For a couple of days now I have been working on an article to answer this question. The problem is that the question is a moving goal post: things happen almost on a daily basis that makes it difficult to nail down a coherent, workable plan for the continent. I have an answer, but let me first give yet another example of why this is such a dynamic and difficult question to deal with. GoldMoney.com discusses the consequences of the French credit downgrade:
Despite the lack of agreement over the latest (insignificant) iteration of the Greek bailout, what has really shaken the Eurozone to its very core was the new rating downgrade for France, coming on the heels of headlines calling France the “timebomb at the heart” of the EU, it means that sovereign debt concerns are slowly working their way from the periphery to the euro-core. Officials rushed to downplay the impact and importance of the downgrade.
That would be the French Prime Minister who according to CNN said that:
despite the downgrade, French debt remains among the most liquid and reliable in the eurozone.
This statement says more about the euro zone than it says about France… Anyway. Back to GoldMoney.com, who points out that the consequences of this downgrade are indeed very serious:
France is the second largest contributor to the European bailout mechanism (ESM) and hosts one of the largest sovereign debt markets in the world. The number of solvent countries that could serve as a safe haven can now be counted with one hand, and since many of them seem committed to tying their fates to their not-so-prudent neighbours, savers are left with a lot of uncertainty and few solid options to protect themselves against the ever-increasing probability of a currency collapse or a break-up of the Eurozone.
An astute observation. Any search for a way out for Europe begins here, with the countries that are still operating within some kind of predictable parameters. But what countries can we count to that group? The United States? GoldMoney has its doubts:
US bickering over the “fiscal cliff”, an unfortunate phrase coined by Ben Bernanke, has prevented the EURUSD from weakening too much. It really is a race to the bottom as all major world currencies struggle to print faster than their neighbours. Unfortunately that is an almost inevitable development when you base money on political whim, as Ron Paul explains in this recent podcast with GoldMoney’s Andy Duncan.
Ron Paul is wrong about the virtues of returning to a gold standard. It would be a monetary-policy disaster. Other than that, though, the comment about the U.S. deficit problem is right on the money. Fortunately, there are signs that Congress and the president are moving closer together and may at least reach a patchwork agreement for the next couple of years. That will keep the United States in the small group of international safe-haven investment harbors.
That said, America cannot and should not participate in any European financial rescue efforts. The crisis is European in cause, nature and consequences, and any political solutions must emanate from European politics.
What, then, could the Europeans do? Again given the fact that the problem itself is a moving goal post, here are some recommendations:
1. Acknowledge that the crisis has two layers.
The upper layer, so to speak, is the immediate deficit crisis. Welfare states in southern Europe has gotten into a habit of borrowing to spend, and to borrow based on a credit rating backed by the euro. The euro, in turn, has been considered a trustworthy currency because it is ultimately anchored in Germany. When the euro zone was created this gave Greece, Italy, Spain and other less reliable countries a de facto German credit status. When they coupled their own spending habits with Germany’s credit rating they had created a perfect scenario with seemingly free money. The spending habits that this opened for have caused the urgent deficit crisis.
The lower layer is the structure of government spending. Whenever governments create entitlement programs, they make spending promises that are not backed by dedicated tax revenues. The long-term effect is a budget drift in the direction of persistent deficits. When legislators try to compensate by raising taxes they inadvertently increase demand for entitlements (high taxes reduce people’s standard of living and increase long-term unemployment) and reduce the very tax base they rely on. This budget drift has now conspired with the immediate deficit crisis to create a perfect storm of bad government finances.
If Europe’s political leaders acknowledged this two-layered problem they would open themselves to solving their problems productively as opposed to the haphazard approach that is currently more likely to guide them.
2. Reconfigure the euro zone. Ideally, the euro zone countries should abandon the euro entirely. That is however politically unpalatable, but at the same time the current configuration of the currency union is economically unsustainable. Since the common currency has worked like a supercharger on the structural spending problem plaguing Europe’s welfare states, it is absolutely necessary that the ECB disconnects this supercharger – or else the bank will be stuck with an endless assignment to print money.
Instead of bailing out failing welfare states with new money supply and new loans from German taxpayers, the Europeans need to realize that Greece, Spain and other debt-drenched countries no longer belong in the currency union. It would be more prudent to put those countries on a track to reintroduction of their national currencies. That would allow them a chance to re-establish a connection to reality under their own exchange rates, and it would allow the ECB and the remaining euro countries to return the currency to the strength it had prior to the current crisis.
3. Replace the budget balancing requirements with spending caps. Perhaps the most controversial part of any fiscal policy program, this idea has to do with the second layer of the European crisis. Even if Europe had not created its common currency, its welfare states would still have reached a point where they were drowning in their own debt. It would have been less dramatic and probably taken a bit longer, but they would have gotten there anyway.
This means that a solution to the problems related to the currency union will only remove the immediate crisis. Down the road, the troubled welfare states will inevitably be back in the deficit hole again. A reconfiguration of the euro zone will give Greece and its most troubled peers some time to solve their underlying, structural spending problems. In short, they need to dismantle their welfare states and allow people to take control over their own lives again.
This is a superficial three-step framework for putting Europe back on track again. The third step is of course the critical one, and it requires a lot of hard work based on carefully designed reform proposals.
Those proposals do not yet exist, but they will. Soon. I am working on a research paper where I discuss such solutions.
With all this in mind, I would point out that I am not optimistic about the prospect of saving Europe. I do not believe that there is enough political insight, let alone fortitude, to comprehend and act upon an understanding of the true nature of the continent’s crisis. I hope I am wrong, which is why I am working on a “solutions catalog”. But as the goal post keeps moving I grow a little more pessimistic that the Europeans can avoid sentencing 500 million people to a future in industrial poverty.