Euro crisis: Paradigm Lost

The BBC’s Europe editor, Gavin Hewitt, has been examining “an in-depth analysis of the crisis in the eurozone” by the Carnegie Endowment for International Peace – “Paradigm Lost – the Euro in Crisis”. From Gavin Hewitt’s blog

So what’s to be done? According to the economists in the Carnegie report, the PIIGS will have to reduce their debts, which most are attempting to do with austerity packages. The debt-to-GDP ratio needs to be on a firm, downward path and to be stabilised within three years. The European Central Bank should maintain an expansionary monetary policy, which it is doing. The authors also believe the eurozone should embrace higher inflation, as it “will ease the necessary cuts in real wages”. Germany should stimulate domestic demand. And the eurozone should actively pursue a weak euro. But there are real doubts as to whether all that will be enough.

From the report’s notes on Ireland: From Bubble to Broke

To escape the trap now ensnaring the GIIPS, Ireland must follow a path similar to the others—restore competitiveness and return public finances to a sustainable trajectory.

Competitiveness is already returning. Since its peak in mid-2008, the REER has fallen by 10 percent and exports are adding to growth. The wage adjustment is already underway as well, as public sector wages were reduced by 5 to 15 percent in December of 2009. This will help rebalance the economy away from services and the financial sector and—drawing on Ireland’s sound business climate and flexible labor market—towards exports.

Irish leaders have already taken bold steps—including expanding the tax base, increasing the minimum pension age, reducing social welfare benefits, and cutting public wages—to lower spending by 2.5 of GDP in 2010 and reduce the deficit below 3 percent of GDP in 2014. Achieving these goals will be difficult: as increasing unemployment and still-retreating domestic demand continues to cut into tax revenues, deficits are still expected to exceed 10 percent of GDP through 2011. Both steady, tenacious leadership in Ireland and the “ruthless truth telling” of the IMF—now a major player in resolving the European crisis—are critical in ensuring that these much-needed reforms persist, especially if public support wanes.

The financial sector still presents a difficult-to-evaluate risk to Ireland’s budget reform. If events in Ireland or Europe shake banks, the government will be forced to make good on its guarantees and debt could balloon even higher. To reduce this risk, flexibility is needed in how financial support programs respond to continuing trouble and, when appropriate, unwind these guarantees. 

The case of Ireland underscores the fact that flexibility and dynamism do not make a country immune to the disease now afflicting southern Europe. A financial bust can overwhelm public budgets in a matter of months, even after many years of rapid growth and budget surpluses. 

During the boom, the Irish state could have moderated the economic misalignment toward services and real estate through taxes: for example, a large VAT hike on services and home construction. This would have both reduced the tidal wave of capital that flooded real estate markets and the financial industry and cushioned the fiscal adjustment when the boom ended. As Ireland discovered, reducing spending during lean years is much more difficult than withholding expenditures during a boom.

And one of the report’s authors, Uri Dadush, proposes a three-point plan to save the euro

Hopefully accompanied by a world trade recovery, the aim of such a programme should be to keep the aggregate European growth rate in the 2%+ range, even at the risk of slightly higher inflation in surplus countries.  Reforms favouring consumption and domestic investment in countries with budget surpluses, a continuation of a policy of low interest rates in the eurozone and an explicit favouring of a weaker euro would help boost growth. The G20 should support the programme as a means of avoiding a string of sovereign-debt crises endangering the global recovery.

It is high time for the eurozone leaders to move from denial to action – not only in Greece, but, just as importantly, at home.

If all goes well, this episode may be remembered as the eurozone’ s adolescent crisis.


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