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Europe’s Debt Crisis: The Most Difficult Decisions Are Ahead

Why is the euro area’s debt crisis only beginning — and how can it be overcome?

March 9, 2011

Why is the euro area's debt crisis only beginning — and how can it be overcome?

Chancellor Angela Merkel and I will never let the euro down, never,” President Nicolas Sarkozy said at the World Economic Forum in Davos. “To those who want to bet against the euro, watch your money, because we are fully committed to defend the euro, in a structural way.”
Now, both France and Germany must walk the talk. Still, the question remains: How?

The pivotal role of Germany and France

After two devastating world wars, the European Economic and Monetary Union was developed to defuse the tensions between France and Germany. In the near future, the commitment of the two nations to the original vision will be tested.

Despite current promises of “full commitment,” each nation is under rising economic and political pressures.

In 2010, the French budget deficit amounted to 7.7% of GDP. The government’s short-term growth projections of 2-2.5% are simply too optimistic.

For now, there are no serious austerity programs in place in the country. In late 2010, the proposed pension reforms sparked huge mass demonstrations. And it would be naive to expect tighter fiscal discipline until after the presidential election of 2012.

In the coming months, the eurozone debt crisis is likely to prompt new waves of downgrades, which may not spare even the region’s highest-rated borrowers. In such circumstances, France could lose its top AAA rating.

If the French prospects are not immune to uncertainty, what about Germany?

Truth be told, Germany is drifting toward a new crossroads as well. If, however, France’s turning point is economic, Germany’s moment of truth will be political.

In the United States, the 2010 midterm elections occurred in a single day. In Germany, a series of seven elections in the 16 federal states is a multi-month marathon, which will continue until September 2011.

The outcome of these elections will determine the composition of the Bundesrat, the country’s upper legislative chamber. As a result, it will have a direct impact on Angela Merkel’s ability to conduct policy — in Germany and in the euro area.

The current polls do not favor Merkel’s Christian Democratic Union (CDU) and its coalition partner, the Free Democratic Party (FDP), whose support has already collapsed from almost 15% to less than 5% in barely two years.

This series of state elections could turn into a nightmare for Merkel and CDU/FDP, while testing Merkel’s authority as the ultimate eurozone guarantor.

Her credibility has already been harmed by the resignation of the Bundesbank head Axel Weber, whom she saw as the successor of Jean-Claude Trichet as president of the European Central Bank, and the resignation of the popular Minister of Defense Karl Theodor zu Guttenberg following allegations of plagiarism.

As the government is increasingly divided about what to do next about the euro, coalition lawmakers are distancing themselves from the government. While Merkel’s former coalition partner, the social-democratic SDP, has signaled that it is more prepared to undertake the steps necessary to advance the cause of European economic integration, its voters — like those of Merkel’s CDU — might beg to differ.

Falling behind

The European turmoil centers on soaring levels of debt in peacetime, insolvent eurozone countries and “too big to fail” banks, as well as eroding
competitiveness and innovation.

In the coming years, the debt must be contained with an effective stabilization fund (read: about €1,500-2,000 billion). The European zombie banks must be restructured, and systemically critical banks should be recapitalized. Third, an enduring solution requires the debt restructurings of the insolvent eurozone economies.

But even that is not enough. Since the 1990s, the competitiveness and innovation of the entire euro area has been steadily eroding. It must be upgraded as well.

Historically, economic growth begins to stagnate when debt climbs to 90% of GDP. In 2010, the eurozone debt amounted to 84% of regional GDP. Now it is time to pay the bill.

According to the Lisbon Review survey (spring 2010), which ranked major countries and regions based on their overall economic competitiveness, the ranking of East Asia is now higher than that of the United States and significantly ahead of the EU 27 economies, including France and the UK. It is not that the East Asian countries are “not playing fair.” Rather, the source of Europe’s problems is that, after decades of relative prosperity, the eurozone countries have grown complacent.

There is little doubt about the shape and form of the reforms that are required. It is the execution that has failed.

What is needed in Europe is more competition across industries and product markets, especially in the labor-intensive service sectors. Most importantly, flexible labor markets are vital to respond to current challenges. Global competition requires deepening European integration to sustain economies of scale.

In order to counter the problems of aging and rapidly rising dependency ratios, immigration should be liberalized. Finally, R&D expenditures remain too low and innovation investments should be increased.

During the past few weeks, Chancellor Merkel and President Sarkozy have advocated the so-called Pact for Competitiveness. The controversial plan essentially conditions the financial support of the large euro economies on structural reforms in troubled euro nations. The plan has backfired, due to the proposed harmonization of tax rates (which alienated Ireland), debt containment (which angered the deficit-countries) and the adjustment of retirement ages (which estranged most of the euro area).

The simple reality is that, given the current trends, increasing debt is speeding up the secular decline of the entire euro area. Today, the share of the four leading European economies is about 24% of G20 GDP. Even relatively benign scenarios indicate that it will decrease to about 10% by 2050. A fragmented euro area would fare even worse.

Spreading volatility

Today, no advanced economy remains safe from the debt crisis. In Europe, these problems stem historically from the breach of the Stability and Growth Pact criteria of 1995. Before the euro crisis, the 3% budget deficit limit was violated almost 100 times — and the public debt ceiling of 60% was never taken seriously.

Except for wartimes and immediate aftermaths, the public finances of most eurozone countries are in a worse state today than at any time since the Industrial Revolution.

The eurozone crisis also poses penetrating questions about the sustainability of the welfare model, which has been funded at the expense of the living standards of future generations.

Indeed, it is sobering to keep in mind that even if the global crisis had been averted, the average net debt for the G7 economies would have been 200% of GDP by the early 2030s and more than 440% by 2050, as estimated by the IMF.

After this crisis, there is no return to “business as usual.” The European Union is entering a turbulent era.


According to Lisbon Review, East Asia is now more competitive than the United States — and is well ahead of the EU-27.

Western laissez-faire capitalism has failed, and there is no return to "business as usual."

Except for wartime and its immediate aftermaths, the public finances of most eurozone countries are in a worse state today than at any time since the Industrial Revolution.

As with France, Germany is also drifting toward a new crossroads. However, if the French turning point is economic, the German moment of truth will be political.