Europe’s hair-trigger economy

By Lawrence Summers
March 18, 2013

Europe’s economic situation is viewed with far less concern than was the case six, 12 or 18 months ago. Policymakers in Europe far prefer engaging the United States on a possible trade and investment agreement to more discussion on financial stability and growth. However, misplaced confidence can be dangerous if it reduces pressure for necessary policy adjustments.

There is a striking difference between financial crises in memory and as they actually play out. In memory, they are a concatenation of disasters. As they play out, the norm is moments of panic separated by lengthy stretches of apparent calm. It was eight months from the Korean crisis to the Russian default in 1998; six months from Bear Stearns’s demise to Lehman Brothers’ fall in 2008.

Is Europe out of the woods? Certainly a number of key credit spreads, particularly in Spain and Italy, have narrowed substantially. But the interpretation of improved market conditions is far from clear. Restrictions limit pessimistic investors’ ability to short European debt. Regulations enable local banks to treat government debt as risk-free, and they can fund it at the European Central Bank (ECB) on better-than-market terms. The suspicion exists that, if necessary, the ECB would come in strongly and bail out bondholders. Remissions sometimes are followed by cures and sometimes by relapses.

A worrisome recent indicator in much of Europe is the substantial tendency of stock and bond prices to move together. When sentiment improves in healthy countries, stock prices rise and bond prices fall as risk premiums decline and interest rates rise. In unhealthy economies, however, as in much of Europe today, bonds are seen as risk assets, so they are moving, like stocks, in response to changes in sentiment.

Perhaps it should not be surprising that Europe still looks to be in serious trouble. Growth has been dismal; the euro-zone gross domestic product has been below its 2007 level for six years, and little growth is forecast this year. For every Ireland, where there is a sense that a corner is being turned, there is a France, where questions increasingly arise about the political and economic sustainability of policy.

The controversy surrounding the decision by the European authorities to bail in Cypriot bank depositors suggests the degree of fragility in Europe. The idea that converting a small portion of deposits into equity claims in an economy with a population of barely more than 1 million could be a source of systemic risk suggests the hair-trigger character of the current situation.

Everything is compounded by political uncertainty. Italy’s last election was inconclusive even by Italian standards. Scandals and staggeringly high unemployment are taking their toll in Spain. France is much calmer about its situation than are many outside observers. And Germany’s primary concern is avoiding turmoil ahead of its fall elections. Given a choice, all would almost certainly prefer some kind of macroeconomic unorthodoxy to the breakdown of their monetary union. But there is a serious risk that as nations pursue their parochial concerns, the political and economic situation will deteriorate beyond repair.

Continued structural reform in the most troubled economies is essential, and the work of building a more satisfactory institutional foundation for the euro must go on. Critical to success will be (the belated) recognition of the paradox that in economic policy, as in so much of life, what is good for one is not good for all.

German policymakers constantly note that fiscal consolidation and structural reform were key to Germany’s rise from “sick man of Europe” to today’s position of strength. But Germany’s export growth and huge trade surplus were enabled by borrowing on the European periphery. If Europe’s debtor countries are to follow Germany’s historic adjustment path without economic implosion, there must be a strategy that assures increased external demand for what they produce. Simply put, there cannot be exports without imports. This could come from a German economy prepared to reduce its formidable trade surplus, from easier European monetary policies that spur growth and competitiveness, or from increased deployment of central funds such as those of the European Investment Bank or perhaps other sources. The crucial point is that no strategy for debt repayment can succeed without providing for an increase in the demand for the exports of debtor countries.

Invocation of necessity is not a strategy. As any student of Germany’s experience of the 1920s knows, it is far from a viable strategy to require a nation to service large debts by being austere when there is no growth in demand for its exports.

European policymakers, the International Monetary Fund and others with a stake in Europe’s outcome need to recognize that the history of financial crisis is a history of windows of opportunity missed. New business is always more exciting than unfinished business. And where matters are controversial, forced moves are easier for policymakers because they can be portrayed as moves of necessity rather than choice. So outsiders avoid confrontation and insiders embrace drift. The consequences could be grave.

PHOTO: A police officer walks in front of a bus station where an anti-bailout banner is placed outside the parliament in Nicosia March 18, 2013. REUTERS/Yorgos Karahalis

5 comments

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Excellent, lucid article.
Two of Europe’s main problems are the unwillingness to see the truth or speak it.
Another problem is the European welfare state, a model that worked for decades by providing stability to economies fueled by debt. Now, with low and negative population growth and a currency that distorts the markets, this model is no longer sustainable in most EU countries, and the inability to recognize this fact, let alone do anything about it is increasing the likelihood of major political crises down the road.

Posted by reality-again | Report as abusive

The Eurozone is an artifical construct based on wishful thinking and deception. The sorcerers’ apprentices who conceived it know that is has already failed, but they keep pretending they can somehow save it by trying different experiments.

Posted by pbgd | Report as abusive

Europe’s most fundamental problem is the same as America’s: In every department store shelf, every item says Made in China.

The solution is rather simple: A protective tariff of 25% on every good manufactured outside of Europe.

But big money has no patriotic notions. Big money families, who inherited their wealth, have betrayed both the European worker and the American worker.

The WTO (World Trade Organization) is made up of big money families, spoiled rich kids now with gray hair, and they prey upon the destruction of the middle class.

How can we expect Europe or American middle classes to exist when it can’t feed or cloth itself, but instead depends on Chinese factories?

All your recipes for fixing Europe will fail. First and foremost Europe needs to protect its middle class with a protective tariff. Then European factories will spring up like blades of grass after a rain.

Posted by AdamSmith | Report as abusive

Yes, very lucid article as most statements of Mr. Summers are. Problem is that a way out of this mess is impossible as long the credibility of the democratic process in Europe lies in tatters. Germany will not go along with any sort of EU Marshall plan as long many countries’ governments are driven by greedy and opportunistic politicians incapable of looking after the interests of the sovereign. The social contract between rulers and the sovereign has been broken in to many EU countries. Any reflation funds will flow into the hands of special interests groups and political parties in need of financing and not into productivity gains leading to economic growth.

To a great extent, the ‘easy’ life under the Euro, the lack of foreign exchange alarm bells, artificially low interest rates due to the glow effect of belonging to a club led by the DM, turned our politicians into businessman looking after their own interests and not the interests of the public good they serve. Until that is changed, there is not much hope for the EU currency union. Poor communication on Germany’s part and and a narrow view on the substance of having power on Mrs. Merkel part does not help either.

Posted by lisandro | Report as abusive

isn’t the I.M.F. essentially bankrupt themselves ? so, basically, the insolvent I.M.F. that has no money is stealing other people’s money to pay their own bills. if i didn’t know better, i’d say this is a bank heist by the bankers !

Posted by lynd | Report as abusive