Desmond Lachman is a resident fellow at the American Enterprise Institute and, before that, a managing director and chief emerging market economic strategist at Salomon Smith Barney. He's also been, from the very beginning, one of the most clear-eyed observers of the European crisis. So earlier Wednesday afternoon, I asked him why these mini-crises keep happening. A lightly edited transcript follows.
Ezra Klein: Let’s back this up a bit. I think, for a lot of people, the crisis in the euro zone feels like something that happened in 2010 and 2011 and maybe 2012 but, in recent months, seemed to be over. So why do we keep seeing eruptions, like the crack-up in Cyprus?
Desmond Lachman: It’s basically because you had huge imbalances build up in a fixed exchange-rate regime. For 10 years these countries didn’t play by the rules of having given up their currency. They should have kept public finances in good shape. They shouldn’t have permitted housing booms. They shouldn’t have had a financial sector making bad investments. But they did all these things. So now what these countries have to do is get their public finances in good shape. But they don’t have their own central banks to pump up the money supply and offset austerity and nor can they depreciate currencies. The reason you’re seeing these crises recurring is they’re trying a recipe that can’t work. And so the economies just keep weakening.
EK: And that’s leading to more crises?
DL: Italy has been in recession for seven or eight quarters. In Spain, unemployment is around 26 percent. This has messed up public finances, but it also causes a political reaction. So look at Italy, which is much bigger than Cyprus, over the last month. They had an election in which they basically have a political stalemate. Sixty percent of the electorate said they don’t want this austerity anymore. So why does it keep happening? Because they’re constrained, they’re forced into a policy path leading you nowhere.
EK: There’s a view in some quarters that this is just a painful, grinding adjustment, but that eventually, the imbalances will be worked out and the euro zone will be on stronger footing, and we can go pretty much back to normal. But what would seem to follow from your view is that weaker economies will lead to worse political situations will lead to more crises.
DL: My view is that things are getting worse. If you just want one metric just look at unemployment. Overall euro-zone unemployment now keeps grinding up, it’s at 9 or 10 percent now. Youth unemployment is in the 20s. Or look at Spain. Spain isn’t a Mickey Mouse economy. They’re at 26 percent unemployment and youth unemployment is 60 percent. This is a social explosion waiting to happen.
And what is the policy recommendation? They need to do more austerity. They need to stay the course. Greece has been in recession for five years, and they still need to tighten their budget. The Cypriot case is their financial sector got out of control. It was 8.5 times the economy. What they managed to do was use Russian deposits to buy Greek bonds. When the Greek bonds got restructured, they suddenly had a big hole in their balance sheet. The Germans, because they have an election coming in September, aren’t prepared to bail out banks in Cyprus because they feel that what they’d be doing is using German taxpayer money to bail out the oligarchs. That makes this a complicated mess.
EK: One theme in your analysis is that the underlying problem here, or at least the mechanism that could pull the whole thing apart, is politics -- that bad economies are creating more unstable politics, and that more unstable politics is leading to more crises.
DL: My view is that what you’re seeing already is the politics coming unstuck in a lot of places in Europe. Greece is the worst example. The extreme left and right has 45 percent of the vote now. The longer that process goes on, the more you’d expect the center to disintegrate. I don’t understand how you can extend this for many more years. But the game plan is they apply this fiscal austerity in 2013, 2014, and 2015. And my problem with all this is I don’t see how, if you’ve got significant fiscal austerity at a time when banks are cutting credit, and Germany is slowing down, and, in Spain, the housing bubble is bursting, I don’t see how this recession ends. And if you don’t have hope -- the politicians keep selling the idea that this will hurt a bit but in six months time we’ll see the green shoots; if you don’t see them, you’re just inviting a political mess.
Take Italy. This guy [Beppe] Grillo came from nowhere. He gets more votes than the two parties. He’s an anti-establishment kind of figure. That’s a measure of how mad Italians are with austerity. I’m just assuming that if the economy doesn’t improve and then gets worse, you can’t expect the politics to get better. When politics gets bad it feeds into economics. Who in their right mind is investing in Italy right now? That begins to drive the economics further into the hole, which strengthens the position of those against the establishment.
EK: So you’re not of the view that we can grind this out without the euro zone either coming apart or some more comprehensive and ambitious solution being attempted. You’re more of the view that the longer we grind this out, the more likely a political problem arises that we can’t solve.
DL: The fact that you’ve got dysfunction in at least five countries -- something is going to happen. What will also happen is policy mistakes will be made. This weekend has to rank as one of the bigger policy mistakes Europe has made. The reason they made the mistake isn’t that they’re stupid. There’s a process. There’s an election in Germany where they would have made a big deal out of bailing out Russian oligarchs. That limited [Angela] Merkel's maneuverability. So what looks like a foolish decision from the economic system might have been a smart move politically. But with five of these countries teetering on the brink, I’m quite sure these crises will keep happening.