© Dr. Mark Melatos
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The Eurozone's current problems arise from a crisis of insolvency among some members. Eurozone policy makers, however, have reacted as though they are facing a liquidity crisis. Unfortunately, there are no painless ways to solve an insolvency crisis. Either, countries must be given time to repay their debts – a probably impossible task in the case of Greece; or a large portion of those debts must be written-off. Alternatively, the ECB could allow higher inflation to reduce the real value of these debts – a scenario unlikely to gain German support.
Quantitative easing to purchase peripheral country bonds will buy time but will not solve the fundamental problem of insolvent sovereigns which, at some point, must be addressed if the sovereigns are to regain access to global bond markets. The ultimate solution should involve three elements to "reboot" broken financial systems:
(i) a hard default by the insolvent sovereigns,
(ii) the exit of insolvent members from the Eurozone to allow them to quickly raise their international competitiveness via currency devaluation while allowing them to print their way out of the inevitable cash crunch that will follow such a move and
(iii) massive ECB support for remaining (solvent) member bonds to minimize the threat of contagion.
Long-term, deeper political and financial integration will be necessary. Note that the common argument that Germany should somehow "bail out" the Eurozone (either through pooling Euro debt or by raising domestic spending) is unrealistic. Germany is neither large enough, nor rich enough, to undertake such a task. In any case, Germany has done more than its fair share of European nation-building with the integration of East Germany.
Do you regard austerity measures imposed by the ECB to the struggling member countries effective?
In the context of insolvent (or soon-to-be insolvent) sovereigns, austerity is "too little too late". Moreover, in the short term, austerity measures deepen the recessions in the peripheral Euro members, makes their debt burdens even greater and, indeed, reduces economic growth throughout the Eurozone.
On the other hand, fiscal stimulus is not the answer either. Insolvent or near-insolvent governments cannot spend more to prop up their economies. In countries like Spain and Ireland, the crisis arose mainly as a result of excessive private (not public) sector debt. The private sectors in these countries will not be in a position to contribute significantly to economic growth for many years. The fiscal position in these countries is not sufficiently robust to allow the government to take up the slack until the private sector recovers.
What outcome of the crisis do you expect? Do you anticipate that any of the countries will leave the region? In case it happens, what consequences there might be both for a country and for the Euro bloc?
The bond markets are signaling that Greece, Ireland and Portugal are already insolvent, while Spain and Italy are nearly so. Austerity is imposing (or will soon impose) intolerable economic hardships on the populations of these countries. Eventually, this will result in a political consensus in these countries to "take the easy option"; namely, default on existing debt and currency devaluation (and high inflation) via a Eurozone exit.
Contrary to popular opinion, I do not believe that Germany will act to push any of the insolvent countries out of the Eurozone. The Euro has provided Germany with a devalued currency (relative to the Deutschmark) while simultaneously committing peripheral countries to higher exchange rates. This, rather than domestic labour market reforms, is most likely the main source of Germany's miraculous gains in competitiveness over the last decade. As such, the exit of some Eurozone members will reduce the competitive advantage enjoyed by the core European countries. Germany, thanks to its technical prowess, will be less hard hit. France will be especially vulnerable.
In the short term, the exit of some countries from the Eurozone will create dislocation in financial markets as investors and business seek to address contractual problems arising from the introduction of a new currency. But these costs may well be less severe than commonly assumed; business and investors have had ample time to prepare for the exit scenario.
How long may it require solving the problems in Eurozone?
Unfortunately, there are no "free lunches" in economics! Even with an appropriate policy response, the hangover from Europe's private and public sector debt binge will last into the medium term. At this point, perhaps the most important task for policymakers is to signal their readiness to address the fundamental problem – insolvency.
The current austerity strategy provides no hope for anybody. Even if Greece follows the Troika's roadmap to the letter, in 2020 its debt to GDP ratio is envisaged to still be at least 120%. This is where Italy's current ratio stands, to the consternation of the markets – and Italy is a fundamentally stronger economy. In other words, the current policy response provides no hope of a solution within the next decade. Under a scenario of default, exit and robust ECB support for solvent members, there is at least a chance that, like Iceland, Europe could begin a steady recovery within three-five years.
The more fundamental structural problems inherent in the Eurozone can only be solved over the long-term via deeper political and financial integration.