Europe’s Elephants in the Room

According to Herman Van Rompuy, the President of the European Council, the Summit of Heads of State and Government of the European Council held at the end of March will allow Europe to “turn the corner” on its public debt crisis. Yet, when the 27 members of the European Union met on March 24, the most intractable—and not coincidentally the most important—issues were left unaddressed.The so-called “Pact for the Euro," which Mr. Van Rompuy trumpets, does include some serious reforms. The bargain, struck at a meeting of the 17 Euro Zone members earlier this month, is ostensibly based around three pillars: sustainable public budgets, improved competitiveness, and a stable financial system. Specifically, it includes new austerity measures such as caps on government spending and an agreement to reduce government debt to GDP ratios to 60 percent. An agreement was also reached to create a successor to the European Financial Stability Facility (EFSF), the bailout fund, which is currently set to expire in 2013. While these measures may seem substantial, they cannot and will not solve Europe’s debt crisis because they do not address three fundamental problems: large sovereign debt burdens, the fragile banking sector, and diverging competitiveness.First of all, the budget reforms are focused on tackling fiscal irresponsibility, which, with the exception of Greece, was not the cause of the crisis in the peripheral countries. Ireland, for instance, was actually running a fiscal surplus prior to the crisis. Moreover, the problem of existing debt is left unaddressed. Debt levels in the periphery are unsustainable; the gross debt to GDP ratios stand at 130, 93 and 83 percent of GDP in Greece, Ireland, and Portugal, respectively. Ratings agencies have steeply downgraded the default ratings of all of these countries, and their problems will only get worse. The prevailing interest rates—5.8 percent in Ireland and even higher in Greece and Portugal—far exceed the growth rates these countries can hope to achieve in coming years. To make matters worse, their governments continue to run large fiscal deficits. This means that without intervention, these countries will become progressively more indebted with each passing year.Secondly, the proposals do not address Europe’s fragile banking system. While a “stable financial system” was a stated goal of the Summit, nothing substantive was proposed to achieve this objective. Existing measures have been lackluster. For instance, last year’s stress tests—intended to relieve concerns about Europe’s banks—were not rigorous. As proof, Ireland’s banking system was declared sound in June, but was bankrupt by November. If this was not enough to tax credibility, the tests did not even consider the possibility of a sovereign default. For European banks, which remain highly leveraged and extremely exposed to government debt on the periphery, this is a serious flaw. As was so painfully learned during the financial crisis, bank problems tend to become government problems.Finally, the competitiveness reforms will be too little, too late. Unit labor costs in the periphery far exceed those in the core, by more than 20 percent in some estimates. Without the option of devaluation, real wages and prices must fall in order to regain competitiveness. This process is slow, and in several countries it has yet to begin. In February, for example, the inflation rates of Greece, Spain, and Portugal all exceeded the Eurozone average . This means that the price of their goods and labor were actually increasing relative to other Euro Zone countries. Only Ireland’s competitiveness is improving, albeit very slowly.Such austerity is painful for any country, but it is especially precarious in democracies unaccustomed to it. Just last Wednesday, the Portuguese Prime Minister was forced to resign in the face of opposition to austerity measures. Investors may come to doubt whether voters will be willing to acquiesce to the years of pain which will be required of them. If the European Central Bank raises interest rates, as they are soon expected to, the pain will only be multiplied.Since the sovereign debt crisis began with Greece in May 2010, European leaders have been playing a game of kick the can. First there was the Greek bail-out, and then came the Irish package. The markets have become less impressed with each passing “rescue.” It is time for European leaders to begin addressing the real problems facing the euro. If they do not, either the markets or voters in the periphery will. They may not like the results. Jordan Heim is a Master’s Candidate at the Elliott School of International Affairs. He is studying International Trade & Investment Policy, with a concentration in International Economic Policy Analysis. This image is being used under Creative Commons licensing. The original source can be found here.