Governments may soon fall in France and Holland, and are quickly losing legitimacy elsewhere in Europe, because the EU-wide austerity programs and a common currency risk throwing the continent into an endless recession.
Europe’s infamous labor laws, which make layoffs expensive and businesses reluctant to invest, have long impeded investment and productivity growth.
During the expansion of the 2000s, the competitive core—Germany, other northern economies and important parts of France—coped better and accomplished stronger productivity. Consequently, the euro became undervalued for those economies and overvalued for Mediterranean economies—specifically, goods made in the north became bargain priced and those made in Club Med states too expensive.
Southern economies suffered large trade deficits with the north and insufficient demand for what they make. Governments in Italy, Greece and Portugal borrowed feverishly to keep folks employed, finance early retirements, and provide inexpensive health care.
Even as northern Europe and the United States recovered, the sovereign debt carried by Italy, Greece and Portugal's governments alarmed investors and interest rates soared. Each was forced to accept bailouts from more solvent European governments, led by Germany, on the condition they accept draconian austerity and pledge allegiance to the common currency.
Certainly, Mediterranean states must trim government spending and reform labor markets, but to pay back what they owe, they must earn euro by growing their economies and exporting more than they import. Together, those require more gradual reductions in government spending and abandoning the euro; or their economies will endure years of high unemployment to push down wages and prices and make their economies competitive with the north.
In the end, all this will not be enough and endless recession will result, as new investments dry up and existing capital—both machines and workers’ skills—atrophy or leave. The collapse of the south is now threatening the vitality of the north, as Germany, Holland and others may fall into recession without customers further south for what they make.
Excessive government spending did not undo all the troubled economies of Europe. Spain, the next government likely to need a bailout, ran persistent budget surpluses until the financial crisis. However, it enjoyed real estate and property booms, as wealthier northern Europeans sought vacations and second homes in its sunny climate.
Ireland and Iceland, the first European countries to collapse, were undermined by banks that helped finance Europe’s wider real estate bubble by selling bonds and taking deposits from foreigners. When the financial crisis came in 2008, their central banks could not print money in the manner of the U.S. Federal Reserve to shore up bank balance sheets. Instead, their governments were forced to sell bonds to raise euro to bail out banks, and borrowing requirements were too large relative to the size of their economies. Investors fled and their national finances collapsed.
The 2011 Fiscal Stability Pact, which requires all EU governments to push down deficits to 3 percent of GDP before the continent as a whole has recovered from the Great Recession, makes the problems of accomplishing recovery in Italy, Greece, Ireland and other troubled economies impossible—they have fewer customers for their exports, high unemployment and hence, can’t earn the euro and grow their tax bases to pay off their debts.
Exacerbating matters, the big European banks are burdened with huge amounts of private debt that will never be repaid. Since December, the European Central Bank has been aggressively lending to them, but with bank regulation remaining the province of national governments, it lacks the clout to force reforms the Federal Reserve enjoys when doling out aid.
Hence, the European banks, rather than raising enough new capital and writing off failing loans, are employing questionable bookkeeping—reminiscent of practices employed by U.S. banks before their collapse—and are using ECB funds to paper over dodgy loans.
To get Europe back on its feet, the Germans and broader EU must first dial back a bit on deficit reduction while continuing labor market reforms. However, they will never get out of their long-term quagmire without abandoning the euro in favor of national currencies.
This would permit exchange rate adjustments that would better align prices in weaker economies with those in Europe’s strong core, and permit exports and debt repayment by troubled economies. Also, the central banks of individual European countries, armed with their own currencies, would be able to tie aid to banks with genuine reforms—increasing capital and restoring credible lending practices.
Peter Morici is a professor at the Smith School of Business, University of Maryland, and a widely published columnist. Follow him on Twitter@pmorici1.