Morici: German Chancellor Angela Merkel Reforms Will Worsen Euro Crisis

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German Chancellor Angela Merkel

European leaders are working feverously to create what German Chancellor Merkel is calling a “fiscal union” to restore private investor confidence in Europe and rekindle growth.

Unfortunately, what she advocates will thrust Europe into a deeper economic crisis, and leave European leaders without the fiscal and monetary policy tools necessary to combat recessions.

The reforms Chancellor Merkel is pushing—hard caps on national government deficits--will ensure either the ultimate demise of the euro, years of economic stagnation or worse. For many governments, those caps will be one half or even one quarter of recent annual deficits, and to comply they will dramatically raise taxes, cut spending and curtail pensions and other social benefits.

Already, the Mediterranean economies are contracting rapidly, and Germany and other more prosperous states are near zero growth. Harsh austerity in France, Italy, and elsewhere will be “negative stimulus” and thrust most if not the entire continent into a deep and prolonged recession .

Rising unemployment will feed on itself, national tax bases will shrink, and sovereign debtwill become less manageable. Private investors, though perhaps initially comforted after Merkel’s reforms are adopted, again will become skeptical that Italy and the others will pay their debts and flee government bonds.

European governments will be impotent to address the recession, because Merkel’s enforceable caps on national budget deficits will not create a “fiscal union.” The euro zone as a whole and the larger European Union will continue to lack the fiscal and monetary policy tools U.S. and Japanese governments have to manage recessions.

The U.S. federal government has broad taxing, spending and borrowing authority, and jointly with the states, finances social security and pensions, health care and other essential public services. Although the 50 states face significant limits on how much they can borrow during a recession, Washington can increase its deficit to further assist states, and it cuts taxes and spends more directly on new projects to stimulate the private sector.

The Great Recession would have been longer and deeper without those fiscal powers— powers the European Union now lacks and still lack after Merkel’s reforms.

Until now, responsibilities for combating recessions in Europe fell entirely on the individual member governments. With Merkel’s reforms, those governments won’t be able to increase deficits to stem unemployment, and Brussels still won’t be able to do it for them, as Washington does for the 50 states.

The European Central Bank could push down short term interest rates but as we have learned, yet again in the United States, that primary instrument of monetary policy is not much help for stemming recessions. Moreover, because the European Union lacks taxing powers and does not issue euro denominated bonds, the ECB, for example, can’t buy long-term debt on a scale similar to the Federal Reserve to engage in quantitative easing. Simply, the ECB has fewer tools than the Fed.

German leaders advocate Italy and other troubled countries adopt German labor market and fiscal reforms and thereby foster growth. That’s puzzling.

Germany’s whole economic strategy is substantially premised on amassing trade surpluses—its federal and Lander governments pursue vigorous industrial policies to boost exports and impose significant institutional constraints on outsourcing. As one country’s trade surplus must be another country’s trade deficit, not all European states can simultaneously accomplish Germany’s mercantilistic alchemy and growth.

Moreover, to pay their foreign debts and restore investor confidence, Mediterranean states must earn euro by exporting more than importing, and they must accomplish budget surpluses. However, such a feat would require Germany and other northern countries to endure trade and budget deficits—Germany and others are not likely to embrace that easily or quickly.

To make the euro work, austerity and hard budget caps must be complemented by EU-wide genuine disciplines on beggar-thy-neighbor industrial policies, and substantial EU taxing authority and responsibilities to finance, with member governments, health care, benefits for seniors, infrastructure, and other private public services—for example, an EU-wide value-added tax—matched by comparable reductions in national levies—to finance a Eurozone-wide social safety net and other spending.

That’s what fiscal union looks like—and the hard caps on deficits Merkel is pushing are not that. And that is what is required for the EU to have the fiscal and monetary policy tools to manage a continental economy.

Short of such genuine fiscal union, a workable single currency is more than Europeans can expect.

Peter Morici is a professor at the Smith School of Business, University of Maryland, and former Chief Economist at the U.S. International Trade Commission.