Addressing the Root Cause of Europe’s Debt Woes
Why will a short-term debt relief plan for Europe lack credibility?
- The sovereign debt crisis is a symptom. The disease is a profound loss of competitiveness.
- The euro area is the target because it is easier for speculators to pick off euro area countries one by one.
- Europe must abandon its culture of entitlement. Prosperity is not a birth right.
The euro is playing the starring role this week in a global loss of confidence in bonds issued by governments, although the average government deficit and debt situation of euro area countries is actually no worse than that of the United States, the United Kingdom and Japan.
The euro area is the target because it is easier for speculators to pick off euro area countries one by one. But this is not the root problem. Even if the euro were somehow broken up, the underlying problem of the credibility of sovereign debt would still be there.
The real problem of almost all developed countries, except Germany, is that we have used government and/or private borrowing to alleviate the symptoms of a deeper loss of earning capacity.
The sovereign debt crisis is a symptom. The disease is a profound loss of competitiveness.
Since about 2000, the developed world, except Germany, has lost ground in the competition to produce goods and services at prices the rest of the world is willing to pay. China, India, Brazil and others are now competing for markets that the developed world previously monopolized. They are doing so with technologies developed in the West, but at costs much less than those prevailing in the West.
This loss of market dominance over the last decade should have meant a fall in relative living standards over the same period. But almost all developed countries avoided this, and kept their standards up, by borrowing more, either directly as households or indirectly through their governments. In Ireland during the boom, the number employed in the trade sector actually fell, while the number employed in services ballooned. This was all too easy because the countries, like China, that were winning markets lent their profits back to us at cheap interest rates.
In essence, the cause of today’s debt problems is that developed countries awarded themselves a living standard they had not earned. That could not go on forever. Now we must tackle the disease as well as its symptoms.
What we should have learned along the way, and may yet need to fully come to terms with, is that the terms of trade actually do move in both directions, not just in favor of what used to be called the “Global North.”
Any short-term fix for the euro area’s finances must be accompanied by a long-term plan to rebuild our capacity to produce goods and services that the rest of the world will want to buy on a greater scale than they are doing today.
Europe must abandon its culture of entitlement. Prosperity is not a birth right.
For example, there must be education reform. Third-level education in Europe must be changed from being an undemanding and free rite of passage for young people into an innovative and flexible system to help people of all ages, particularly those who have lost their jobs, to readapt themselves for a world that has changed dramatically.
Getting our costs down will also require an end to restrictive practices, and padded costs, in the government sector, in schools, in the labor market and in the professions. However indirectly, all these reduce Europe’s ability to reduce its export prices enough to win back markets abroad. This is particularly necessary in countries like Italy and Greece, but also in Ireland.
And yes, this will entail postponing increases in living standards, paying more in taxes and getting fewer benefits from the government than before. Saying anything else would be a lie. Germany did this in the 1990s when it dealt with the huge costs of reunification. Since 1990, living standards in Germany increased by only 20%, whereas they increased by over 100% in Ireland, for example. Germany kept its costs down, shared the burden of adjustment by short time working rather than unemployment, and focused on exports.
Some will argue that what worked for Germany will not work for Europe as a whole. They will say that if the rest of Europe adopts an austerity and export model, there will be no market for the exports because of the austerity. Their preference would be for Germany to start inflating its economy, so as to buy the exports of the rest of Europe.
That will not work for a number of reasons. If Germany did inflate its demand, the imports would come from the rest of the world, not from the rest of Europe (unless, of course, the rest of Europe becomes competitive). Furthermore, as is the case with other European economies, Germany has an aging population and needs to save now to support its future retirees.
This is also a problem with proposals for the issue of eurobonds to meet the funding needs of euro area countries that are too weak to borrow commercially on their own account. Until the rest of Europe becomes competitive, these bonds will essentially be issued against the credit of Germany. Given the country’s demographic challenges, Germany’s credit has limits.
The European Central Bank (ECB) can give out more credit as a way of getting through our present short-term difficulties. That is what it is doing by buying bonds of countries like Ireland, Italy and Spain. It could also extend a credit line to the European Stability Fund to allow it to buy bonds, too. To the extent that such activity increases money supply faster than present, or future, economic activity justifies, it builds up future inflation.
And just whom does inflation hit hardest? Elderly people with fixed incomes, and those with savings.
Of course, you can guess which European country has the biggest number of people who will soon be in that category: Germany.
Germany was compelled to increase the money supply to pay for the cost of World War I and for reparations after it, and that led to the inflation of the 1920s which, in turn, wiped out the German middle class. That is not just part of some vague German folk memory, but families’ real-life experiences. It explains why Germany insisted that the ECB’s mandate be concerned solely with keeping inflation in check.
What is needed now for Europe as a whole is a convincing overall plan, a plan that links short-term relief for those with financial difficulties, with long-term plans to permanently lift productive capacity. Only in that way can Germany be convinced that short-term relief now will not lead to more inflation later.
It is not reasonable to expect German Chancellor Merkel to produce such a plan on her own. That would be seen as an imposition, or worse, as a German diktat. Every euro area government has to contribute.
We all must start thinking as true Europeans and devise a plan that is based on realism and modesty in what we ask of our neighbors, and strict honesty in what we ask of ourselves. None of us can solve our problems on the back of someone else’s sacrifice.