Robert Samuelson: Europe has no exit

May 2, 2013

For most Americans, Europe is out of sight and out of mind. We figure that the worst of its debt crisis has passed. Italy has a new government. To mute social unrest, some countries are slightly relaxing austerity policies. The European Central Bank (ECB) has stabilized the bond market for weak debtor countries. Despite problems, Europe is muddling through.

Be skeptical — very skeptical.

That’s the main takeaway from a talk Wednesday by economist Hans-Werner Sinn at the Peterson Institute for International Economics, one of Washington’s leading think tanks. Sinn, head of the German think tank Ifo Institute for Economic Research, is a controversial figure in Europe. He has been a regular critic of Europe’s responses to the crisis and has gotten into public tiffs with, among others, multibillionaire George Soros. Sinn doubts that the worst has passed. (Reflecting Europe’s economic weakness, the ECB cut its main interest rate Thursday to 0.5 percent.)

The basic problem, Sinn argued, is that years of easy credit lowered unemployment and raised inflation in debtor countries. As a result, they lost competitiveness, especially compared to Germany. From 1995 to 2008, he noted, prices rose 9 percent in Germany, 40 percent in Italy, 56 percent in Spain and 67 percent in Greece. When private credit dried up (Greece, Portugal and Ireland) or threatened to (Spain, Italy), countries were left at the mercy of official lenders — Europe’s other governments, the ECB and the International Monetary Fund — and their insistence on austerity.

Debtor countries must restore their competitiveness, Sinn argued. Only that will reduce Europe’s massive trade imbalances — Germany’s huge surpluses and debtor countries’ deficits — and establish a foundation for economic recovery. Unfortunately, there are no easy ways to do this, he said. In Sinn’s view, Europe faces three broad choices, all bad.

First, it can continue the present austerity measures, which would reduce wages and prices through steep unemployment and unused production capacity. But those punishing policies are “destroying societies” and would be maddeningly slow. Already, he said, youth unemployment is near 60 percent in Greece and 55 percent in Spain. How much further can countries go? Ultimately, many would default on their government debt (as Greece already has) rather than submit to endless national torture.

Second, debtor nations can regain competitiveness if Germany undoes its price advantage by embracing higher inflation. Annual price increases of about 5.5 percent for a decade might suffice, “which Germany will not accept,” Sinn said. German inflation is running at about 1 percent annually, and the unemployment rate is 5.4 percent, compared with 12.1 percent for the euro area (the 17 countries using the euro).

Third, debtor countries could temporarily drop the euro, restore national currencies and rejoin the euro zone after improving their economies. This would involve default, because most — or all — debts, bank deposits, wage agreements and commercial contracts would be redenominated in national currencies (say, the Greek drachma). There would be damaging side effects, Sinn said. Bank runs would be unavoidable, as depositors would try to get euros before they’re converted into cheaper national currencies. As in Cyprus, governments might impose capital controls restricting money flows in and out of their countries.

Maybe Europe can “muddle through” with some mix of these policies, Sinn said. But he wasn’t optimistic: “We have to have debt relief [in effect: defaults] in a large scale. . . . It’s obvious that some countries borrow too much and don’t have the competitiveness to repay.”

There was pushback to Sinn’s glum prognosis. Economist William Cline of the Peterson Institute said that predicting default was more likely to bring it about. The ECB’s pledge to support debtors’ bonds had lowered interest rates. Resurrecting the possibility of default would raise interest rates and increase debt burdens. Jacob Kirkegaard, also of Peterson, suggested that the ECB can provide the credit needed to sustain trade imbalances. The alternative would be much worse.

Broadly measured, Europe represents one-fifth of the global economy. The question is not who’s right and who’s wrong. No one really knows. Europe may be out of sight and out of mind, but it’s not out of trouble. Europe has no obvious exit — and this weighs on the rest of the world.

Read more from Robert Samuelson’s archive.

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