We may be living through the making of another eurozone crisis. As with all crises, there are two central elements: the history and the tragedy itself.
The history is clear. The eurozone was an ill-conceived project from the start: for a motley group of countries, one monetary policy was a case of one-size-fits none. In particular, Italy needed the crutch of continuous currency devaluation, which became impossible once it gave up the lira. Italy is now stuck with ultra-low growth and the smallest of shocks can push it into recession.
The eurozone’s tragedy arises not just from the hubris of an enterprise that many warned would go badly wrong. It arises also from the mindset that came with the project.Early on, it became clear that member countries would not establish a fiscal union to transfer funds to countries in recession, to compensate them for the lack of their own currency and independent monetary policy. As I describe in my book EuroTragedy: A Drama in Nine Acts, a fiscal union was politically impossible: countries protected their core national sovereignty and refused to give up their tax revenues. In April 1998, chancellor Helmut Kohl stated bluntly that Germany would never pay the bills of other countries. If he had not made that commitment, there would have been no euro.
Given the impossibility of a fiscal union, the right response would have been to abandon the idea of a monetary union. Instead, at Maastricht in 1991, under German insistence, European authorities created fiscal rules—at whose core lay a 3 per cent of GDP limit on the budget deficit—as the basis for moving forward. National frugality, the accompanying narrative said, would ensure a “stable” eurozone.Economists immediately warned that the rules were deeply harmful. They enforce austerity precisely when a country is about to enter recession, making the recession worse, possibly much worse. Former European Commission president Romano Prodi famously said the fiscal rules were “stupid.”
Yet, lemming-like, European authorities insisted on them. The rules became a part of EU identity. Leaders believe that they are not “good” Europeans if they do not pay homage to them. They formed a deeply flawed monetary union and, for them, the rules and the narrative of “stability” justify that decision and underpin their claim that the eurozone will survive. Identification with such damaging principles has profound macroeconomic consequences, as Nobel laureate George Akerlof has emphasised.
In 2010, with the Greek economy falling into recession, European governments and the IMF demanded that the government rapidly raise taxes and cut expenditure as the price for receiving loans to pay off panicky private creditors. Olivier Blanchard, then the IMF’s chief economist, rang the alarm bells. The proposed austerity was virtually unprecedented, he wrote in an internal memo, and would debilitate the Greek economy. But the European viewpoint—adopted also by the IMF’s management—would not allow otherwise. As Blanchard had previewed, the Greek economy nose-dived, tax revenues fell and, perversely, the austerity caused the government’s budget deficit to widen. In what became a dystopian cycle, the official creditors demanded more austerity, which sent Greece hurtling into one of the worst economic depressions in living memory.
Thrift, wrongly timed, spawned distress and instability.
Disregarding that evidence, the pattern of austerity-induced recession continued with other eurozone economies through the years 2011-2013, creating prolonged economic distress, which raised political anxieties and caused bitter divisions between the creditor and debtor countries of the eurozone.
But the rules became even more encrusted into the European identity. In January 2012, amid a seemingly unending Italian recession, Italian prime minister Mario Monti said that Germany had won Europe’s economic debate. Berlin’s “precious” vision, Monti genuflected, had been “marvellously exported.” He advised high-debt countries to “concretely” demonstrate “the imperatives of discipline.” In June 2014, Chancellor Angela Merkel said that the rules were “guard rails” that offered protection.
Fast forward to today. The philosophy remains intact.
In May this year, Italians elected anti-establishment, protest parties. The right wing, anti-immigration League and the left leaning, eurosceptic Five Star Movement formed a government. World trade was decelerating and the Italian economy, with its fortunes tied closely to global trade, was slowing in tandem. The League-Five Star government announced a politically resonant but unrealistically ambitious agenda of tax cuts and the roll out of a universal income.
“A recession would make Italy’s already high debt burden harder to repay”A clash was imminent. European authorities were primed to protect their economic philosophy, which they stubbornly hold on to even though, instead of protecting, it has repeatedly exposed Europe to new wounds. Hence, as European officials insisted on adherence to rules, Italy’s leaders made electoral promises they cannot keep.
While the Italian government needs to rein in its fiscal largesse, European authorities need to recognise that a well-designed stimulus is necessary to prevent Italy from falling into recession. A recession would make the government’s already high debt burden harder to repay, which would drive up interest rates and deepen the crisis—heaping potentially unbearable stress on the country’s fragile banks. Instead of seeing reason, the two sides have talked past each other.
The Commission has insisted that the high debt and large deficit, which the new government inherited, requires fiscal tightening. Support for this position comes from two different sources. One group argues that Italy’s real problem is chronically low productivity growth and that a fiscal stimulus will do nothing to raise productivity. Which is true, but beside the point. Fiscal policy does not raise long-term growth, but it prevents an economy from falling into a long-drawn and politically polarising downturn, a worrisome risk for a country with chronic low productivity.
A second argument is that since the Italian government has a high debt burden, fiscal spending to stimulate the economy will “scare” investors, who will demand higher interest rates and, hence, negate the beneficial influence of the stimulus. This argument is influential because it comes from Blanchard, now at the Peterson Institute of International Economics.
Blanchard, while at the IMF, consistently took a pro-stimulus position. He led the intellectual case against over-the-top austerity. In a deservedly famous paper coauthored with another IMF staffer Daniel Leigh, Blanchard highlighted that austerity is particularly debilitating when inflicted on a country in recession, a finding widely echoed in the economics literature.
In follow-up research, Leigh and his IMF colleagues debunked another myth: that countries with high levels of debt need to undertake austerity or else alarmed investors will demand higher interest rates, which could increase the debt burden dangerously. That paper, published in a top-tier refereed journal, reports that even for countries with high levels of debt, fiscal austerity is a bad idea.
Hence, fiscal stimulus can help even high-debt countries facing a looming recession. However, an army of commentators, including the influential editorial board of the Financial Times, is invoking Blanchard’s recent Italian commentary to defend the Commission’s insistence on austerity.
The Commission itself, meanwhile, continues to invoke the sanctity of the rules. In language reminiscent of Merkel’s “guard rails,” European Economic and Monetary Affairs Commissioner Pierre Moscovici tweeted, “Because the eurozone is like a condominium: it is the task of the administrator to enforce the common rules so that no one touches a supporting wall!”
Through much of the global financial and eurozone crises, the European Central Bank (ECB) made matters worse with its tight monetary policy. At first, the ECB’s excessively high interest rates aggravated recessionary conditions. Then, restrained by Germany and other northern eurozone member states, the ECB delayed the introduction of bond purchases (quantitative easing) to bring down long-term interest rates. With monetary policy doing so little, starting in early 2013, the underlying (core) inflation rate in the eurozone fell to about 1 per cent. The German rate has been somewhat higher than 1 per cent and the Italian rate has been lower.
“The unifying force around which eurozone leaders rally is frugality”Low inflation causes consumers to delay purchases, which curtails growth and raises debt repayment burdens. Yet, despite the risk of prolonged low inflation, the ECB declared victory in September this year and decided to phase out its bond purchase programme.
This tendency to limit the use of monetary stimulus is as much a part of the eurozone’s philosophy as the emphasis on fiscal austerity.
The risk now is that if Italy falls into a recession, its inflation rate will go down further, which would raise its real (inflation-adjusted) interest rate. Already the real interest rate is over 2.5 per cent, which is extraordinarily high for an economy on the threshold of a recession. The combined interest rate and fiscal austerity squeeze could prove unbearable for Italy’s economy and its wobbly banks.
Thus, Italy faces the specter of a weak economy that worsens the government’s finances and raises the likelihood of borrowers defaulting on their bank loans. Italy could easily spiral into an unmanageable financial crisis.
If such a fate does befall the country, the narrative will be that the Italian government was unreasonable, that its outlandish fiscal plans triggered the crisis. True, the Italian government’s plans are unreasonable—there is no way that the government can achieve its fiscal objectives. Equally, however, the Commission’s insistence on fiscal contraction could result in a fearsome crisis. Given the risks, the Commission’s reckless manner means that it has little moral authority to accuse the Italians of intransigence.
The eurozone is trapped in an identity crisis. Long-held claims that the euro catalyses trade within the eurozone have been discredited (here and here), leaving no tangible benefits to celebrate. In contrast, the risks of a one-size monetary policy that fits none are evident enough. The ECB’s tendency towards tight monetary policy makes matters worse, especially for the weaker countries.
With no real benefits and all-too-real risks, the unifying force around which eurozone leaders and intellectuals rally is the virtues of temperance and frugality. The contorted arguments to justify austerity arise from the self-image of European leaders. Yet, this approach, cloaked in the aura of prudence, magnifies the dangers Europe faces.
The tug of war between the Italian authorities and the Commission severely limits the ECB’s ability to contain the crisis. To access ECB support, Italy would be required to agree to a regimen of austerity and reforms that could prove domestically explosive. But without agreement on such a regimen, the ECB will be unable to trigger its Outright Monetary Transactions authority to purchase Italian government bonds, and thus contain the rise in the interest rate demanded from the Italian government by investors. Even if the Italian government complied with the demands, some members of the ECB’s Governing Council may hold the bank back from purchasing the bonds, fearing that an Italian default on those bonds would cause them to bear the losses.
There will be no winners from this game of chicken. Well before reaching the point of no return, a constructive agreement—backed by a cooperative public narrative—is required: an appropriately sized and well-spent stimulus is in everyone’s interest. Unfortunately, there remains an unwillingness to pay the bills of others—a frugality which clashes with reality. It seems that we are stuck on a tragically antagonistic course.
