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Deeper Flaws in Euro Will Take Years to Fix

Monday, 24 October 2011 09:39 AM

Markets want European leaders to find a convincing way to ease the eurozone debt crisis by the middle of the week.

Fixes for the deeper problems that plague the monetary union, however, will remain on their to-do calendars for years to come.

The turmoil over some eurozone governments' excessive debt has exposed flaws in Europe's 13-year-old monetary union that are more complicated than Greece's admittedly disastrous decisions to spend and borrow too much during good times.

In the short run, officials must reduce Greece's crushing debt and cushion banks against the losses they would take on Greek bonds, measures they worked on over the weekend and are hoping to agree on by a second summit Wednesday. They also need to expand the financial firepower of their too-small bailout fund, so it can backstop countries such as Spain and Italy and reassure bond investors they can pay their debts.

When those steps are taken, however, the broader issues that let so much debt pile up will remain — and take years to solve.

If, that is, the 17 eurozone governments can ever come together on the answers, after struggling to find agreement on short-term patches during the 22 months since the crisis hit when Greece admitted it was broke.

The tough issues include chronic imbalances in both growth and trade between euro countries, who cannot even them out by shifting exchange rates, as non-euro countries can. Meanwhile, there are no proven, workable rules to keep countries from running up too much debt.

Most of the solutions proposed to such problems would require altering the fundamental European Union treaty, a process that could take years.

It was already known at the euro's launch in 1999 that differences in how fast economies grow presented a challenge. The euro has a single, central monetary authority, the Frankfurt-based European Central Bank, that can impose only one interest rate. A rate low enough to help a big country like Germany through a slow patch could contribute to inflation in smaller, faster-growing ones, undermining their export competitiveness.

That is exactly what happened during the mid-2000s, as the ECB held its key borrowing rate at 2 percent. The low rates boosted Germany and France, but in places like Greece and Ireland, Europe's so-called periphery, cheap credit helped enable irresponsible spending and lending booms that swelled salaries and prices.

The way countries within the eurozone trade with each other is also seriously imbalanced.

Germany is an export powerhouse, running an estimated trade surplus of 5.5 percent of economic output this year, while the troubled countries run deficits: Portugal 8.5 percent, Spain 4.5 percent, Italy 0.9 percent and Greece 4.2 percent.

The normal way countries adjust is through shifts in exchange rates. An exporter's currency appreciates, making its goods more expensive, while the importers can see their currencies fall and their industries become more competitive. That can't happen within the euro. Greece, Ireland and Portugal have to cut business costs and raise their export competitiveness through a brutal "internal devaluation," with a chief tool being pay cuts for government workers, which also undermines private sector pay.

Economist Simon Tilford at the Centre for European Reform in London said the currency bloc will not straighten out its problems "unless they do something about trade imbalances within the eurozone, which at the moment are primary causes of the very big budget deficits in places like Spain."

Trade shortfalls "are draining demand and employment out of these economies" and thus boosting government budget deficits.

Eurozone officials are working on improved economic coordination, including having eurozone leaders meet regularly. They intend to begin tracking trade and debt imbalances. But it's not clear how, in political terms, exporters such as Germany or the Netherlands can be forced to consume more and export less, which could require cutting taxes and increasing government spending and deficits.

Another way of stopping debt from building up could be a European Union budget agency or finance ministry, as proposed by retiring European Central Bank chief Jean-Claude Trichet. The ministry would be able to veto spending by national governments.

The problem then would be how to make that ministry accountable to voters, given that taxpayer money is at stake. Some fix-it proposals include commonly backed "eurobonds," with access to the money controlled by bureaucrats who would rule on whether a country's finances were under control. Their decisions could be submitted to the elected European Parliament. The idea remains controversial.

The EU has tightened existing rules against running up too much government debt, but whether they are strong enough for governments to actual face sanctions remains to be seen. Rules that limit debt and deficits to 3 percent and 60 percent of gross domestic product were flouted repeatedly, even by France and Germany, in the past.

That illustrates what Harvard University economist Alberto Alesina says is a core problem with rules: They are either too rigid or unenforceable.

If spending limits are too strict, governments cannot deficits to stimulate the economy in downturns. But if the rules are adjustable for the ups and downs of the economy, Alesina said, "people will find a way to justify the deficit even when it is not justified by the cycle."

It's more practical to put debt limits in national constitutions, he said, as Germany and Spain have done and as Italy and France have proposed. But "a rule can only help a government that is well-intentioned enough to do the right thing," said Alesina.

He is skeptical of rules above the national level. "History and theory show that it is very hard for national governments to delegate fiscal policy to the supranational level," he said.

The real solution to debt, Alesina says, is promoting growth through structural reforms such as cutting bureaucracy and red tape and eliminating excessive rules on hiring and firing — reforms that the EU has been talking about for years but is often slow to enact.

Spain has taken some such steps; but they take years to show results.

"A financial engineering solution may help in the short term," said Alesina, referring to the debate over boosting the eurozone bailout fund's ability to intervene in markets. "But without those reforms we are in trouble."

One deterrent to piling up debt may simply be the misery of the budget and wage cutting that Greece, Portugal and Ireland have been through.

"It should be," said Alesina. "If a crisis of such magnitude is not enough to teach some lessons, then we are in trouble."

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Markets want European leaders to find a convincing way to ease the eurozone debt crisis by the middle of the week.Fixes for the deeper problems that plague the monetary union, however, will remain on their to-do calendars for years to come.The turmoil over some eurozone...
Monday, 24 October 2011 09:39 AM
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