The Clock Ticks for Europe

Posted by on 8 April 2009

Time is running out for the European economy. As Angela Merkel’s German government stubbornly rules out further fiscal stimulus, all too many East European countries move closer to debt default. And as the European Central bank takes its sweet time to aggressively ease monetary policy, the Euro-zone’s Mediterranean countries, together with Ireland, sink deeper into recession. Connecting the dots, one must expect that the very survival of the euro will soon be thrown into serious question.


Eastern Europe is the region most severely impacted by the global economic crisis. Overly dependent on exports to Germany, countries across Eastern Europe are already in the throes of deep and painful recessions, which are sorely testing their fragile democracies. Highly reliant on short-term bank borrowing to finance their large external deficits, even the currencies of the strong countries in the region, like Poland and the Czech Republic, are virtually in freefall as external bank flows into the region suddenly stop in the wake of the global financial market crisis.


Already at this stage, the economic crisis in Europe’s periphery is exacting a steep political price that threatens to only deepen that crisis. In the short space of a few months, governments have now fallen in the Czech Republic, Hungary, Iceland, and Latvia. Meantime countries like Ukraine are gripped by political paralysis as Russia seeks to politically exploit the crisis, while mass disturbances have become commonplace in Greece and Ireland.


Any further deepening in the East European economic crisis is bound to reverberate across Western Europe. After all, West European banks have loaned Eastern Europe over US$1 ½ trillion, which now threatens to become the European banks’ equivalent of the US banks’ sub-prime fiasco. Compounding matters, this lending has been concentrated in the banking systems of a handful of countries. Austria, Belgium, Sweden, and Switzerland are particularly exposed to further economic turmoil in East Europe since banks in these countries have loan exposure to the region equivalent to between 25 percent and 60 percent of their respective countries’ GDPs.


Of even greater concern for the global economy are the cracks that are appearing in the Euro-zone as the euro now faces its most serious challenge since its 1999 launch. At the core of this challenge is the fact that the one-size-fits-all interest rate and exchange rate policy involved with euro membership cannot simultaneously meet the needs of all of the Euro member countries, many of which are now characterized by acute economic weaknesses.


In present circumstances, what might be an acceptable interest rate for Germany and France becomes overly burdensome for countries like Ireland and Spain, which are in the throes of major housing busts. It also becomes excessively onerous for countries like Greece and Italy, which have highly compromised public finances. Similarly, what might be an acceptable Euro exchange rate for member countries that have strong external fundamentals might be excessively punitive for countries like Greece, Portugal, and Spain that do not.


The acute strains that lie ahead for the Euro are perhaps best illustrated by Spain's present predicament. Until very recently, buoyed by a housing market bubble that made that in the United States pale, Spain's economy was amongst the fastest growing in the Euro-zone area. However, now that its housing bubble has burst, Spain is in the grip of a severe recession as indicated by an unemployment rate that has already risen from 8 percent to 14 percent. Yet trapped within the Euro, Spain cannot emulate the United States in reacting to its housing bust by sharply reducing interest rates and by allowing its currency to weaken. And its room for fiscal stimulus is now highly constrained by the widening of its budget deficit towards 7 percent of GDP as a result of its deepening recession


Further clouding Spain's long-run economic outlook is the fact that, during the boom years, Spain lost more than 20 percent in cost competitiveness to Germany. That loss has contributed importantly to a widening in Spain's external current account deficit to US$180 billion, or to an absolute level that is second only to that of the United States and that now approaches 9 percent of Spain’s GDP. Yet without its own currency to devalue, Spain is forced to regain lost competitiveness by a prolonged period of deflating against a highly competitive Germany.


Spain's grim economic outlook raises two basic questions about its continued long-run membership in the Euro. Will Spain have the political will to endure the prolonged period of very high unemployment and deflation necessary to restore Spain's international competitive position?  Can one count on the rest of Europe to continue financing Spain's outsized external current account deficit?


Seemingly oblivious to the break up of other "immutably" fixed exchange rate systems like that of the Argentine currency board in 2001, the optimists argue that the prohibitively high financial and economic costs of exiting the Euro leaves a country like Spain with little alternative other than to endure the rigors of Euro membership. It is supposed that somehow the political leadership will prevail in explaining to the people that there is really no choice to staying in the euro. However, the recent riots on the streets of Athens and Spain's own fractured politics should give one pause. 

Turning a blind eye to the present lack of European financial institutions to conduct massive IMF-styled bailouts, the optimists also contend that the stronger members of the Euro will in their own self interest rally to the financial support of any Euro-zone member country under real pressure. However, this line of reasoning fails to factor in today's present reality that not one but rather five Euro member countries are simultaneously being shocked by the global slump. For different fundamental economic reasons, the economies of Greece, Ireland, Italy, Portugal, and Spain, derisively referred to as the PIIGS on Wall Street, are all under increased market pressure that makes any sustained bailout of these countries prohibitively expensive.


In the end, the Euro might very well survive its present stress test. However, policymakers in Europe risk making a big mistake by seemingly ignoring the rapidly deteriorating East European situation and the recent rating agency downgrades of Europe's Mediterranean countries.



Desmond Lachman,
American Enterprise Institute