The root of Europe’s crisis

By webadmin on 11:33 pm Dec 02, 2011
Category Archive

Wijayanto

George Papandreou lost his job recently. Jose Socrates resigned from his position. Silvio Berlusconi has stepped down. And the three leaders are not alone. Even though less dramatic than the story in Greece, Portugal and Italy, leaders in various countries have lost or will lose power at general elections.

The latest developments in the political arena have made the situation in the European Union (EU) even more challenging. Politics has become very dynamic: Just as in the Arab world, an EU Spring is happening.
It is debatable which came first, economic turbulence or political crisis, but it is clear that politics and economies are inseparable, like two sides of a coin.

Finding a comprehensive solution is very critical for the EU and, for this to happen, leaders have to be able to understand the root of the problem.  If not, then all the solutions will only be temporary in nature and the EU economy will be dragged further toward a slippery slope.

Imported crisis from the US?

Over the last decades, the cross-Atlantic link has become very strong both in trade as well as investment. A large portion of the US collateralized debt obligations (CDO), the derivatives of mortgage-backed securities (MBS), was in the hand of European investors. Interestingly, there are some interesting facts in regard to the investors in these “poisonous assets” – the new post-crisis name for MBS-CDOs.

European investors held a large portion of the low-quality CDOs, while US investors only held a small portion. With high-quality CDOs, the situation was different, with US investors more dominant. A deep study needs to be done on this interesting issue to ascertain how this could happen. As a consequence, however, when the sub-prime mortgage crisis erupted in the US, the EU felt the impact almost instantly.

Even before 2008, most EU countries had relatively high public debt and trade deficits as well as budget deficits. Public debt has risen gradually since the 1980s, and recently reached an unprecedented level for post-World War II Europe.

This was a sign that the problem began in the EU, and especially in countries in the eurozone. The US sub-prime mortgage fiasco triggered the crisis in the EU but it is not too risky to conclude that even without the crisis in the US, the European economic crisis would stilll have been very likely to happen at a later occasion.

Beyond sovereign debt

The crisis has pushed countries in the eurozone to ask for external support in order to avoid default on their sovereign debt. Unfortunately, liquidity and solvency as portrayed in the sovereign debt crisis are only symptoms, not causes. The root cause of the problem is the lack of competitiveness of many EU economies, especially those in the eurozone.

A friend of mine visited Greece some time ago and found it to be a very expensive country. “For the same quality of hotel, food and services, in Turkey it was almost half price” he said. Greece, where 20% of the economy and employment rely on the tourism industry, has failed to maintain its competitivess. Something similar has happened in a variety of industries in Portugal, Spain, Italy and Ireland.

The lack of economic competitiveness has created continuous trade deficits, en route to budget deficits. The European welfare system requires governments to budget for large expenditures on health, education, public facilities and the like to ensure that the public has access to these services at affordable cost. As a consequence, tax rates in most EU countries are among the highest in the world.

From the budgetary point of view, the nature of government expenses is inelastic while the nature of its revenue is elastic. During economic crises, despite the decrease in government tax revenue, it is politically incorrect to reduce benefits. Austerity measures in Greece have been very successful at pushing Papandreou out of his job, but rather ineffective in reducing spending.

Euro makes the situation tougher

In the past the issue of competitiveness could be addressed by devaluing currencies. If Greece were to devalue its currency, then its industry would gain competitiveness, even though Greece would have lower purchasing power globally.

Its shipping industry would not lose market share against Chinese and South Korean producers; its tourism industry would not lose business to Turkey and other neighbouring countries. Similar policies would be helpful for other ailing economies.

Unfortunately, under the current system the central banks in each country have no authority over monetary policy, including determining the currency rate, money supply and interest rate base. Their role is more one of monitoring and regulating the domestic banking industry. With the euro as the single currency, monetary policy is managed by the European Central Bank (ECB) with a one-size-fits-all approach.

Without addressing the root of the problem – economic competitiveness – there is no guarantee that a debt bail-out will improve the situation. A bail-out will save the country in the short term but will burden it with more expenditure to serve debt. Sustainability would remain in question.

No easy solution

Some economists suggest that the eurozone should push integration among its members further, shifting towards a United States of Europe. In contrast, others  suggest to reduce the level of integration by ending the role of the euro as a single currency and return to the DM, lira, franc and so on.
These suggestions are great, but probably not realistic due to ideological issues as well as the current economic situation. The transistion process could take decades and would be detrimental, especially for the ailing economies which need a quick solution.

Eliminating the euro is not good news for the world, since we need an alternative currency, in addition to the US dollar, as a global currency. The appropriate solution is to continue the current recovery plan and to combine it with effort to reduce the competitiveness disparity among eurozone members through a fiscal policy approach.

Existing infrastructure is far from adequate. In addition to the ECB, the eurozone needs to establish a new office to manage some aspects of fiscal policy across eurozone members, such as cross-country investment stimulus and taxation. This could be a stepping stone before transforming the EU into the United States of Europe.

It is difficult but possible for the EU to recover and leave the ICU. In the past Europe played a role as an important global economic engine and a center of inovation and culture. It is only a healthy EU that can continue this role in the future.
 
Wijayanto is the deputy rector of Paramadina University and is the co-founder and managing director of Paramadina Public Policy Institute. He can be reached at wijayanto@paramadina.ac.id