Sinking Ship Jayati Ghosh

Talk about re-arranging deck chairs on the Titanic. The economic news from Europe is alarming, no doubt, but it is also ludicrous. At a time of the most severe economic and financial crisis that has affected the region since the early 1930s, politicians from the major countries involved rush around to meeting where they agree, once again, to disagree, and to put forward more of the same policies that are manifestly failing.

There is now almost no doubt that the collapse is imminent, of the economic and monetary union that took over half a century to evolve. At least, the eurozone as it now exists is not likely to exist in future. The more likely scenario is that it will have to lose one or more members, and fairly soon at that. This will not be an easy process, of course, and the associated pressures on banks in the core countries will necessarily create all kinds of other problems, especially as the design of the monetary union contained no exit clause and there are no legal and institutional formulae for this eventuality. But unless drastic and ambitious action is taken to avert it, this is what will happen.

The alternative scenario to this involves a major restructuring of the very basis of the monetary union, to create even deeper integration. The countries within the eurozone will have to work towards some sort of fiscal union that also prevents large imbalances from building up between its constituent parts. To avoid breaking up, the eurozone will have to reconstruct itself to become a real fiscal union in which transfers from surplus to deficit regions will be almost taken for granted. In particular at present, Germany will have to agree to a significant increase in its own external liabilities to deficit countries in the eurozone. And a genuine single market would have to be created, in which not just commodities but also labour move freely across borders within the zone, so that national price differences cannot persist as they have done.

This is unlikely to happen, because the political will to do this is currently missing, to the point where it is almost unthinkable at the moment. In any case, to build up such a consensus will take more time than the region has. Even if such a process can be gone through, it simply cannot occur with the speed required, because the eurozone is not simply one large and unwieldy animal, but a confusing mixture of many different animals of different sizes. Well before the governments concerned are able to mobilise, meet and converge on a new institutional framework for the eurozone that allows more fiscal federalism, get the framework passed within their own countries through whatever process is nationally mandated, and so on, bond markets will have driven at least one and probably several countries to unsustainable positions. The attempts to create a fiscal union on the sly, without going through all the complex and lengthy procedures legally required, is unlikely to work as long as financial markets remain so openly cynical about it.

For outsiders, the eurozone has always been an extraordinary experiment, indicating the triumph of an integrating vision over divisive tendencies. Its survival over the past decade, with some measure of stability and success, has been no mean achievement. To be sure, the process was corporate-driven and the macroeconomic rules associated with the union did not emphasise productive employment generation and better living conditions, but actually constrained those goals.

But as it turned out, these rules (as written in the Growth and Stability Pact of the Maastricht Treaty) were barely followed by any country. It is common to point fingers at Greece and Italy today, but the early rule-breakers on the fiscal front were actually Germany and France. That ability to ”work around” the rules was in fact the source of success for the eurozone, but inevitably also led to the imbalances that now threaten the currency union’s very existence. Public memory is short, but only four years ago, at the height of the boom before the US financial crisis transmogrified into the global Great Recession, the great economic success stories in the region were seen as Ireland and Spain, celebrated by the IMF and the European Central Bank alike for their ability to pull in private capital to finance rapid expansion in construction and other activities.

The comparison made frequently is with the United States – another large region with a currency union that is controlled by one federal authority. The states of California and Florida have budgetary problems that exceed those of Greece, but since they are part of the US, the starkness of the Greek situation is not repeated there. Further, labour is much more mobile within the US than it currently is in the eurozone, where differences in language and culture persist in preventing significant labour mobility even when there are no official restrictions on people’s movement.

So, faced with these starker choices that are growing even starker by the minute, what do European leaders do? They meet, of course, with increasing frequency. Some leaders do so in a way that indicates their clear sense of urgency and priority, such as Nicholas Sarkozy, who put off attending the birth of his daughter by Carla Bruni so as to meet with Angela Merkel. And what do they do at these meetings?

First of all, they agree to meet again, fairly soon – which is always useful, of course, and also keeps the financial media occupied. Then they agree to have even larger meetings with more countries involved, such as G20. Sometimes they set deadlines for decisions by the next meeting, which are usually superseded at the last moment, just before the meeting concerned, by another deadline for a strategy by the time of the meeting to follow. Occasionally, they read the riot act to leaders from problematic deficit countries like Greece, Italy or Spain, insisting that they have to do much more to enforce austerity and suppress domestic consumption. (At no point do they seem to remember that surplus countries also have a responsibility for adjustment.) Every now and then they point to a faint glimmer of hope on the horizon: Look, yields on Irish bonds have fallen by a fraction of a per cent! Look, China says it will buy Spanish and Italian bonds so we can still scrape by!

The governmental activities that can be most easily ridiculed are those directed at financial markets. Instead of putting forward serious and careful measures to regulate finance and make it safe for the real economy, European governments persist in thinking that they can somehow trick financial markets into behaving well with sleight-of-hand tricks, shadows and mirrors. The so-called ”stress tests” that are supposed to reveal the required recapitalisation of major banks are probably the most classic example of this.

These stress tests were recently conducted, and revealed that major banks would require recapitalisation amounting to less than 100 billion euro – almost one-third of the amount estimated by the markets. Of course the stress tests themselves rest on assumptions that all but preclude real stress, of the kind that is clearly on the cards. What happens, for example, if French government bonds get downgraded by credit rating agencies? How would that play out in terms of the viability of the banks in general?

Similarly, there is a plan to allow the European Financial Stability Fund to borrow from the markets, so they will have even more funds available to provide countries in distress, effectively making the EFSF a monoline insurer for sovereign debt. But this only adds to the fragility, rather than reducing it – just as the Special Investment Vehicles produced by US banks in the run up to their financial crisis did not actually reduce risk but simply added another layer of intermediary in the effort to disguise it.

None of the proposed solutions addresses the heart of the problem: the only way the eurozone can now be economically tenable is if it involves a significant increase in fiscal integration (including funds transfer to deficit regions) which in turn necessarily involves a significant loss of national sovereignty within the union. Immediately this must involve fiscal transfers that enable the deficit countries to grow their way back to sustainability, rather than persist in the self-destructive pattern of austerity that lowers economic activity and worsens debt and deficit ratios.

At the moment, it is evident that the major players do not have the stomach for even making the attempt to pursue this line, which is why they are playing these mindless games in the hope that the whole tangle will somehow just sort itself out with time.

And so, until the denouement (which may now be just a few months away) we will have more and more of such meetings among the eurozone leaders. On the Titanic, at least they played music with gay abandon as they approached the iceberg.

( This article was originally published in the Frontline, Volume 28, Issue 23, November 5-18, 2011)