As European austerity ends, so could the euro

The euro currency is a malady that condemns at least a generation of Greeks, Italians, Spaniards, Portuguese and Irish to the economic infirmary.

In these nations, unemployment rates are now at their highest levels in recent decades, and there are few prospects for recovery in sight. The economists and politicians who created the system still proclaim it can survive. Their time would be better spent recognising they made a bad mistake and preparing for an orderly dismantling of the euro before the damage spreads and further undermines European unity.

The problem isn't just the region's lack of competitiveness or its budget deficits or the high stock of existing government debt, which the International Monetary Fund now puts at 90 per cent of the euro area's gross domestic product. It is all of the above, compounded by five years of complete political denial.

For three years, capital has been fleeing Europe's periphery for Germany. That country's liquid banks, competitive labour markets and sound fiscal policies have made it the ideal location in Europe for investment. The periphery's illiquid banks are sharply contracting credit to the productive sector, as their governments are cutting back and political protests are mounting. Wages are too slow to adjust to dent these powerful forces: Germany looks ever more attractive for investors, further exacerbating the imbalances that brought us to this point.

Fiscal union

Is there any hope for the euro dream?

One potential way forward would be to create a European-level fiscal union that assumes all national debt, much like what Alexander Hamilton did as first US secretary of the Treasury. That isn't going to happen in modern Europe. Why would German taxpayers and savers agree to pay for the good times previously enjoyed in Greece, Italy or Spain? Who could even ask them to do so?

As a result, all eyes are turning to the European Central Bank, because some in the euro policy elite still hope loose monetary policy and higher inflation rates will provide an escape hatch. But addressing fiscal issues through monetary means generally doesn't work, and it does nothing to improve the competitiveness of the struggling euro-area periphery.

It appears that the euro-area politicians and the ECB agreed to a pact last year whereby banks bought government debt, and the central bank provided the financing. In return, the ECB got national governments to sign on to fiscal austerity. So far, the results are disturbing.

Employment levels and leading indicators in Spain and Italy imply the economic decline has accelerated. Greece continues to fall. Ireland is held up as a success story, but its debt levels are enormous, a great deal of fiscal adjustment remains to be done, and the domestic economy declined over the past six months. Voters are already tired of what they perceive as austerity — see Greece, Spain and now France — and the policy debate has begun to shift. The changed tone of the discussion is gradual but it would be a mistake to overlook this development: Austerity programmes have been huge social and political failures, removing one more hope for saving the euro area.

The ECB surely has more "firepower" to deploy. And it probably will, not least because the institution itself could disappear if the euro area fails. Its natural reaction will be to double or quadruple its bets, issuing potentially limitless credits to banks to keep sovereign-debt markets afloat (and bond yields down).

Allowing inflation

The ECB will also lobby for austerity, which would reduce the amount of credit it needs to create. But democratically chosen governments will simply refuse to comply. The central bank will jettison its inflation-fighting credentials, and instead pray that the monetary issuance needed to keep troubled nations afloat isn't too large and that inflation expectations don't start to increase.

But here's the problem: Pursuing such a monetary policy is a recipe for a dangerous loss of confidence in the euro system.

— Bloomberg

 Peter Boone is a non-resident senior fellow at the Peterson Institute for International Economics, a visiting senior fellow at the London School of Economics and an adviser at Salute Capital Management. Simon Johnson is a professor at the MIT Sloan School of Management as well as a senior fellow at the Peterson Institute for International Economics. Opinions expressed are their own.