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Europe Confronts Stein’s Law

Thursday, November 18, 2010

If something cannot go on forever, it will stop. This aphorism appears particularly apt for the current Eurozone.

European policy makers remain in denial about the severity and immediacy of the sovereign debt crisis in Greece, Ireland, Portugal, and Spain. At a time when recent economic and financial market developments underline the intractability of these countries’ solvency problems, European policy makers mainly confine themselves to addressing the liquidity aspects of the crisis. At a time when the peripheral European countries’ massive budget deficit train has long since left the station, European policy makers vainly wrestle with proposals to reform the Eurozone’s architecture to prevent the recurrence of budget profligacy. By so doing, they only delay facing the reality that the euro is presently well on its way to unraveling.

The essence of the Eurozone periphery’s present economic predicament is that the countries there have all run up very large internal and external imbalances that will be extraordinarily difficult to correct without the benefit of their own separate domestic currencies. Stuck within the Eurozone straitjacket, these countries cannot resort to currency devaluation to restore the sizeable losses that they have registered in international competitiveness. Nor can they devalue their currencies to boost exports as a cushion to offset the highly negative economic impact from the major fiscal retrenchment that the International Monetary Fund (IMF) and the European Union are requiring as a condition for their financial support. Attempting to adjust under these conditions must be expected to entail many years of painful deflationary and recessionary conditions for these countries that will only compound their indebtedness problems.

Stuck within the Eurozone straitjacket, these countries cannot resort to currency devaluation to restore the sizeable losses that they have registered in international competitiveness.

The late Herb Stein was fond of observing that if something cannot go on forever, it will stop. This aphorism appears particularly apt for the current Eurozone. It seems unreasonable to expect that voters in the Eurozone’s north, and especially in Germany, will indefinitely acquiesce to transferring large amounts of bailout money to the Eurozone’s south in an effort to keep those countries afloat. And it seems even more unreasonable to expect voters in the south to indefinitely endure the severe economic and social pain associated with continued euro membership and the austerity measures attached to the financing they receive from the north.

In May 2010, a cautionary warning was sounded for Eurozone policy makers in the Westphalian state elections. The voters of Westphalia, Germany’s largest state, handed Chancellor Angela Merkel’s Christian Democratic Union a crushing defeat largely in protest of Merkel’s active role in the Greek bailout package. Electoral considerations of this sort will likely make it all but impossible to enlarge the European Financial Stabilization Facility when it expires in three years.

It seems unreasonable to expect that voters in the Eurozone’s north will indefinitely acquiesce to transferring large amounts of bailout money to the Eurozone’s south.

As recent European Central Bank (ECB) experience amply attests, in principle, European policy makers can use ECB financing to the periphery as a much less transparent form of keeping the periphery afloat. The obvious advantage of using the ECB for that purpose is that its rediscount operations are not subject to the same close parliamentary scrutiny as the budgetary appropriations required for the Eurozone’s other bailout operations. One would think, however, that there must be limits as to how much further the ECB can bend its rules. There also must be limits as to how much further the ECB is prepared to contaminate its balance sheet by accepting more collateral of lesser quality from the periphery’s banks.

European policy makers understand full well that a default in Greece or Ireland is almost certain to trigger contagion to Portugal and Spain. They are also highly aware that a wave of defaults in the periphery would more than likely precipitate a full-blown European banking crisis. These considerations suggest that European policy makers in the north will not lightly turn off the financing spigot that presently keeps afloat the periphery, and thereby the European banking system. Rather, one must expect that European policy makers will continue to kick the can forward in the forlorn hope that something will turn up to rescue the periphery. They might also do so hoping that time will allow the Western European banks to strengthen their balance sheets to more easily absorb the shock of a sovereign debt default in the periphery.

The more likely trigger for the euro’s eventual unraveling will be in the periphery itself. The Greek, Irish, Portuguese, and Spanish governments already have tenuous holds on political power. A deepening in their economic and financial crises could very well result in the ascendancy of more populist governments, which might be less willing to hew to the hair-shirt austerity programs dictated by the IMF or to remain within the euro straitjacket. This essentially precipitated the demise of Argentina’s Convertibility Plan in 2001 after an earlier futile attempt to effect a large-scale, IMF-imposed budget adjustment in a fixed exchange rate arrangement.

Desmond Lachman is a resident fellow at the American Enterprise Institute.

FURTHER READING: Lachman also asks "Do We Really Need a Bigger IMF?" announces "The Emerging Markets' Century," and warns this is "No Time to Underestimate the Eurozone Crisis." Jonah Goldberg observes that "Fools Rush In Where Europe Rushes Out" and Arthur Brooks wonders, "Why Isn't Spain Happy?"

Image by Darren Wamboldt/Bergman Group.

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