by Sara Eisen
Table 4-1 Tax Burden and Government Expenditures as a Percentage of GDP
The odds do not favor a dramatic increase in growth while the Bismarckian social compact remains intact and the statist control of the commanding economic heights continues. The Wild West of Shenzhen and Silicon Valley is not about to erupt in the European heartland. Before that happens, the continent will have to undergo hellish hard times and an agonizing reassessment on a scale equal to, or greater than, that experienced by the Eastern Europeans after the collapse of Communism.
As the European population stalls and the birthrate continues to register far below the replacement level of 2.1, a growing awareness of the financial implications of this reality and the future that it implies will breed a deep psychological depression that will hold the continent back. The horrifying long-term impact of this shrinking process is that it will take many, many decades to reverse. European cities may still be beautiful and well preserved in 2100, but the countryside will be drained of people and less vibrant. House prices cannot move higher when there is a continual decline in family formations. As a result, residential construction and renovation will stagnate, and abandoned homes and towns will be seen everywhere.
Historical records, always better in Europe, note three previous times when the population declined: through the first half of the seventeenth century, in most of the fourteenth century, and through the tenth century and into the early eleventh century. Although each of these periods seems to have been dominated by specific social fears—expectations of the end of the world around 1000, multiple plagues in the fourteenth century, and wars in the seventeenth century—they all exhibit a shrinkage of land under cultivation, a decline in the arts, and a reduction in rational activity, combined with an increase in uncivilized activities like witch trials, homicides, and atrocities.
Although modern society can be expected to do better, there is a high probability that Europe will suffer a brain drain as the stagnation that is so apparent at home drives the best to other parts of the world. The most that Europe can expect is a worldwide appreciation for its long-term role as a font of civilization, a quiet place to retire or visit. Offsetting this dowagerlike existence will be an increasing in-migration of Africans and Middle Easterners taking advantage of the job opportunities that cannot be filled by native Europeans. Although the next generations won’t be able to bring Europe out of its swoon, if the three previous instances of population decline prove at all instructive, Europe will arise stronger than ever in the twenty-second century, sparked by the new blood from outside its borders.
Taking a slightly shorter-term view of Europe and the euro, a more recent historical example might be appropriate. In 1815 (after the French Revolution of 1789 had upset the European monarchies, setting off a tumultuous 26 years capped by more than a decade of war in which Napoleon’s armies upset the entire military, political, and judicial landscape of Europe), the triumphant old guard put Europe back together again. Count Metternich and the others put all the pieces back where they had been before, as best they could, and promised never to let this happen again.
The concept behind the activities creating the European Coal and Steel Community in 1950, leading up to the Treaty of Rome in 1956, bears more than a passing resemblance to that of the Congress of Vienna in 1815. The architects of the peace in Austria wanted things to return to a better time and were successful for the following 33 years, but then a series of government-shaking riots erupted in the major European capitals as the people began to react to the economic and social changes that had altered their relationship to their governments. In the next 23 years, between 1848 and 1871, the political landscape of Europe was redrawn in a long, but stop-and-go process in which Italy and Germany became countries, Switzerland and Austria were reconstructed, and France was finally firmly set on the republican road. After 1871, Europe was at peace until World War I. Jean Monnet and Walter Schumann were even more successful than Metternich, as their reconstruction of the pre–1914 idyll has proved more durable, lasting from 1950 through today. The six original members of the European Union put the pieces back together after the 31 years of carnage beginning with World War I and running through the rampages of Hitler and World War II, swearing never again.
These political architects have succeeded beyond their wildest dreams, but going back to the past works only for a while. The impact of scientific advances and the industrial and postindustrial revolutions means that it cannot work forever. Europe in 1848 was politically the same as it was in 1788, but economically, scientifically, and socially, it was not. It needed to be changed, and the result was 23 years of intermittent revolution. Europe today has a political structure that is very similar to that of 1913, but economically, scientifically, and socially, it is incredibly different.
Change is necessary. How many years of political and economic crises will it take before Europe finds an appropriate new form that matches the realities of today? If we were to be optimistic, the answer would be several decades, but with the population decline and the Minsky debt crisis added to the list of systemic problems, it could take much longer to find a solution.
Valuing the euro through the coming years of traumatic changes in the eurozone, within the wider frames of Europe and the world, is not really possible, but some major tendencies are obvious. Although the euro is the second most important currency in the world today, whether one considers trading volumes or its position as an investment vehicle in terms of reserves, fixed-income markets, or equities, it will decline in importance over the next decades. Although it is unlikely to disappear, the process of restructuring will force a negative reassessment. This process, compounded by the debt crisis and the political struggles within some of the eurozone countries, will force Europe to retreat within itself and will see the rest of the world standing apart from its problems.
Without dramatic action, the continent will seem like the modern-day version of the Austro-Hungarian Empire, tottering toward its eventual demise. By mid-century, its population will drop to less than 4 percent of the global total, and its GDP will probably be in the high teens, a far drop from today’s prominence. The world will grow, but Europe will not. It will be dwarfed by China and India, the emerging Asian giants, while Korea, Indonesia, and Thailand will each surpass the GDPs of the largest European countries. Brazil will outpace Europe as well. Although the United States will retain its dominant position, because of its economic weakness, it will be forced to share its preeminence with the Asians.
As the reserve currency structure is not likely to survive in its current form, the dollar will probably share the responsibility for global liquidity with a basket of other currencies and commodities, but the euro is unlikely to play a major role, having been replaced by the Asians and others. Because Europe will not be central to world development, it will slide into a position similar to that of the United Kingdom today. The euro will be forced to adapt to the economic policies of the more dominant countries. As sterling moves primarily in relation to the euro, and Australia trades as a satellite of the Chinese economy, so too, will the euro react to the Asian and North American lead.
CHAPTER 5
THE FUTURE OF THE EUROZONE: AN AMICABLE DIVORCE IS BETTER THAN AN UNHAPPY MARRIAGE
MEGAN GREENE
“The one currency is irreversible.”
—Mario Draghi, December 2011
A number of myths surround the euro crisis, the most common of which is that the best outcome for all involved would be for the eurozone (the countries that use the euro common currency and the European Central Bank) to stay together in its current formation. It is difficult for analysts and policy makers to contemplate the practicalities of the eurozone’s actually breaking up. After all, the common currency was never a purely financial arrangement—it was part of the broader political project to prevent a return to war in Europe as well.
Even partially dismantling the eurozone would be a logistical nightmare, with contracts needin
g to be redenominated into new currencies and with cascading defaults potentially being triggered across the region. This would undoubtedly be painful and messy. But so is the endless path of retrenchment and bailouts on which the debtor and creditor countries in the eurozone have embarked.
What’s more, history is not on the eurozone’s side; the vast majority of currency unions have eventually been torn apart. Only those in the United States of America and the United Kingdom have survived. The European Commission, the European Central Bank (ECB), and the International Monetary Fund (IMF)—together referred to as the “troika"—have gone to great lengths to keep all 17 member states in the eurozone. But it seems increasingly likely that some of the weaker countries will eventually peel out of the euro area, starting with Greece. This should not alarm us. Both the countries that leave the eurozone and those that remain as members of the common currency will be better off for this parting of the ways. In the medium to long term, an amicable, albeit expensive, divorce is preferable to an unhappy marriage.
The Benefits to Greece of Exiting
Greece has a long history as a trailblazer, whether as the cradle of democracy or for its numerous mathematical, scientific, philosophical, and athletic developments over the centuries. In the next few years, however, Greece will blaze a trail of a very different sort by becoming the first country to choose to default and exit the euro. It will not be the last country to do so. European leaders have gone out of their way to declare Greece a unique case, but Greece will come to be a model for how the weaker countries will be handled.
After months of negotiations, in March 2012, the troika and the Greek government finally agreed to a deal on a second support package for Greece and on private-sector involvement (PSI) to reduce Greece’s stock of debt. But this deal will fail to return Greece to fiscal sustainability, particularly given that the second support package agreed upon involves further austerity measures and structural reforms, both of which will undermine economic growth in the short term. This, in turn, will send Greece’s debt-to-GDP ratio soaring higher as output contracts.
The planned structural reforms are aimed at opening up product and labor markets so that Greece can regain its competitiveness and eventually return to sustainable growth. But prior to the second support program, the Greek government was effective only at legislating structural reforms rather than actually implementing them. There is no reason to expect any turnaround on this, particularly given rising levels of opposition to reform among Greece’s public, politicians, and trade unions. The second bailout and PSI deal will temporarily address Greece’s stock-of-debt issue, but it will do nothing to address the much more important flow-of-debt issue. If the Greek government fails to liberalize its economy and boost competitiveness over the next few years, Greece’s debt burden will ramp right back up over time.
While the Greek government is often accused of having done nothing to comply with the terms of its bailout agreements, this is not strictly true. Woefully few structural reforms have been implemented, but the fiscal adjustment in Greece over the past few years has been significant, with public- and private-sector wages and pensions having been cut sharply. The middle class has been hit hard by austerity. But while there have been some violent antiausterity protests in Syntagma Square in central Athens, the vast majority of Greeks believe that they are better off in the euro than outside it.
It also seems unlikely that the troika will abandon Greece in the short term. During negotiations on the second support program, it was clear that patience with Greece had waned amongst the eurozone’s creditor countries. Senior German and Dutch policy makers were openly discussing a Greek exit from the eurozone, something that would have been unfathomable just a year before. Despite this, however, there are two reasons for the troika to continue to keep Greece on life support. First, before the troika turns off the funding taps for Greece, it aims to create a firewall between the rest of the eurozone and a Greek default and exit from the eurozone. Second, the German elections scheduled for September 2013 made it unlikely that Chancellor Merkel would allow her election campaign to be clouded by whatever would be unleashed by a Greek default and exit.
However, with Germany’s elections over in late 2013 and the Greeks further squeezed by new austerity measures, both Greece and the troika will consider alternatives to the current cycle of austerity and bailouts. Greece will face a stark choice about how to return to growth. On the one hand, it can continue along its current path of austerity as a means of achieving an internal devaluation, thereby regaining competitiveness and eventually seeing its economic performance improve. But this would probably result in a decade of depression. On the other hand, Greece could choose to exit the eurozone, reissue the drachma, and allow the currency to devalue significantly. This would see Greece regaining competitiveness and returning to growth much more quickly. Exiting the eurozone inevitably entails sovereign and bank defaults and bank runs. This scenario is painful, but increasingly, it has seemed that Greece would experience these things anyhow, whether sticking with the common currency or not. The country might as well benefit from a nominal devaluation to provide an immediate boost to economic growth.
A Greek exit involves the troika and Greece coming together and agreeing that an amicable divorce is needed because the relationship is simply not working any longer. The troika then provides Greece with bridge financing. This cushions the financial blow of exiting the eurozone, but with continuing conditionality attached, it could also serve as a stick to ensure that Greece finally implements the structural reforms necessary for the country to achieve sustainable growth.
Opening Pandora’s Box: Who Will Choose to Follow Greece?
A Greek default and exit from the eurozone will be painful and messy. Nevertheless, some of the other weaker eurozone countries will still choose to follow in Greece’s footsteps in order to return to growth more quickly.
Unlike Greece, Portugal has so far managed to achieve the fiscal targets set out for it in the troika’s bailout program. However, Portugal’s success has been largely due to a series of one-off measures—such as shifting banks’ pension funds to the government’s social security budget—that cannot be repeated in the future. This, combined with the fact that Portugal’s GDP will be contracting significantly over the next few years, suggests that Portugal will not continue to meet its fiscal targets. According to the first Portuguese bailout program, the country is expected to return to the markets in 2013. This is highly unlikely, given how unsustainably high Portugal’s borrowing costs have risen during the crisis, and the country is likely to follow Greece’s model in requesting not only a second bailout package from the troika, but also a reduction of its debt burden in a PSI deal.
As in Greece, PSI in Portugal will address the stock-of-debt problem but will not deal with the flow-of-debt issue over time. In order to regain competitiveness and return to sustainable growth, therefore, Portugal will face the same choice that Greece currently faces: either Portugal can experience a decade of depression, or it can choose to exit from the eurozone and undergo a nominal devaluation.
Ireland might have a fighting chance at returning to growth within the eurozone, but this is looking increasingly uncertain. Ireland’s GDP will stagnate at best in the short to medium term as its main export markets—the United States, the United Kingdom, and the eurozone—go into stall speed or recession. Ireland is entirely reliant on exports for growth, with domestic demand exerting a negative drag on GDP.
Furthermore, concerns about Ireland’s banking sector remain. While the number of mortgages in arrears has risen sharply, mortgage defaults have yet to crystallize. The longer mortgage defaults are delayed, the larger they tend to be. Reforms in the personal insolvency regime in Ireland will allow individuals to write off some of their debts, including mortgages. This should reduce the cost of mortgage default for the banks, but they may still need to be recapitalized. Of the €35 billion earmarked for the banking sector in the original bailout packag
e, only around €16.5 billion was used, with the remainder being reallocated to the Irish government in order to delay the sovereign’s having to return to the bond markets. If Irish banks need to be recapitalized, the funding will once again have to come from the government, pushing the Irish sovereign debt burden up even higher.
But even if Ireland can make its creditors whole, there is a significant risk that it will choose not to. Once Greece and Portugal have defaulted and exited from the eurozone, Ireland may decide on a strategic default and eurozone exit. Unlike Portugal and Greece, Ireland already benefits from open product and labor markets and a highly skilled labor force. Rather than continuing to implement austerity measures, Ireland may choose to default, reissue its national currency, the punt, and use a nominal devaluation to return to growth quickly.
Buying Time for Italy and Spain
The response to the eurozone crisis has centered on buying time for the single currency’s weaker, peripheral members. Particular attention has been focused on Italy and Spain, because the sheer size of both their economies and their debt burdens threatens to transmit the crisis to the currency’s core countries. The aim has been to buy enough time for Italy and Spain to implement structural reforms and for those reforms to have taken hold and begun to facilitate growth. This is a lengthy process that generally takes about five to ten years, particularly in countries like these two, with rigid labor markets and no control over monetary policy.