Europes sovereign debt crisis has sown confusion and opportunity. While the continents southern flank will be forced into painful, growth-sapping fiscal consolidation, the industrial-exporter bloc to the north is rebounding much faster than expected. The weakness of the euro will help this recovery gain traction.
What we have now is a twin-track EMU. On one track is the austerity bloc, which includes Ireland, Belgium, France, Spain, Portugal, Italy and Greece; on the other, the industrial-exporter bloc of Germany, Austria, the Netherlands, Denmark and Finland.
The austerity bloc has bigger government, larger debts and deficits, pays higher interest rates, imports much more than it exports. Its competitiveness has steadily eroded. Its a mess that needs to be rectified quickly if EMU is to survive.
Blocks to recovery
The great fear now is that, even in the face of private sector stabilization, the deflationary impact of public sector retrenchment will prevent nominal GDP in the austerity bloc from recovering. The heavy lifting of fiscal consolidation will have to be structural (spending cuts and tax rises) even in those countries that have debt burdens below 100% of GDP. For those, such as Greece, with debt burdens well above 100% of GDP, it might well be that in a low-growth (or even deflationary) environment, deficit reduction cannot happen quickly enough to prevent debt burdens rising. This is worse than running to stand still.
With so many EMU countries tightening budgets at once, the consensus views the euro as a one-way, downward bet. Normally the euro would be a clear short on its way to parity with the dollar. But these are not normal times.
First, while many southern European countries fiscal positions are in poor shape, as I have argued in this column they are not fundamentally worse than those of the US, the UK or Japan. Second, its hard to argue that the euro is overvalued at todays levels. Although the intra-regional variation in current account balances is wide, the EMU bloc as a whole runs a balanced external account and the euro trades in line with its 10-year average.
Net government debt and structural budget deficits
2009 (Percent of GDP)
Source: OECD, Independent Strategy
The consensus argues that Germanys blinkered determination to impose tough measures on the austerity bloc will have a negative impact on net exports to the region and prevent Europe as a whole from recovering. I dont agree. The austerity bloc countries account for only 12% of German gross exports and 15% of its net exports. German export growth was running at a respectable 10.5% year on year in the first quarter of 2010, with all regions making a positive contribution to that expansion. The German economy overall is growing at 1.5%.
Halfway through the pain
The more serious contagion risk lies in the exposure of the banking system in northern Europe to the possibility of debt default or voluntary restructuring in the south. The European Central Banks latest financial stability report estimates that eurozone banks might need to make provision for a further 90 billion in losses during 2010 and perhaps an additional 105 billion in 2011. In other words, the banks are probably only halfway through the likely pain.
Last year, Germany unilaterally decided to impose upon itself a constitutionally binding quasi-balanced budget amendment. This ensures that with even modest rates of economic growth, Germanys debt/GDP burden will be on a sustained downward trajectory from 2016 onwards. Over the longer term, it will also allow the state sector to shrink, lowering taxes and borrowing costs, thereby liberating the more productive private sector.
The big question is whether the rest of Europe will be able to follow suit? Treaty changes are out of the question for now as there is insufficient support for controversial pan-European rules that undermine fiscal sovereignty. But as the price for its own continued presence in the eurozone, Germany will hector national parliaments to follow it on fiscal rectitude.
Germany is determined to reshape Europe according to its own philosophy of living within ones means. And although the risks of an EMU abandonment have undoubtedly risen, I think the risk of euro demise is still low and that the single currency will hold together, with Germany successfully championing reform.