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Groundhog Day in Europe

Friday, July 6, 2012

European policymakers have to be concerned that the half-life of their band-aids is getting shorter and shorter while resistance to these measures gets stronger and stronger.

More than two years into the European debt crisis and 19 European summits later, an all-too-familiar pattern has established itself. Generally, these summits are convened in response to an intensification of a crisis, and generally they come up with just enough of a policy response to defuse the crisis for a short while. However, once markets figure out that the policy response merely addressed the symptoms rather than the underlying causes of the crisis, it soon re-emerges in a more virulent form.

Last week’s European summit seems to have followed this pattern and it remains to be seen whether this time around it buys Europe as much market calm as previous summits. By allowing the European Stability Mechanism (ESM) to lend directly to the Spanish banks and by allowing the ESM to buy sovereign debt of Italy and Spain in the markets, the European summit has provoked a sharp short-covering rally in European equity and bond markets. However, one would have to be blind to the experience of past European summits to think that last week really provided a long-term solution to the European debt crisis.

Among the reasons for skepticism as to the longer-run efficacy of last week’s agreement is that it did not add new money to the European firewall for Italy and Spain. All that it did was to make it easier to use the existing funds that had been set aside for that purpose. One would expect markets to quickly come to the conclusion that the firewall established to prevent the crisis from engulfing Italy and Spain remains woefully inadequate to the task of bailing out both of those countries.

It will not take the markets too long to recognize that the summit did nothing to defuse a number of potential triggers that could set the European crisis off later this summer.

At a more basic level, it will not take the markets too long to recognize that the summit did nothing to defuse a number of potential triggers that could set the European crisis off later this summer. In particular, one would think that it did nothing to relieve the countries in the periphery from the excessive degree of fiscal tightening that their German paymaster is requiring of them at a time of economic weakness and at a time that they are experiencing a credit crunch. This is all too likely to cause a pronounced deepening in the European recession in the months ahead that will not only undermine efforts at budget consolidation but will also accentuate austerity fatigue in the periphery.

The gathering also did not do anything to address the potential for Greece to default on its external debt or for Greece to exit the euro before year’s end. And it did not do so even though those occurrences are recognized as having the potential to cause real contagion to the rest of the periphery in the sense of triggering bank runs in Ireland, Italy, Portugal, and Spain. Nor did the summit do very much to support Mario Monti, Italy’s beleaguered prime minister, who is now coming under attack from former PM Silvio Berlusconi in the context of a deepening Italian recession. In recent statements, Berlusconi has gone so far as to suggest that it is not blasphemous to talk about  the relative merits of  Italy leaving  the euro.

If past is prologue to the future, it will only be a matter of weeks before we get another swoon in Italian and Spanish bond markets that will elicit yet another European summit to provide yet another band-aid solution to the European debt crisis. However, European policymakers have to be concerned that the half-life of these band-aids is getting shorter and shorter at the same time that resistance to the band-aids is getting stronger and stronger. Beyond European policymakers, all of this has to be very troubling to the Obama administration, which desperately needs the Europeans to kick the can forward another four months to get it safely past election day.

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

FURTHER READING: Lachman also writes “The Predictable European Summit Ritual,” “Does Greece’s Election Really Matter?” “Europe Can't Kick the Can Much Farther,” and “Who Lost Greece?” Arthur Herman explains “Why the Death of Europe Is America's Opportunity.” Michael Auslin contributes “Europe Whole or Divided (Or 1648 and All That).”

Image by Darren Wamboldt / Bergman Group

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