The Euro in a Shrinking Zone

The recent European Union summit was a disaster. Both Britain and Germany played the wrong game: British Prime Minister David Cameron isolated Britain from Europe, while German Chancellor Angela Merkel isolated the eurozone from reality.

Had Cameron brought an economic-growth agenda to the summit, he would have been fighting for something real, and would not have lacked allies. As it was, he fully accepted Merkel’s austerity agenda – which his own government is implementing independently – and chose to veto proposals for a new European treaty to protect the City of London. This cheered up the Euroskeptics in Cameron’s Conservative Party, but it offered nothing to counter the lethal medicine prescribed by Germany’s Iron Lady.

The agreement reached in Brussels forecloses any possibility of Keynesian demand management to fight recession. “Structural” budget deficits would be limited to 0.5% of GDP, with (as yet undisclosed) penalties for violators.

This is the wrong cure for the eurozone crisis. The Merkel doctrine holds that the crisis is the result of government profligacy, so only a “hard” balanced-budget rule can prevent such crises from recurring.

But Merkel’s analysis is utterly wrong. It was not deficit spending by governments that fueled the economic collapse of 2007-2008, but excessive lending by banks. Government’s mounting debts have been a response to the economic downturn, not its cause. What ought to have been hard-wired into the EU’s institutional structure was not permanent fiscal austerity, but tough financial regulation. Of this there is little sign.

More immediately important is the failure of the proposed “fiscal union” to do anything for European recovery. The figures are grim: before the summit, the European Central Bank slashed its eurozone GDP growth forecast for 2012 from 1.3% to 0.3%. That is almost certainly optimistic. In fact, the eurozone will contract in the first half of next year – and probably in the second half, because of the deficit-cutting policies now being pursued – placing further pressure on banks and sovereigns.

The reason why recovery from the crash of 2007-2008 has been so anemic is straightforward. When an economy shrinks, government debt grows automatically, because its revenues decline and its expenses rise. When it cuts spending, its debt grows even more, because its cuts cause the economy to shrink further. This makes the government more, not less, likely to default.

In the eurozone, most government debt is held by private banks. As this debt increases, the value of banks’ assets falls. So the crisis of the sovereigns engulfs the banks. To put weakened governments on iron rations, as Merkel did, was to make a financial crisis inevitable. To continue to preach salvation through austerity as the economy declines and banks collapse is to repeat the classic mistake of German Chancellor Heinrich Brüning in 1930-1932.

To be sure, the eurozone needs more than a bailout. The periphery needs to recover competitiveness, and some have taken heart from the Mediterranean countries’ shrinking trade deficits – the structural trade imbalances within the eurozone are correcting themselves, they say. Unfortunately, these corrections are not based on increased exports, but on declining imports, owing to depressed levels of economic activity.

The idea that a country can achieve a trade surplus by importing nothing is as fanciful as the idea that a government can repay its debt by starving itself of revenue. One person’s spending is another person’s income. In insisting that its main trade partners cut their spending, Merkel is cutting Germany off from the main sources of its own growth.

So, will the single currency survive? Two policies that might, in combination, save it are off the agenda. The first is quantitative easing (printing money) on a heroic scale. The ECB should be empowered to buy any amount of Greek, Italian, Spanish, and Portuguese government bonds needed to drive down their yield to near the German rate. This might stimulate real growth through several channels: by reducing lending rates, by raising the nominal value of public and private assets, and by weakening the euro against the dollar and other currencies. But the effects of quantitative easing on economic activity are uncertain, and such an inflationary policy might well invite retaliation from Europe’s trading partners.

That is why quantitative easing should be run in conjunction with a eurozone-wide investment program designed to modernize the creaking infrastructure of eastern and southern Europe. Capital spending by governments, unlike current spending, can be self-financing through user charges. But, even if it is not, well-chosen public investment produces high returns: new roads reduce transportation costs, and new hospitals produce a healthier workforce.

An institution, the European Investment Bank (EIB), already exists to carry out such a program. It should be recapitalized on a sufficient scale to offset the contractionary effects of Europe’s national deficit-reduction programs.

Quantitative easing, combined with public investment, would impart the growth impetus that the eurozone sorely needs to bring about a gradual reduction in its aggregate debt burden. But it is almost certain that neither policy, much less both, will be implemented.

The ECB is stealthily buying government bonds on the secondary market, but its new governor, Mario Draghi, insists that such intervention is temporary, limited, and intended solely to “restore the functioning of monetary transmission channels.” No one at the recent EU summit suggested making the EIB an engine of growth. So the bleeding will go on.

This means that the eurozone is beyond saving; the euro will survive, but the zone will shrink. The only question is the scale, timing, and manner of its breakup. Greece, and probably other Mediterranean countries, will default and regain the freedom to print money and devalue their exchange rates.

This will send shock waves throughout the world. But sometimes shock waves are needed to break the ice and start the water flowing again.