Stability Mechanism, Europe’s bailout fund. Despite the ECB’s imposition of conditionality on beneficiaries of its “potentially unlimited” bond purchases, financial markets across Europe and the United States staged a major rally.

It seems, however, that the euphoria was short-lived. Yields on Spanish and Italian government bonds have been inching up again, and equity investors’ mood is souring. So, what went wrong?

When I welcomed Mario Draghi’s strong statement in August, I argued that the ECB’s new “outright monetary transactions” program needed to be complemented by progress toward a more integrated eurozone, with a fiscal authority, a banking union, and some form of debt mutualization. The OMT program’s success, I argued, presupposed a decisive change in the macroeconomic policy mix throughout the eurozone.

There has been some progress, albeit slow, toward agreement on the institutional architecture of a more integrated eurozone. The necessity of a banking union is now more generally accepted, and there is a move to augment the European budget with funds that could be deployed with policy or project conditionality, in addition to ESM resources. (Germany and its northern European allies, however, insist that this be an alternative to some form of debt mutualization, rather than a complement to it.)

The ESM, supported by the ECB, could become a European version of the International Monetary Fund, and the new funds in the European budget could become, with support from the European Investment Bank, Europe’s World Bank. All of this will take time, but there is some movement in the right direction.

Where there has been virtually no progress at all is in the recalibration of the macroeconomic policy mix. The prevailing strategy in Europe remains simply to force internal devaluation on the southern countries, with excessive austerity aimed at causing severe wage and price deflation. While some internal devaluation is being achieved, it is producing so much economic and social dislocation – and, increasingly, political upheaval – that there is no supply response, despite the accompanying structural reforms.

Indeed, the deflationary spiral, particularly in Greece and Spain, is causing output to contract so rapidly that further spending cuts and tax increases are not reducing budget deficits and public debt relative to GDP. And Europe’s preferred solution – more austerity – is merely causing fiscal targets to recede faster. As a result, markets have again started to measure GDP to include some probability of currency re-denomination, causing debt ratios to look much worse than those based on the certainty of continued euro membership.

While all of this is happening in Europe’s south, most of the northern countries are running current-account surpluses. Germany’s surplus, at $216 billion, is now larger than China’s – and the world’s largest in absolute terms. Together with the surpluses of Austria, the Netherlands, and most non-eurozone northern countries – namely, Switzerland, Sweden, Denmark, and Norway – northern Europe has run a current-account surplus of $511 billion over the last 12 months. That is larger than the Chinese surplus has ever been – and scary because it subtracts net demand from the rest of Europe and the world economy.

Inflicting excessive austerity on the southern European countries while limiting their exports by restricting effective demand in the north is like administering an overdose to a patient while withholding oxygen. The political and economic success of southern Europe’s much-needed structural reforms requires the proper dose and timing of budgetary medicine and buoyant demand in the north.

The northern countries argue that permitting wage growth and boosting domestic demand would reduce their competitiveness and trade surplus. But that misses the entire point: surplus countries must contribute no less than deficit countries to global and regional rebalancing, because the world economy cannot export to outer space. This argument was always emphasized when the Chinese surplus was deemed excessive, but it is virtually ignored when it comes to northern Europe.

If conservative politicians and economists in Europe’s north continue to insist on the wrong overall macroeconomic policy mix in Europe, they could yet bring about the end of the eurozone, and, with it, the end of the European project of peace and integration as we have known it for decades. This is not to argue against the need for vigorous structural and competitiveness-enhancing reforms in the south; it is to give those reforms a chance to succeed.