By Thomas Cooley
The views expressed are his own.
The European debt crisis has put the banking system in peril and is threatening to end the grand European experiment. It is a test of whether European governments can find enough political common ground to find a solution to the problems created by sovereign fiscal policies in the periphery countries. Severe as the fiscal issues are, there are other problems that are likely to divide Europe into prosperous and stagnant zones for a very long time to come. The periphery countries have underinvested in human capital since the Euro was created and this will continue to exacerbate the economic division of Europe. Persistent inequality cannot be good for the stability of the union.
For all of the Eurozone countries faced with unsustainable fiscal policies the solution will involve considerable pain in the form of budget cuts, shrinking public sectors and increases in tax collections. Because draconian fiscal remedies impose a substantial drag on the economies concerned there is now the worry that Europe will become a two-speed continent with the healthier economies like German, France, and the Nordic countries experiencing strong growth and the periphery countries like Portugal, Greece, Italy and Spain growing more slowly.
Fiscal drag is not the only problem facing the periphery economies. These countries struggled to get their inflation rates in line before joining the EMU but when they did they surrendered the ability to alter the terms of trade for their exports. In many of these countries it meant surrendering a weak currency for a strong one.
For some countries this was a deathblow for domestic industry. A good example is the textile industry in Portugal. In 2001 it was the largest industrial sector accounting for nearly 25 percent of manufacturing employment and 19 percent of exports. But the strength of the Euro made Portuguese textiles uncompetitive and those jobs left for lower wage countries never to return. Similar transitions took place in Greece (the maritime industry), Spain and Italy. It may be that those jobs would have left in any event, but the ability to adjust exchange rates might have dampened the rate at which they left.
The usual solution for countries faced with the loss of lower-wage, lower-skilled jobs is to move up the value-added chain. That is, to replace lower skilled employment with jobs requiring more human capital. This is what Japan did in the post WWII era, what South Korea has done and what China is doing now.
