One European scenario shows Germany dominating Europe, forcing austerity on its southern neighbours as a price for staying in the eurozone. A second scenario suggests a eurozone break-up in protest against humiliating austerity.
Greece has just voted for a new austerity package after a heated Cabinet debate led to the exit of several ministers. Optimists see this as proof that, when push comes to shove, eurozone members will do what was earlier politically unthinkable. But pessimists argue that Greece is notorious for making promises that it does not implement, and this is just one more.
Despite pledges over a year ago to privatise massively and slim down the civil service, not a single significant Greek asset has been privatised, nor a civil servant sacked. Greeks view public sector assets and jobs as untouchable, and are furious at having to sacrifice these at Germany’s behest. Strikes and agitations galore have erupted against the proposed austerity, which may imply deep recession for years.
All southern eurozone members, jointly called the Piigs (Portugal, Italy, Ireland, Greece and Spain), are in dire fiscal straits, and have been forced to adopt austerity and politically-difficult structural reforms to qualify for a German-led rescue. Not just Greece but the others too may rebel against wage freezes and recessions. Disgust in Germany fully matches disgust in Greece.
The integration of East Germany into West Germany took a decade and cost billions. So, German voters don’t want to spend vast additional sums on what they view as the lazy, spendthrift bums of southern Europe. Academics say that to survive, the eurozone must become a fiscal union that permanently ensures transfers from surplus to deficit states (as happens between Maharashtra and Assam). But Germans and other northern European voters bristle at the prospect.
If Greece cannot get rescue funds by March, it will default on debts, have to abandon the euro and restore its old currency, the drachma. While doing so, it can devalue massively, making its exports far more competitive. Remember, Russia defaulted in 1998 and Argentina in 2002, and both bounced back brilliantly.
Some Greeks would prefer the Russian-Argentinian path to a decade of frozen wages. However, the short-run consequences of defaulting and leaving the euro will be traumatic. Greek citizens with bank deposits or other financial instruments will find their euro assets redesignated in devalued drachmas, wiping out half or more of their value.
Many Greeks are already switching deposits from Greek banks to foreign ones to protect them from forced exchange into drachmas. If Greece exits the eurozone, its banks will go bust, foreign exchange will be scarce and rationed, inflation and unemployment will soar.
This is why Greek politicians have agreed to once-unthinkable welfare sacrifices. Yet, not even these may suffice. The fundamental flaw of the eurozone it that high-productivity members (Germany, Holland and Finland) and low-productivity Piigs are locked into a common currency, the euro. The euro is very undervalued for productive Germany, which, therefore, has booming exports. But the euro is too strong for the Piigs, who have worsening trade deficits.
Most discussion of the crisis focuses on the fiscal deficits of the Piigs. Yet, Martin Wolf of the Financial Times has sho-wn that the Piigs are by no means the worst in the eurozone if measured by their fiscal deficits or debt/GDP ratios. However, the Piigs have huge trade deficits. So, the eurozone crisis is fundamentally a balance of payments crisis. Since all members use the euro, trade imbalances between them are not headline news.
But they are massive. The Piigs have unpaid trade deficits of over 500 billion, mostly with Germany, via TARGET 2 balances within the European payment system. This trade problem has translated into a fiscal problem because an uncompetitive exchange rate has saddled the Piigs with very slow or negative GDP growth, creating revenue shortfalls and, hence, rising fiscal deficits.
Some northern Europeans want to expel Greece, making the survival of the rest easier. They say Greece should never have been allowed into the eurozone; that it qualified by cooking its books; and that after the cooking was discovered, expelling the cook was regarded as politically impolite. They argue that other weak members – Portugal, Spain, Ireland and Italy – are capable of reforming, but not Greece.
However, the problem of an unfavourable exchange rate affects all Piigs. Many have initiated deep structural reforms of their rigid labour laws, welfare systems and excessive holidays. But they may need a wage freeze and recession for 5-10 years to bring about an ‘internal devaluation’ that makes them competitive with Germany. Will their political systems withstand such forced austerity year after year?
The chances are low in Greece, which looks most likely to default and exit. But the chances of default are also significant in the other Piigs. Portugal is already paying an unsustainable 11% on its bonds. Italy, a G7 member, is paying 5.5% interest on 10-year bonds. This is down from 7% in December, a positive trend. Yet, even 5.5% is unsustainable unless Italy starts growing reasonably fast. Nobody can guarantee this.
If the current crisis continues for years, southerners may rebel against continued austerity while northerners may rebel against non-stop rescues and transfers to the lazy bums. So, political pressures for breaking the eurozone could build up from both ends. European politicians are trying manfully to save the eurozone, but they have a very tough task ahead.