Comment on Europe by Norbert Walter

A European economic renaissance is still within reach
Summer 2012
by Norbert Walter

A European renaissance is not only possible but is within reach, argues Norbert Walter. He analyses the different components that make up the eurozone crisis, and assesses the strengths that could overcome them.
What constitutes a crisis? Is it sustainable misery, meaning lasting economic decline, both high and long-term unemployment, poverty, rampant inflation, a precipitate fall in the exchange rate of a currency, fiscal deficits and high-cost finance? Most would agree that any situation would be labeled a crisis if just some of these “misery indices” were being registered. Yet although Europe is in the middle of what is widely perceived as a eurocrisis, only a handful of these variables are in place, and in only a few eurozone countries.

Although repeatedly used, the “eurocrisis” label is inappropriate. The euro, which at birth was already a strong currency at 1.18 to the U.S. dollar, even though the consensus view was that its fair value was more like $1.10 to the euro – has become stronger still. Today, the euro is valued at $1.30, a good 10 % higher than at its launch. And how about its internal value, meaning the performance of the new currency’s inflation rate? The 12-year record is in line with the European Central Bank’s (ECB) inflation target of slightly below 2% and is clearly more impressive than the much-lauded performance over 50 years of its most stable predecessor, the German D-Mark at almost 3% Consumer Price Index increase per annum.

So why is there a eurozone crisis and what is it? Time and again it is argued that the single currency does not fit the different needs of the countries using it. This in turn has encouraged predictions of unsustainable economic divergence that will require abandonment of the euro.

What divergencies between these national economies would warrant such action? Those most commonly referred to are differing growth rates, job creation and unemployment levels and dramatic imbalances in countries’ current accounts. These divergences may be caused by wide deviations in unit labour costs. If perceptions of such divergencies exist, there will be considerable risk premiums for problem countries, with the inevitable result of accelerating capital flight to safe havens.

These are all developments that can unquestionably be observed in the euro area, particularly in its peripheral countries. Risk premiums started rising above benign levels in 2009, and then more strongly in 2011-2012, while capital flight became rampant in 2011, when massively increasing balances in the TARGET2 accounts in the European Central Bank system began to show up.

But if one considers the underlying factors that may have caused capital movements of this sort, suspicion must also fall on unsustainable policies that are wider and more numerous than just monetary and fiscal macro policies, and that also extend to countries well outside the eurozone. In Europe, countries like the UK or Hungary are as much afflicted by structural deficiencies as are some of the peripheral eurozone countries. They have not been greatly helped by having a flexible exchange rate, or at least they have chosen not to exploit it. And internationally there are countries with government debt problems as big if not bigger than Europe’s periphery – with the U.S. and Japan being prime examples. There are also countries like Norway and Switzerland with current account surpluses greater than 10% of their GDP that are resisting currency revaluation.

It’s worth remembering that Germany, which is nowadays seen as the eternal paymaster in a European transfer union, was labelled the “sick man of Europe” for the decade up till 2005. It was a completely uncompetitive Germany that entered the eurozone thanks to excessive wage and price increases that had followed the country’s reunification after the fall of the Berlin wall. Most agree that Germany entered the euro with an overvalued currency – a problem that has since been overcome by competitiveness improvements within the single currency. A nominal devaluation was not therefore needed. And the same has held true for the most recent member to join the eurozone. Estonia’s rigorous wage restraint made the country competitive in the single market in a very short space of time.

Why then should there be such fierce doubts about whether the euro can survive? Some say that the attempts of the IMF and the EU institutions to enforce sound policies in the peripheral countries are bound to fail, and that sacrificing some of their democratic rights in order to keep the currency union afloat is too high a price to pay.

It is not at all clear that this is the right way to look at it. It seems rather more obvious that the efforts of governments and international institutions in fact point the way toward better conditions and more sustainable solutions. Who would have predicted the very welcome changes of government in almost all the peripheral countries? And who six months earlier would have believed that the fiscal pact adopted in March 2012 would have been possible? And despite fluctuations has there not been a considerable reduction of the risk premiums for the problem countries? And did this not happen without adding to the financing costs of donor countries?

There are many questions that only time will answer. Are we currently seeing the tentative signs of our escape from the eurozone’s malaise? Will the readiness of others to help those most deeply affected be sustained? Will the debtor countries be able to stick to really tough reform programmes, or will the man in the street there reject these austere policy prescriptions? And will donors, too, succeed in staying the course and avoiding the sort of backlash that might push them into populist and protectionist actions?

In my view, a European renaissance is not only possible but is within reach. Europe has strategic answers to pressing international issues like energy efficiency, environmental protection and coping with ageing. Europe holds the key for liveable cities and also knows how to overcome narrow nationalism.

We need to keep these strengths in mind when assessing the crisis. Intelligent co-operation within the limits of ensuring we don’t create moral hazard, should be able to prevent panic, while reducing risk premiums and allowing the fuller use of resources. These include the potential for transnational migration flows which should certainly be made easier and more attractive. High levels of unemployment, particularly among young skilled workers, could be avoided if donor countries that need migrants to infuse new blood into their own workforces were able to attract them. More immigration would raise skills and income levels and reduce those governments’ fiscal problems by cutting expenditure on unemployment benefits. Greater labour mobility inside the EU single market would yield other benefits too; it would help create a more open European mindset and thus weaken old nationalistic prejudices.

So will Europe be able to reconfigure its integration process? Will it commit to moving the agenda forward to political union, and thereby address the question of something that has remained missing despite the Single Market, the Schengen Agreement and the Single Currency? The model for a future United States of Europe is Switzerland, a country with four languages and ethnicities, fiscally strong cantons, a single quality top currency and a federal structure in Berne that has a parliament with genuine, even if limited, budget rights.

Europe can achieve positive results it if makes better use of its social endowments, and by encouraging entrepreneurism. If the EU made the most of the competences it already has, and governed more effectively in areas like energy efficiency, alternative energies, environmental issues and liveable cities, it could help the EU as a whole to achieve faster economic growth for at least the next decade, with 2.5% a year certainly not out of reach. More generous support for countries in trouble is essential for achieving this, because the euro must be preserved, even if not necessarily on the base of a larger eurozone. Financial markets would be more easily convinced if support for servicing the peripheral countries’ high levels of government debt was complemented by their acceptance of the fiscal pact along with technical help to strengthen their governance. In Greece, anticorruption officers from the U.S., Italian specialists on increasing tax efficiency, German privatisation experts and Spanish tourism professionals should be made available to speed up the modernisation process there. This all amounts to the much-needed Marshall plan for Greece that is so often called for, but not in the shape of more funds. The shortcomings in Greece’s planning and administrative capabilities has meant over the last decade that the country could only make use of a fifth of the funds being made available by Brussels for modernisation.

There’s a lesson in all this for Europe as a whole as EU member states grapple with the realities – and with the myths – of the euro crisis.

Norbert Walter is the former chief economist of Deutsche Bank Group and head of Deutsche Bank Research.

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