Europe's Queasy Status Quo

Europe remains a mess. Portugal has barely escaped a political crisis over the austerity demanded by European Union (EU) and International Monetary Fund (IMF) aid, while Greece has failed, again, to take the required steps for its aid. France, also failing to meet EU strictures, has turned to partial sales of state-owned firms to raise money. Talk of default and contagion has returned. But there is a difference from past bouts of crisis. EU leadership has shown much less anxiety. Markets are calmer, too. There is a general confidence that the common currency zone will hang together for the foreseeable future. It is a reasonable expectation, too, not because the crisis has lifted but because the major players see the continued cohesion of the eurozone as in their narrower interest.

However well people have taken the recent stress, this latest spate of problems speaks to the tenuous state in which Europe still lives. Portugal is especially significant, since it had been the poster-child for European cooperation. It readily embraced EU and IMF demands for austerity, raising taxes and cutting spending in a variety of ways. Portugal's persistent, severe recession may offer proof that austerity alone was never the answer to Europe's economic and financial problems, but the recent ministerial resignations and cabinet reshuffles now argue forcefully that austerity also lacks political viability. Failure in Greece, of course, hardly surprises. That country has fallen short of all its policy objectives since it started the European crisis in 2010. Nor are Cyprus's problems resolved. All of the above is a reminder that Italy, Spain, Ireland, and perhaps even France, probably could not bear too much scrutiny either.¹

This time, official Europe has responded to those problems very differently than in the past. In 2010, 2011, or 2012, the Continent's leadership, faced with such questions, would have called summits, reconsidered past measures, and surely assembled a raft of recriminations. This year, however, the authorities have behaved as if nothing much has gone wrong. Though Portuguese problems reflect sharply on EU policies, they have gone unremarked. More startling, no one has raised a critical word against Greece. Its finance minister has publically voiced misgivings about further spending cuts, while Athens has fallen short on budget reform and the privatizations demanded by its official EU creditors. Yet, neither Brussels nor Berlin nor the IMF has raised a question or an objection. On the contrary, Europe's finance ministers and the IMF readily approved Athens' next €4.0 billion financing traunch. The Germans, once Greece's toughest critic, have actually become boosters. German finance minister Wolfgang Schäuble has spoken of the "great respect" Berlin has "for what Greece has done," adding that "[i]t wasn’t easy, but this is the right way."²

This new approach surely reflects some important lessons learned during the past three years of crisis. For one, European officials have acquired a greater understanding of and sensitivity to markets. They can see that when they have made a fuss in the past, market participants have picked up the emotion and uncertainty, raised interest rates on questionable credits, and so compounded the financing problems that the authorities, in the beleaguered periphery and in the rest of Europe, have dearly wanted to overcome. By keeping calm, the authorities have reduced the chance of such complications. There is more. The Germans in particular, but also the European Central Bank (ECB), can now see that their particular, narrower interests lie with avoiding turmoil and keeping the eurozone intact, even if it is costly.

The ECB's zeal for a broad-based euro has at least two motivations. First is the bank's genuine desire to stimulate economic activity across Europe. ECB president Mario Draghi has certainly committed the bank to monetary stimulus, stating just recently: "Our policy stance has been, is, and will stay accommodative for the foreseeable future." Because he knows that any breakdown in the common currency system would thwart this objective, he also reaffirmed his powerful remarks from last year that the bank will do "whatever it takes" to preserve the euro in its current form. Reinforcing the bank's resolve is the success this stance has had calming markets during the past 12–18 months, even as member nations have repeatedly failed to meet agreed budget targets. The second ECB motivation is narrower and more cynical, but no less powerful. Draghi and all at the bank can see that without a euro there is no need for a European Central Bank, and a diminished euro diminishes the power and prestige of the institution. Germany too, has powerful interests in holding the larger eurozone together. There are at least three.³

First, Berlin has finally come to realize that it cannot avoid paying. It will either help Europe's periphery stave off default or it will have to bail out its own banks. If it refuses to do either, Germany, as well as Europe generally, will suffer an even more severe recession than exists at present. The degree of pressure is impressive. A report by German banks some months ago indicated an exposure of about €400 billion to Greek, Spanish, Portuguese, and Irish debt alone. This amounts to 260% of the banking system's primary capital and more than 16% of the German economy. Adding Italian holdings to the mix would add substantially to this vulnerability. Default by any member nation—or just the fear of default—could then easily cripple German finance and render it incapable of supporting the German economy, much less Europe in general. Financially and politically, then, it is easier for Berlin to rally support for a European rescue of its weaker member nations than face a need to channel public funds into what otherwise would become a zombie banking system.⁴

Second, German industry has come to love the euro. Consider, as no doubt German business has, the problems it would face today if Germany were alone with its old deutschmark. As the only viable economy of size in the eurozone, money is pouring into the country. A separate deutschmark long ago would have risen into the stratosphere, pricing German exports off world markets by raising their prices in terms of dollars, yen, yuan, reals, whatever the currency. The euro, particularly because it has weak members that hold down its foreign exchange rate, has allowed German exporters to compete around the globe much more effectively than they otherwise would. There can be little doubt that their representatives have repeatedly explained this important fact of economic life to policymakers in Berlin.⁵

Third, the common currency also serves German interests within Europe. If the euro were to go, a rising deutschmark would, of course, impair the competitiveness of German product elsewhere in Europe as it would in the rest of the world. But there is more. Because Germany joined the euro while the deutschmark was momentarily weak, and other nations, those in Europe's periphery in particular, joined when their respective currencies were strong, the common currency effectively enshrined a German pricing edge within the eurozone. IMF figures indicate a built in German edge of some 6% when the euro was launched. Since then, German economic gains, especially compared to the disruption and high financing costs in Europe's periphery, have widened that pricing edge further, well into double digits, according to recent calculations from IMF figures. Even if the data and calculation techniques leave ample room for cavil over the exact extent of Germany's pricing advantage, Berlin knows that a dissolution of the euro would erase that advantage.⁶

The resulting willingness to extend support to Europe's beleaguered periphery has quieted markets and raised the possibility that the eurozone will hang together under its common currency for the foreseeable future. Europe will still teeter on the edge of crisis. Aid, after all, is just a palliative, not a solution. The threat of crisis will persist if and until Europe can steel itself to more fundamental economic, fiscal, and financial reform. The periphery needs to take steps of the sort Germany took some years ago under former Chancellor Gerhard Schröder to make its product and labor markets more flexible, efficient, and, hence, more competitive. These could ultimately lift Europe out of this mess. The free flow of aid and confident words can buy time from chaos and disruption to allow for such fundamental economic reforms, but Europe's periphery must make them, and so far, it has hardly begun this crucial next step.