There are three possible ways out of the eurozone crisis: austerity, investment or the route taken by Argentina in the 90s
The next 12 months will decide the fate of the eurozone. The problems of the single currency have not gone away and will again dominate this week’s meeting of the International Monetary Fund in Washington. Every one of those in attendance knows that the crisis could erupt again at any moment; last week’s sell-off in Spanish and Italian bonds was like the puff of smoke billowing out of a volcano getting ready to blow.
Here’s a summary of how things stand. The euro was constructed on the false premise that monetary union would lead to a harmonisation of economic performance across member states. Greece would become like Germany; Portugal would be similar to Finland. Instead, the euro has led to a widening gulf between rich and poor, and this has been brutally exposed by the financial crisis and its aftermath.
It became clear that the countries on the periphery of the eurozone had a cocktail of problems. Their economies were much less productive than those at the core, so they were gradually becoming less competitive. They had shaky banking systems. And they had weak public finances.
Investors, unsurprisingly, came to believe that holding Greek, Italian or Spanish bonds was risky and demanded higher interest rates for doing so. This added to the pressure on both banks and governments, and by pushing up the cost of borrowing, affected growth prospects as well.
By late last year, the eurozone was on the brink of meltdown. At that point, the European Central Bank stepped in and announced long-term refinancing operations (LTROs). These pumped unlimited amounts of ultra-cheap money into the eurozone banking system to satisfy the funding needs of banks for three years.
The idea was to kill two birds with one stone. Banks would have more cash and could use it to buy government bonds in their own countries, thus driving down interest rates and so boosting growth.
This was a high-risk strategy that depended on the crisis-affected countries quickly returning to steady and robust growth. If they didn’t, their banks would be loaded up with government bonds and vulnerable to a sell-off in the markets.
In the past couple of weeks, this possibility has dawned on markets. They have started to mull over a scenario in which a deepening recession in Spain leads to the government missing its deficit-reduction targets, prompting rising bond yields and eventually necessitating an international bailout.
There is much talk in European circles about how Greece was a one-off. Few in the markets believe that.
In the very worst case the euro breaks up entirely, leaving the ECB nursing big losses and ruing the day when it embarked on an expansion of the money supply. As George Soros noted last week, the Bundesbank perceives the risk, which is why it is campaigning hard against any further LTROs. The message from Germany, and from some of the other core countries, is that it is time for Spain, Italy, Greece and Portugal to start delivering on the structural reforms they have promised.
All that explains why Christine Lagarde, the managing director of the IMF, keeps insisting that Europe has bought itself a little time to sort out its problems but no more than that. Lagarde is absolutely right about that: the single currency has arrived at a three-pronged fork in the road.
Route number one is Austerity Avenue. The eurozone continues on its current road with the poorer countries on the fringe making themselves more competitive by what is known as internal devaluation. This involves driving down the costs of production through wage reductions, welfare cuts and the sell-off of state assets. Living standards take a big hit for a prolonged period, but eventually countries such as Greece bridge the gap between themselves and Germany.
There are both economic and political problems with this route. Austerity is killing growth, making it harder to reduce government borrowing, and it is inflaming populations unhappy at the prospect of year after year of falling living standards. This is a bumpy road; it may also prove to be a short one.
Next up is the High-Investment Highway. The premise for this route is that the single currency can survive but only if measures are taken to stimulate growth. Soros proposed a scheme last week in which all countries would be able to refinance their debts at the same rate – but, as he admitted, this would never get past the Bundesbank.
Another idea, put forward by the former Labour MP Stuart Holland, is for a bond-financed investment programme modelled on Roosevelt’s New Deal. This would have two components: the creation of Union bonds, under which a country would be able to convert up to 60% of its national debt into non-traded Union bonds; and the launch of Eurobonds, which would be traded and actively marketed to the fast-growing countries of the emerging world that are looking for an alternative to holding reserves in dollars.
The idea, which has attracted the interest of the socialist candidate for the French presidency, François Hollande, would be to use Union bonds to stabilise debt and Eurobonds to finance investment.
As with the Soros proposal, the Hollande plan would no doubt run into stiff opposition from Germany. It would also involve a much higher degree of fiscal integration. But if Austerity Avenue is a dead end and High-Investment Highway is a road to nowhere, that really leaves only one other exit: Buenos Aires Boulevard.
A paper published last week by Capital Economics described the similarities between the struggling countries of the eurozone today and Argentina in the late 1990s. The South American country had fixed the peso against the dollar irrevocably at the start of the 1990s but, after a few good years of strong growth and low inflation, by the end of the decade it had come under severe strain.
The solutions being tried now in Greece – austerity, debt rescheduling, IMF programmes – were tried in Argentina, to no avail. Indeed, output crashed, making the country’s debt position even worse. Eventually the pressure became too much and Argentina devalued and defaulted.
Far from the sky falling in, which was what the IMF and the other proponents of orthodoxy predicted, Argentina’s growth averaged 9% a year between 2003 and 2007.
As Andrew Kenningham of Capital Economics accepts, Greece would not be expected to do nearly as well as post-crisis Argentina, which benefited from rising commodity prices and did not have to cope with the inevitable contagion effects that would result from a country leaving the single currency. He argues, however, that Argentina’s example offers a “painful but viable” route out of the crisis which the current deflationary policies do not. And unless policymakers in Europe can offer their citizens something more enticing than endless austerity, a stroll down Buenos Aires Boulevard will become increasingly enticing.
From the Guardian