It’s been awhile since we looked at the mess in Europe, but this is a big week. European leaders are meeting in Brussels to adopt a new deficit treaty. And depending on whom you ask, talks over Greek debt restructuring are either progressing nicely — or threatening the continent. Here’s a rundown:
Didn’t the 17 euro nations already have a deficit rule like this? Yes, the Stability and Growth Pact, which has been in place since 2000. Only three of the 17 countries — Estonia, Luxembourg and Finland — managed to keep annual deficits under 3 percent before the crisis. (Note that even Germany was an offender.) This time, though, the countries are supposed to really, really mean it. It now looks like participating countries will agree to put loose language into their national constitutions expressing their good intentions (making good use of the word “preferably”). And the fines for shirking could be big — up to 0.1 percent of GDP for rule-breakers.
But can Europe really fix itself by reducing its deficits? Probably not. As Wolfgang Munchau recently argued in the Financial Times, the new pact commits Europe to adopting pro-cyclical fiscal policy, which means they may have to cut spending and raise taxes whenever a recession hits and the deficit automatically rises. That, in turn, could worsen economic growth and increase debt burdens in the short term. Indeed, many European leaders seem to be coming around to the view that austerity isn’t a very good way to reduce debt burdens when the economy is weak. See, for instance, Spain. Everyone now agrees that economic growth is the best way to curb debt.
If growth is the answer, how does Europe get more growth? That’s a little murkier. There’s the usual list of proposed labor-market reforms. In many euro zone countries, workforce participation among women and the elderly is incredibly low, thanks to various policies and institutions that implicitly discourage work. Licensing and regulatory restrictions also make many regions in Europe less productive than, say, the United States. As a recent International Monetary Fund research paper found: “Making better use of available labor would allow the euro area to live up to its growth potential and secure its inclusive social model.” Most of these reforms will take some time to put into effect.
Is Europe still facing an immediate financial crisis? It doesn’t look that way for the time being, though things could change quickly. For instance, Italy’s borrowing costs have been dropping of late. That’s not because foreign investors suddenly feel confident about the prospects that Italy will pay down its debt. Instead, the European Central Bank moved last December to basically lend lots of cheap money to euro zone banks, in the hope that they’d buy up their country’s troubled debt. For now, that’s working — Italian banks are buying up Italian bonds, giving the country some breathing room.
Moving on, what’s the deal with the Greek talks? Separate from the new euro treaty — but very much related — are the ongoing negotiations over restructuring Greek debt. Greece, you’ll recall, is insolvent. There’s no conceivable way that the government can pay off everyone who lent the country money. So Greece is now hoping to offer all of its investors a new deal: We’ll trade you new bonds that promise to pay you some of the money back, but not all. Otherwise, we might have to default, in which case, you’ll all get nothing.
That seems fair enough. What’s the sticking point? Private investors mostly seem amenable to Greece’s proposal. The sticking point is that Greece needs a lot of money from the IMF, the European Central Bank, and the European Commission to stay afloat. Those three — referred to as the “troika” in the press — are willing to bail out Greece to prevent chaos, but they also want to impose some harsh conditions, including sweeping budget cuts. Given that Greece’s government has already slashed budgets and watched helplessly as unemployment, poverty, homelessness, and crime rates have spiked, that’s a tough sell.
For example, Germany has insisted that Greece’s budget be controlled by a eurozone commissioner, in exchange for a further €130 billion bailout. Greece, as you might expect, doesn’t like this proposal much. That’s led some observers, such as Fed Watch’s Tim Duy, to predict that Greece might just be angling for one more shot of aid before it finally defaults and exits the euro zone.
“Absent real transfers from Germany, staying in the euro zone now means crushing recession under German rule,” Duy writes. “Exiting just means crushing recession.”
So Europe is still a mess? It sure seems that way. The European Central Bank has managed to ease the short-term market turmoil through its backdoor bailout scheme. But various euro zone countries are still trying (and failing) to cut their debt loads with growth-suppressing austerity. And there’s still very much the possibility that the Greek debt talks could break down. If Greece ends up leaving the euro zone, which would be terrible for everybody.