Markets rallied last week on news of central bank intervention to ease indebted European governments’ liquidity problems, but the central problem remains. Europe is in a solvency, not a liquidity crisis, and it has to pay its debts sooner or later. Where will the money come from? If the markets are betting on the U.S. taxpayer, they are in for a big shock.
Europe’s problem is based on the crazy idea that separate national governments could share a fiat currency. When the euro was created, it seemed like win-win. Southern European countries, whose currencies had been relatively weak, could now borrow money at the same rate as Germany. Germany got access to Southern European markets, where the weak currencies had once kept expensive German goods out. The Greeks got to live like Germans, and the Germans were happy as their goods kept rolling out to the new markets.
There was a fly in this ointment, however. Greece has always had an inefficient public sector. I remember a Greek friend at business school in London telling me that in Greece the phrase “lazy like a public servant” is a common taunt. All of a sudden, these same epithet-inspiring public servants were being paid in Euros, which made them a lot more expensive than when they were being paid in drachmae.
As long as the Greek state could borrow quite cheaply, this wasn’t an immediate problem, but the debts eventually piled up. Having lost its comparative advantage of low wage rates, the Greek economy crumbled. The public sector became far too large. Greece is now unable to pay its bills without help from outside.
Greece is not alone. Italy, Ireland, Portugal, and Spain all lived high on the hog, too. For instance, Spain invested massive amounts of money in a renewable energy program that bought plaudits from President Obama but cost the economy two jobs for every “green job” created. Spain has abandoned such extravagances, now that the money has run out, but it’s not enough.
Ordinarily, governments would simply monetize their debt and allow some inflation, which would reduce the value of their debts and bring real wages down to affordable levels. With the euro, this is impossible. The Germans, given their experience with hyperinflation in the 1920s, will not allow the Euro to inflate for political purposes.
Therefore, the logical step for the indebted countries is to leave the Euro on a voluntary basis. This, however, is deeply problematic.
The Euro was not designed to allow countries to leave. It is part of the greater European project of “ever closer union” and central to the technocratic dreams of European Union bureaucrats. Moreover, Germany would lose its current easy access to Southern European markets. One partial solution would be fiscal union, with the Southern countries losing budgetary independence. That would merely transform an economic crisis into a crisis of democracy itself—even more so than it already is, with unelected premiers in Italy and Greece.
If the euro is to survive, the only solution is a bailout of the Southern countries. Again, where will the money come from? The German people take the quite understandable view that debtor nations that ran up their tabs should foot the bill themselves. The German constitutional court is adamant that there be no open-ended commitment by Germany to transfer German taxpayers’ money to other countries.
That’s why the central bank action the other day cheered investors. It looked like an admission that the U.S. would have to get involved. However, any U.S. involvement beyond the Federal Reserve’s limited action to date likely will have to go via the International Monetary Fund. The IMF is currently underfunded, and any changes to increase its funding will have to be ratified by the U.S. House of Representatives. With Congress struggling to get America’s own finances in order, an arrangement to bail out Southern Europe when Germany cannot do so is unlikely to happen, to say the least.
So Europe is now at an impasse. German Chancellor Angela Merkel is said to be trying to alter her country’s constitution to allow a bailout to save the Euro. That is an extremely slow process, and is unlikely to have any impact before 2013.
With all political options exhausted, market forces will take over. Greece and Portugal will likely be forced to default out of the euro early next year, with Italy and Spain following suit. The European dream of the EU technocratic elite will be shattered by the reality of the markets.