November 11, 2011 / 1:46 PM / 8 years ago

Path out of euro zone crisis spells prolonged economic pain

LONDON (Reuters) - Even if the euro zone manages to relieve the immediate financial pressures threatening it, weaker members in particular look set to keep paying a heavy economic price to tackle the imbalances at the root of the bloc’s debt crisis.

The prevailing orthodoxy in the 17-member zone, shared by the European Commission and bond market vigilantes, is that the burden of adjustment must fall squarely on countries with high external deficits, including Italy, rather than surplus states such as Germany.

That points to further belt-tightening ahead, even though Greece is already in a fourth year of recession and other countries are hovering on the brink. Spain said on Friday that growth ground to a halt in the third quarter.

The Commission, the European Union’s executive arm, said on Thursday that stagnation in the euro zone was a high probability. It forecast just 0.5 percent growth in 2012 but said it could not exclude a deep and protracted recession.

“The key for the resumption of growth and job-creation is restoring confidence in fiscal sustainability and in the financial system and speeding up reforms to enhance Europe’s growth potential,” said Olli Rehn, the commission’s vice-president for economic and monetary affairs.

Decoded, that means ever-greater efforts by highly indebted countries to reduce their budget shortfalls to levels at which investors are willing again to buy their bonds at non-punitive rates.

To many economists, not just Keynesians, tightening fiscal policy at a time of weak demand is a recipe for recession that could doom the single currency as debt inexorably increases and austerity-weary voters eventually throw in the towel.

“On current policy trends, a wave of sovereign defaults and bank failures are unavoidable. Much of the currency union faces depression and deflation,” write Simon Tilford and Philip Whyte in a new paper for the Center for European Reform think tank.

France, for instance, fearful of losing its top-notch credit rating, on Monday rushed out plans for spending cuts and tax increases worth 65 billion euros ($90 billion) over five years to keep deficit targets within reach.

“France will be in danger of being one of the countries to be picked off by the markets in the next few months,” former British Prime Minister Gordon Brown said at a banking event in Moscow on Thursday. “I fear that Europe could be mired in low growth not just for a year or two but for a decade.”


Winning agreement on structural reforms to open protected labor and product markets are vital tasks for new Greek Prime Minister Lucas Papademos, a former European Central Bank vice-president, and Mario Monti, a fellow technocrat who is favorite to replace Silvio Berlusconi as Italy’s prime minister.

But much-need change to pension regimes takes years to bear fruit.

What is needed, Tilford and Whyte argue, is easier policy by the ECB, including a higher inflation target of 3 percent that would enable deficit countries to regain competitiveness by holding down wage growth without slumping into deflation.

Critically, the burden of adjusting current account imbalances must also be shared more evenly. If every country saves more, as is the present prescription, demand across the euro zone will drop further, hitting already weak public finances. Coordination of tax-and-spending policies is thus imperative.

“A new fiscal regime needs to be accompanied by a symmetric imbalances procedure. Countries with imbalances will have to demonstrate how they intend to close them, with the onus being as much on those running trade surpluses as those with deficits,” Tilford and Whyte conclude.

This is anathema to Germany and other surplus northern euro zone members who blame the single currency’s ills on the profligacy and budgetary indiscipline of their southern neighbors.

George Magnus, senior economic adviser at UBS in London, agreed that creditors need to act too, a point U.S. policymakers have made to their German counterparts at recent international summits without getting far.

Not all countries should save more simultaneously. If the burden of adjustment falls wholly on debtor nations, global output and employment will again weaken or contract, intensifying social and financial instability, he said.


Ominously, the track record down the decades of reconciling the policy interests of debtors and creditors is poor.

“This is, after all, the same imbalances problem that brought down the gold standard in the 1930s, and the Bretton Woods system four decades later,” Magnus wrote in a report.

“In the first instance, a newly powerful U.S. creditor and ‘old Europe’ debtors were unable to agree how to resolve their imbalances. In the second, the roles were, in effect, reversed,” he said.

Globally, today’s economic imbalances can be unwound only if the United States and China, as the biggest debtor and creditor nations respectively, are prepared to coordinate domestic policy changes that rebalance savings and investment behavior, Magnus argued.

Within the euro zone, a growth and competitiveness agenda, involving both EU structural funds and creditor governments, has to be part of the bloc’s internal rebalancing.

In that context, Magnus said, plans by Chancellor Angela Merkel’s Christian Democrats for a binding minimum wage in Germany might help underpin consumption at the margin — even if she is not motivated by the need to address the bloc’s imbalances.

Additional reporting by Doug Busvine, editing by Mike Peacock

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