Financial Times
June 12, 2012
Here is the biggest question about the eurozone: can we envisage a set of reforms that are not only politically feasible and economically workable, but would let it prosper, as it is. If so, what might they be?
We already know that, as designed, the eurozone did not meet this test. Hence all the improvisation of today. The original design created huge imbalances. When the flow of finance dried up, these delivered a wave of financial and fiscal crises and a legacy of unaffordable debt. Furthermore, the forces driving those imbalances generated divergences in competitiveness. These also need to be redressed, as quickly as possible.
In response, the eurozone has developed a strategy based on fiscal austerity and structural reform. In addition, the European System of Central Banks, as lender of last resort, and the International Monetary Fund and eurozone governments, via the temporary European Financial Stability Fund and, soon, the permanent European Stability Mechanism provide indirect financing for fragile economies and sovereigns. The $100bn proposed rescue of Spanish banks is the latest example of this strategy at work. It is unlikely to be the last.
Will the strategy work? Probably not. As Mark Cliffe and his team at ING note, in a report entitled Roads to Survival, a good way to think about the challenge is in terms of the external and internal imbalances bequeathed by the incontinent cross-border lending prior to the crisis.
If external deficits are to be reduced, domestic demand must shrink. If done too swiftly, this would raise unemployment, possibly enormously (see chart). In the long run, high unemployment, aided by market-oriented reforms, should drive down nominal wages. But this could take many years. Meanwhile, persistently weak economies mean a growing mountain of bad private debt, high fiscal deficits, rising public debt, high interest rates and extremely fragile financial systems.
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