The eurozone’s fault lines

Opinion piece (The New York Times)
14 July 2015

LONDON — The euro was supposed to boost European economic growth and living standards, strengthen public finances and hence the sustainability of welfare states. Politically, it was supposed to bring the European Union’s member states together, and prevent a newly united Germany from becoming too dominant. But the opposite has happened.

The hoped-for convergence in living standards between richer and poorer members of the eurozone has failed to materialize. Far from the single currency nurturing a European polity, relations between northern and southern countries have never been more fraught. And the crisis has put the burden on a German leadership that is poorly equipped to exercise it.

The eurozone’s failure to address the Greek crisis in a calm and fair manner has laid bare these fault lines. The ultimatum issued to the Greeks over the weekend by the rest of the eurozone — acquiesce to all our demands or we will evict you from the currency union — has cast a shadow over the future of the single currency.

Greece is undergoing profound economic and social dislocation, after already having suffered an unprecedented collapse of economic activity, and this should be a wake-up call for Europe’s paralyzed politics. Instead, unelected eurozone officials have taken sides in the standoff, warning of catastrophe if the Greeks refuse to accede to the creditors’ demands. The European Central Bank aided a run on Greek banks by refusing to supply enough liquidity, in the process violating its legal mandate to uphold financial stability across the currency union. Now, the central bank may only restore liquidity in a piecemeal manner as Greece complies with each step of the agreement with its creditors.

Following the deal on Monday, Greece faces a herculean task: Meet a very short deadline to pass a raft of reforms through Parliament, agree to yet more austerity and cede control over privatization of state assets to the eurozone in return for another bailout. The alternative is to quit the currency union, with all the attendant risks.

Greece is a vexing partner, but the factors that drove the country to this point are in evidence across much of the eurozone to a lesser or greater extent. Rather than fostering economic convergence, the euro is driving its members apart. Despite a common eurozone interest rate, borrowing costs vary widely across the currency union because of differing rates of inflation. So-called real interest rates are higher in economically weak member states like Greece, where inflation is negative, and much lower in economically strong countries such as Germany, where inflation is positive.

As a result, capital and skilled labor concentrate in the richer regions. But whereas in the United States, Britain or Germany the negative impact is cushioned by fiscal transfers between the participating states or regions (through, for example, federal unemployment benefits and tax systems), there are no such mechanisms in the eurozone.

What’s more, the eurozone’s fiscal rules leave governments too little scope to boost public spending to ameliorate economic downturns. This heightens the risk of a deep recession, which together with the resulting fall in inflation, can push up the burden of public debt, something which has happened not only in Greece, but also in countries like Spain and Italy. Rising debt in turn can undermine confidence in the country’s banks, which are backstopped by national governments rather than by the currency union collectively.

The eurozone needs a raft of reforms if the single currency is to act as a mechanism for economic convergence: The European Central Bank must work much harder to prevent inflation falling too low and pushing up real interest rates in struggling member states; individual governments have to be free to provide fiscal stimulus; the currency union needs an integrated financial system, so that losses incurred in a downturn in one economy are shared across the currency union; and banks need to be back-stopped by the eurozone as a whole rather than individual governments in order to prevent a country’s enfeebled banks undermining confidence in their government’s finances.

The eurozone needs to embrace these changes whether or not Greece remains in the currency union in the end. But change will be especially urgent if Greece ends up being forced out. The European Central Bank might be able to contain the immediate financial impact of a Greek exit on economies such as Spain and Italy. But the fallout from a country leaving the currency union is hard to predict because there is no precedent. And even if the immediate contagion can be controlled, a Greek exit will have demonstrated that membership is reversible, and that the eurozone is little more than an exchange rate mechanism. This could have profound implications for the currency union come the next economic downturn.

The eurozone economy is growing, but it is a modest cyclical upturn after years of stagnation. It is all but certain to go into the next downturn with interest rates close to zero, levels of public and private sector debt very high, and joblessness still above pre-crisis levels. Crucially, there will be little scope for fiscal policy to counter the weakness of private sector demand, especially in the countries most in need of it. Responsibility for backstopping banks will still lie largely at the national rather than federal level.

And if there is a Greek exit, investors will be fully aware that a sovereign default could lead to a banking sector collapse. Many eurozone economies could face deep recessions despite having barely returned to their pre-crisis size. The course of Greek politics could easily be repeated elsewhere, with anti-austerity and anti-establishment parties coming to power.

The eurozone is likely to remain in a political no man’s land, with member-states having lost control of policy without a corresponding growth of democratic accountability at the eurozone level. The most benign outcome is that the euro stumbles along, undermining Europe’s growth and eroding popular faith in the European project. More likely, the blowup in Greece will be the first of a series of political crises. And next time it won’t be possible to dismiss the country as a “special case.”

Simon Tilford is deputy director of the Centre for European Reform in London.