Stock markets may have soared after central banks around the world, led by the Fed, got together in a rare coordinated action to provide more dollars to Europe's strained financial sector. But we also got an indication of just how bad things have become. There have been concerns for months that Europe's banks were having difficulty getting dollar financing, which is very important to the operation of banks in France and elsewhere, as financial institutions around the world became nervous about lending money to a sector saddled with large euro zone sovereign debt holdings of dubious quality. The scary thing about that problem is that it could have caused a financial crisis in Europe even without a major new event in the debt crisis (like an Italian default). For central banks to act as they did, the situation must have become extremely severe, or was at least deteriorating badly.
And though that potential danger may have been averted (probably only in the short term), the central bank decision has done nothing to alleviate the underlying sovereign debt crisis in the euro zone. We're about to get some more action on that front as well, however, with yet another summit of European leaders approaching on December 9. The indications are that German Chancellor Angela Merkel and French President Nicolas Sarkozy want to push ahead with some sort of "fiscal union," or at least their vision of one. As I wrote in a recent TIME magazine story, a fiscal union would probably be a real solution to the debt crisis. By coordinating national budgets and centralizing at least some decision making over spending priorities, a fiscal union could start repairing the shattered finances of euro zone countries, provide a backbone of support for weaker members like Italy, and convince investors that Europe will truly do whatever it takes to save the euro. (Read "Is Europe's debt crisis becoming a banking crisis?")
We'll have to wait for the details to get the full picture of what's on the table. But based on the early signs, the version of a fiscal union Merkel & Co. seem to advocate is really just an "austerity union," a way of forcing painful budget cuts, tax hikes and other measures onto euro zone countries through stiffer sanctions and regulations, with very little offered in return. That won't work. The euro can't survive on austerity alone. In fact, austerity, as it is being implemented now, is damaging the euro's prospects. Here's why:
The idea behind the German-backed solution to the debt crisis is to fix the broken countries of the euro zone. That, needless to say, does have to happen. But it can't be the entire focus of the crisis-fighting effort. Yes, some euro zone countries have been given financing (bailouts) to support them during their austerity programs, but now the bigger nations infected by the crisis (Italy and Spain) aren't even being offered that much. Instead, their new Prime Ministers are being placed under more and more pressure to cut, cut, cut, cut -- while the rest of the zone sits back and waits. But as we've witnessed for more than a year, cutting alone won't bolster investor confidence. They simply don't believe that the financial adjustments these countries must make can be achieved in any reasonable period of time. What these countries are being asked to do is reverse years -- in some cases, decades -- of fiscal policy in a matter of months. (France hasn't recorded a budget surplus since 1974.) (Read "Bailouts and Austerity Measures Aren't Working: Is This the Euro's Last Stand?")
Most of all, austerity is killing growth in the euro zone, and without growth, the crisis will be much harder to solve. Just look at some statistics. Spain recently downgraded its 2011 growth estimate by half a percentage point to a mere 0.8%. Portugal's GDP contracted 0.4% in the third quarter from the previous quarter. Greece's third quarter GDP plummeted 5.2% from the previous year -- its best quarterly performance of 2011. The OECD in November forecast that euro zone growth would sink to a pathetic 0.2% in 2012 from 1.6% this year. Without growth, closing deficits and stabilizing debt is much more painful. If GDP is stagnant or contracting, the amount of debt you need to eliminate to bring that crucial government-debt-to-GDP ratio down gets larger, and thus more difficult to achieve. Ditto with budget deficits. So to meet euro zone debt and deficit targets, countries have to cut more and more, further suppressing growth, and moving the target further off yet again. They become like a dog chasing its tail.
Investors know this full well, and that's why they remain wary of the euro zone debt situation even as its political leaders slice away at budgets. So borrowing costs remain lofty, making it harder, once again, for Italy and Spain to meet budget targets, which means they have to cut even more. And the pain inflicted by such severe austerity on populaces already suffering from an economic downturn (Spain's unemployment stands near a staggering 23%) only fuels opposition to reform and ire towards the monetary union. So the sick contradiction facing the euro zone is that austerity is necessary to fix the debt crisis, but at the same time, it also feeds the debt crisis. (Read "How to Know When the Euro Crisis Reaches a Tipping Point.")
How does Europe escape the trap? Austerity has to be balanced with something else to help these countries restore growth while repairing their economies. Yes, structural reforms to free up labor markets and decrease regulation will all help, but not in the short or even medium term. Nouriel Roubini argued in the Financial Times the other day that debt restructuring is the answer, to alleviate the burden on Italy. I'd suggest that the euro zone needs to improve the functioning of the common market by implementing EU-wide incentive programs to get companies in healthier countries, like Germany, to invest in weaker nations and hire the unemployed. Or the proposed fiscal union could be a true fiscal union, more like the United States, in which the center has the ability to tax and thus support member states that are economically struggling.
My sense is that none of the above is actively being considered. It seems to me that the only support being discussed is some form of a bailout -- to find a source of money to provide a financial "shield" for Italy and Spain so they can fund themselves at lower cost while implementing reforms. That may help slow the deterioration of the debt crisis, but it won't necessarily solve the debt problem itself, at least not in any acceptable time frame (as we've seen in Greece). If this is the route Europe takes, the members of the euro zone will have to be prepared to financially support its weaker members for an awfully long time before we see a real improvement in their economic health.
The solution to the debt crisis won't be budget cuts, more taxes, and more rules to force them down the throats of Italians, Spanish and Greeks. Merkel, Sarkozy and their counterparts have to find a broader solution. Otherwise, Europe is facing a race to the bottom.
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