By On December 16 2010, European heads of government solemnly declared that they were "ready to do whatever is required" to protect the euro zone. Words are cheap. Skeptics may wonder whether to take them seriously. In this case, they should. The euro zone is highly likely to survive, albeit not without further turbulence. I would advance three arguments: first, the euro zone is backed by a profound political commitment; second, the long-term interests of participating countries are behind it; and, finally, the members can afford it. In short, the euro zone has the will and the wherewithal to keep the euro experiment afloat.
An interesting new report: "Europe will work", published by Nomura Global Economics under the direction of John Llewellyn and Peter Westaway makes the case. As it reminds readers, the euro zone is the product of a process of European integration that began in the aftermath of the second world war. Even for today's leaders, this remains an existential project, even though the memories of the war have faded in their populations. Moreover, the premise that economic integration would create powerful interests for its perpetuation has also proved correct. Finally, the consequences of even a partial break- up of the euro zone are unknowable and frightening. Only in extreme circumstances would European leaders contemplate this step.
Thus, while many Germans are angry over the sloppy behavior of certain partners, the country's elite remains aware of both the perils of isolation and the benefits of the stability that the European project has brought to their country in its relations with all its neighbors. Similarly, the leaders of the countries now in difficulty fear the outcast status that would follow exit from the euro zone. This does not mean that some form of break-up is inconceivable: Germany would exit if the body politic concluded that membership was incompatible with monetary stability; peripheral countries would also exit if they concluded that membership was incompatible with prosperity. Neither is close to that decision, as yet. Debt restructurings are quite likely, any sort of break-up much less so.
Paradoxically, the tragedy of the euro zone is that it worked too well. The convergence of perceived risks stimulated accelerated convergence of incomes. In the euphoria of the time, incautious lenders lent borrowers the rope with which the latter could hang themselves, be they irresponsible governments (as in Greece) or foolish private entities (as in Ireland and Spain). The result was huge indebtedness.
Ultimately, the most purblind of lenders come to their senses. But, when private lenders tighten the noose, notionally private debt tends to turn into public debt, as governments try to rescue imploding financial systems and sustain activity in collapsing economies. Even countries with sound public finances, such as Ireland and Spain, find themselves in such difficulties. Irish public debt is forecast to jump from 25 to 125 percent of gross domestic product between 2007 and 2013, with around a third of this jump due to the bail-out of banks.
The good news is that markets have recognized their error. The bad news is that they have done so on too dramatic a scale. This has bequeathed a huge debt problem to the troubled countries and a painful headache to the euro zone.
As the Nomura report notes, the manageability of public debt depends on just three things: the primary fiscal deficit (before interest); the "snowball" - the relationship between the interest rate and prospective growth; and the impact on public debt of "stock-flow" adjustments - the need to bail out banks or "debt deflation" (jumps in the burden of debt due to falling domestic prices or currency devaluations, when debt is denominated in foreign currency). It is in the nature of crises that they make all three of these far worse.
Particularly important for prospective growth, the fiscal position and the threat of debt deflation is the fact that the indebted countries lost competitiveness sharply during the years of convergence. Unit labor costs, relative to Germany's, rose 31 percent in Ireland, 27 percent in Greece and Spain and 24 percent in Portugal from 1999 to 2007. They face a long road back to competitiveness.
The report presents some disturbing numbers on the scale of the fiscal task ahead for the countries in difficulty. Suppose, for example, that the aim is to achieve a ratio of public debt to GDP of 60 percent - the Maastricht treaty standard - by 2030. Suppose, too, that the interest rate is only 1 percent higher than the growth rate of nominal GDP, then the necessary tightening of the structural primary fiscal deficit between 2009 and 2020 is 16 and 18 percent of GDP in Greece, 14 and 16 percent in Ireland, 10 and 12 percent in Spain and 8 and 10 percent in Portugal. The scale of the challenge is explained in part by the size of the initial primary deficits: 9.8 percent of GDP in Greece, 9.7 percent in Ireland, 7.5 percent in Spain and 5.4 percent in Portugal. It is not surprising that markets have been reluctant to finance some of these countries on sustainable terms.
These are mountainous challenges. I find it hard to believe that debt restructuring will be avoided everywhere. I find it unforgivable that the last Irish government guaranteed bank debt so insouciantly and that the rest of the European Union has supported this decision. For a sovereign to destroy its own credit, to save creditors of its banks, is plainly wrong. It does not make it better, but worse, that it is doing so largely to protect financial systems in other countries.
Even so, debt restructurings are no mortal threat to the euro zone. It is important to remember, that Greece, Ireland and Portugal amount to only 6 percent of euro zone GDP. Even Spain is only 11 percent. Moreover, overall euro zone public debt is only 84 percent of GDP, while its fiscal deficit is 6 percent. Both numbers are better than those of the US.
The euro zone must achieve three aims: halt the banking and fiscal panics; help countries in difficulty regain economic health; and create a regime able to prevent such crises in future. In attempting to achieve this, the euro zone has one big advantage - that convergence euphoria is over - and one big obstacle - that some members are in huge difficulties. Do the ideas now being discussed match the challenges? That question will be the focus of my column next week.