Barack Obama, US president, spoke to Nicolas Sarkozy, president of France,
after the latter’s weekend meeting with Angela Merkel, Germany’s chancellor,
to press for action.

Herman Van Rompuy, the European Council president, has promised that leaders
of the European Union would meet on October 23 to “finalise our
comprehensive strategy”. That would allow the Europeans to present a plan
for restoring confidence to the summit of the Group of 20 leading economies
in November.

So should we feel confident that the crisis will soon be over? No.

At least, nobody now sees the eurozone crisis as a little local difficulty. It
has become the epicentre of an aftershock of the global financial crisis
that could prove even more destructive than the initial earthquake.
Potentially, it is a triple shock: a financial crisis; a crisis of
sovereigns, including Italy, the world’s third largest sovereign debtor; and
a crisis of the European project with unknowable political consequences. It
is no wonder people are frightened. They ought to be.

A straw in the wind of the rising anxiety is that credit default swaps on the
eurozone’s most creditworthy large sovereigns, France and Germany, have
begun to rise (see chart). Astonishingly, Germany’s spread is a fraction
higher than the UK’s. This must reflect concern that bailing out weaker
eurozone members might become an excessive burden. My standing view is that
Germany will do whatever it can to keep the eurozone functioning, provided
it does not threaten its own solvency. As Hans-Werner Sinn of the CESifo
institute in Munich notes, this threat seems to be closer.*

Against this fearsome background, what should (and can) the eurozone do? The
most important part of the answer, as I argued last week, is that it must
deal with the immediate crisis in ways that also help resolve the
longer-term challenges.

The broad consensus of the world’s policymakers and commentators is that the
eurozone must now do the following: divide countries in difficulties into
the insolvent and the illiquid; restructure the debts of the former and
provide unlimited, but temporary, support for the latter; and recapitalise
banks, after stress tests that allow for losses on sovereign debt, either
from national treasuries or from the European financial stability facility,
in accordance with the flexibility given by the decisions taken in July 2011.

Achieving this package will stretch the eurozone’s inter-governmental
decision-making to (and quite possibly beyond) breaking point. The French
government, for example, remains unwilling to accept that its banks need
more capital. Above everything, the eurozone does not have a central bank
willing to ensure liquidity in the market for sovereign domestic currency
debt at all times. This is partly because doing so conflicts with Bundesbank
ideology. But it is also because it would provide a blank cheque to
irresponsible members, ultimately bringing down the euro, just as the rouble
zone collapsed in the 1990s.

My concern is deeper: these ideas, albeit now necessary, deal with the
symptoms of what has gone wrong, not the underlying causes.

As I have long argued, at bottom this is far more a balance of payments crisis
rooted in financial sector misbehaviour and cumulative divergence in
competitiveness, than a fiscal crisis. The architects of the eurozone
thought that balance of payments crises were impossible in a currency union.
They were wrong. In the absence of automatic cross-border financing, an
unfinanceable external deficit will emerge as a domestic credit crisis.
Then, even currency risk will return if the union is among largely sovereign
states.

It is not the case that the countries in difficulties had irresponsible fiscal
policy before the crisis. Greece did. Arguably, Italy did, given its huge
debt overhang. But Ireland and Spain had fiscal surpluses and negligible net
public debt: Ireland’s net public debt was 12 per cent of gross domestic
product in 2006, while Spain’s was 31 per cent, far below France’s 60 per
cent and Germany’s 53 per cent. Even Portugal’s net debt was 59 per cent of
GDP.

What the vulnerable countries shared was reliance on foreign lending, to
finance either private or government deficits (see chart). When the external
finance dried up, economies contracted. Where the private sector had done
the borrowing (as in Ireland and Spain), the bursting of the asset bubble
caused a huge surge in fiscal deficits. When the public sector had done the
borrowing (as in Greece), the fiscal deficit rose still further.

What could and, in the original design of the eurozone, should have happened
was no financing, a huge depression, falling nominal wages, mass defaults
and, after years of devastation, recovery. This would have been adjustment
without financing. What did happen was financing with quite limited true
adjustment, through ECB funding of dubiously solvent banks and via lending
from other governments and the International Monetary Fund, for Greece,
Ireland and Portugal.

Of the crisis-affected member countries Ireland has had a uniquely successful
adjustment, with a huge depreciation of unit labour costs and a massive
adjustment in the external balance. But, in general, as Prof Sinn notes,
there has been a mixture of financing with recession. The huge challenge is
to make managing the crisis compatible with adjustment.

Critics such as Prof Sinn focus on the risk that excessive financing will
undermine, if not destroy, incentives to adjust. Yet there is an opposing
risk, that forcing adjustment on the weak will fail, because of a lack of
offsetting adjustment in the strong. That would not be a huge problem if
those forced to adjust are small. It is a vast problem if they are large.
The risk is of a downward spiral as austerity is exported and re-exported.

No doubt, a way must be found to deal with the immediate crisis that does not
allow another panic. But that would not be a solution if it merely led to
indefinite financing of fundamentally uncompetitive economies. At the same
time, one-sided and unduly hasty adjustment would exacerbate the downturns
in the eurozone and world economies. What is needed is financing and
adjustment. Unless and until that difficult combination is achieved, we are
delivering first aid not a cure.

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