Deep concerns about the European debt crisis and the future of the euro continue to rattle global markets. In a new video Q&A, Uri Dadush says that while European leaders are finally overcoming denial and beginning to respond to the crisis with serious measures, the measures still don’t go far enough. European banks most exposed to sovereign debt pose a special risk and “if these banks are under threat, then the international banking system is under threat.”
- Is the euro in crisis? And can it survive?
- What caused the economic crisis?
- How effectively has Europe addressed the financial turmoil?
- Is Germany providing effective leadership?
- Has Greece taken the appropriate measures to reform its economy?
- Is Portugal following Greece’s path?
- Will Spain avoid economic collapse?
- Is Italy in danger?
- What is the impact on the United States and how can Washington influence events in Europe?
The euro is in crisis. It has fallen 20 percent against the dollar since the beginning of December. I do believe that the Euro will survive, but the composition of the euro zone area could change. One or two countries may drop out the euro zone as a result of this crisis, but I think the Euro itself will remain.
While the headlines of the crisis focus on the fiscal problems in many of the vulnerable countries, in fact the deeper roots of the crisis go back to the establishment of the euro and the loss of competitiveness that ensued in many of these economies.
The loss of competitiveness was, in part, a result of a big confidence boost and the demand boom that raised wages in accessible activity in the vulnerable countries and partly a result of rigid labor markets in some of these countries.
Another important element in the loss of competitiveness was the fact that following its reunification, Germany did a magnificent job of restructuring its economy, increasing productivity and without increasing wages very much.
Europe is getting to the point where it is pushing the right buttons to deal with the very deep crisis of the euro. Unfortunately, it took too long getting there and as the result of this, the cost is going to be significantly higher.
This is most clearly evident in the case of Greece where assembling the rescue package—including the IMF contribution—took too long and was too conditioned I would say, by very divisive politics in Germany and Greece, particularly, which I think delayed and reduced the incentive on the policy makers to act in a more decisive way.
But I think they are getting there, the most recent package (750 billion euros) is obviously a very substantive reaction and the decision by the European Central Bank to its units liquidity operations and even to purchase government bonds has also been a step in the right direction, although a very controversial one. I think this has helped stem the panic—we are still in a very difficult situation, but I think by in large we are stemming the panic.
Germany has not provided effective leadership thus far. It was Germany’s reluctance to intervene in Greece that delayed the package. The decision to purchase government bonds, although on the part of the European Central Bank, although it was an important element in stemming the panic was resistant by the representatives of the Bundesbank.
When Germany decided to act, it did so unilaterally in the case of the naked short selling that we saw recently. This slowness in the reacting, and this recalcitrance is really a reflection of the deep political divisions within Germany, and a strong sense—and understandable in many respects—on the part of the German public, that they did the hard work, that they did become competitive, they did do the restructuring, they did contain spending and now they are having to pay the bill for profligate countries in the European periphery.
Unfortunately, this is only one part of the story. Some countries, like Spain or Ireland actually have smaller government debts then Germany has, but the problem is that these countries are suffering from the same competitiveness loss that they share with Greece, Italy, and others. So the problems are much deeper and the politics I think have not adequately caught up with the realities.
The adjustment measures that Greece has agreed to and has already began to enact in quite an aggressive way are very far reaching, some have described them as brutal adjustment measures. There is a very significant reduction in wages, in the government sector in Greece—perhaps that is the clearest example. There are changes to their pension laws. There are a number of structural reforms that have been agreed.
Greece is reacting quite aggressively as part of the rescue package; however I am among those who believe that in the end, even under a successful adjustment of Greece that that to debt to GDB is going to be so large—that somewhere near 150 percent of GDP,
even if the adjustment works—that at some point we will need to consider a restructuring, or to use a more direct more, a partial default on Greek dept or alternatively some means may be found of forgiving Greek that without it, I’ll try defaulting.
Portugal is definitely as risk. It has a very high debt, not as high as that as Greece. It has a very large fiscal deficit and most importantly Portugal has been going extremely slowly, just about the slowest rate of growth in the Euro zone for many years, so the likelihood that it can grow itself out of dept seems very very low. It has many of the same loss of competitiveness characteristics that we observe in the other vulnerable countries.
At the same time, I think the Portuguese government is clearly moving toward taking some significant action, so this remains an open question, it’s a risk, but it remains an open question.
Spain, in a sense, is the most worrisome situation at the moment. Its imbalances are actually not as extreme, by any stretch as those of Greece. Certainly its debt to GDP ratio is still relatively low, although it is rising very rapidly. Spain is a special concern because the total debt of Spain is over twice that of Greece—this is a significant economy.
The greatest vulnerability of Spain is that it has lost competitiveness, along with all the others, but at the same time, its economy has become far too dependant on what I would call the non-tradable sector, the sector that is sheltered from international competition—housing, services, restaurants, bars—activities that are generally non-tradable have become too big of a part of the economy and not enough of the economy is oriented toward external markets.
For these reasons, the collapse of the housing bubble and of domestic demand in Spain raises a profound question about the speed at which Spain can emerge from these problems. It has, in other words, the same sort of growth constraints that we have been talking about with respect to Portugal and with respect to Greece.
If Italy gets into trouble, we truly have a world class problem because Spain is twice that of Greece in terms of absolute of money outstanding. Italy’s debt is three times that of Spain. Now we’re talking about debt in the region of 1.5 to 2 trillion euros. This is real money.
Now, Italy is a mixed case because on the one hand it has clearly seen very large losses in competitiveness, like the other vulnerable countries, and at the same time, its debt to GDP ratio is very high. It’s about as high as that of Greece. On the other hand, unlike Greece in recent years, at least Italy has seemed to get a handle on its fiscal deficit and its fiscal deficit is modest compared to other countries in Europe. It's about half, let's say, the British deficit, or half the Spanish deficit.
It appears that the Italian government does have control over its finances. That is what it has demonstrated in recent years. However, I would not exclude that possibility that particularly should the crisis spread to Spain in a major way that the markets will become very nervous about Italy. And remember that a lot of this is about market psychology. You cannot just boil it down to arithmetic.
Potentially, this has an important impact on the United States. There are two main sets of impacts. The first set of impact is to trade. Europe is a very important trading partner of the United States; it is the world’s largest trading block. If Europe does not grow and furthermore if the euro is extremely weak, it’s more difficult for the United States to export its way out of its problems. As you know there is an objective, a stated objective on the part of the Obama administration to double exports in five years to become less reliant on domestic demand and more reliant on world demands.
The more important risk to the United States comes to the financial angle and in one word, the concern is about fear. Will we have a return of the credit crunch that sank the global economy eighteen months ago because banks become very concerned about lending to each other or banks lending at all, given the fact that European banks are of course laden with European government debt, as you would expect—after all this was suppose to be the safest possible investment.
If the European banks are under threat, then you should assume that the international banking system is under threat because of the size of Europe and because of the interconnections of financial markets. So, the risks to the United States are significant and this is why President Obama has been on the phone so often with European leaders in the course of the last few months or so.
What can the United States do to help fix the situation? The United States can actually do quite a lot, although it has to do it in a very discrete way because Europeans are understandably very sensitive about the fact that this is a European problem. The United States can and has supported the IMF’s involvement in Europe. A lot of the money that the IMF will lend would come directly or indirectly from the United States. The United States are bigger shareholders, bigger shareholders of the international monetary fund.
The United States can reinstate, and has, done so—swap operations with the Federal Reserve Bank—to provide dollars in the event of an emergency to European countries that need it. The United States can exercise a high degree, I would say, of persuasion, lets call is moral persuasion. It makes a big difference if the call to Jose Luis Rodriguez Zapatero (Spain’s prime minister) to undertake very difficult reforms is coming not just from Berlin or from Paris, but it’s also coming from Washington. I think that has actually made a difference.
And finally, and this is the toughest bit, the United States has to understand that the European crisis is a very deep crisis, it is a competiveness crisis at its heart and should accept that we are going to have a lower exchange rate for the euro for some years to come. Without that it is going to be very difficult for Europe to pull out of its problems.
This doesn’t help the United States but this is part of the sacrifice, or the price that the United States has to pay to maintain global financial stability in the face of this massive debt crisis in Europe.