Saturday, December 10, 2011

A New Europe?

Did the crisis summit change anything? The Eurozone countries agreed to cut their deficits--a pledge of course already made and often violated before the crisis--and consented to a fairly vague enforcement mechanism if they fail. Pledging to cut deficits is one thing, actually doing it is another, so the sighs of relief that were heard on Friday can be counted on to give way to howls of protest when new austerity measures are introduced.

As David Cameron, who was not party to this agreement, has already proved in the UK, austerity can be counted on to lead to economic contraction, which will compound the deficit and debt problems. The Eurozone has effectively imposed on itself an equivalent to the gold standard, budgetary fetters to replace the "golden fetters" that were a source of deflationary pressures in the past.

Why make this choice? To persuade the European Central Bank that it can safely purchase the debt of distressed sovereigns without perpetuating the moral hazard that got them into distress. So the ECB will do just enough--it is hoped--to prevent major defaults or bank failures but not enough to expand the money supply, induce the mild inflation that might help to alleviate the burden of debt, or stimulate new demand and hence new investment. It will be assisted by the IMF, which is to receive 200 billion euros from EU member states, though where they will come up with the money remains mysterious, as does the backing for the new emergency fund that the Eurozone is supposed to set on foot next year. The "leveraged EFSF" was laughed out of existence by the markets; it's not yet certain that the new emergency financing arrangements will meet with any better fate. Meanwhile, unemployment will rise, hard lessons will be learned, and a chastised generation will never again experience the irrational exuberance that inflated the various European bubbles until they all burst. So goes the theory, at any rate.

The reality is likely to be complicated by politics a good deal messier than the already convoluted negotiations at the intergovernmental level. Because the real problems will begin when the heads of state and government unveil to their legislatures their plans for slashing budgets to meet the new requirements. Anti-Union sentiment, already on the rise across Europe, will inevitably increase. Nationalist passions will be unleashed. And President Sarkozy has already set a bad example in this regard by snubbing David Cameron in Brussels: he ostentatiously refused to shake the British Prime Minister's outstretched hand. Cameron was of course Mr. Unpopularity at Brussels for doing what British Euroskeptics have always done: he tried to drive a hard bargain. According to Sarkozy, Cameron proposed a compromise in which the Eurozone powers would have agreed to drop their insistence on a financial transactions tax, which the City of London detests. Sarkozy says that he and Merkel refused Perfidious Albion's unconscionable demands on principle. The principle was perhaps worth defending, but not if the cost is Britain's departure from the EU, which Wolfgang Münchau raised as a likely outcome of Friday's dealing.

Germany and France appear to be aiming for a new kind of European Union, a continental power with a federal government endowed with sweeping powers in at least the economic arena, if not across the board. But that cannot be achieved overnight, if at all. In the meantime the two conservative continental leaders think they have finessed the immediate crisis of the euro, done what they could to preserve their chances of re-election, and begun the process that will transform the Eurozone into an EU-bis, without the UK. I doubt that anyone sees clearly where this process ends, if it has any future at all. I have no confidence in the economic underpinnings of this deal, and its political contours, at best vague, will no doubt be battered into unrecognizability as the consequences of the economics explode in various ways across the continent.

Nothing was settled in Brussels, except perhaps the end of the European Union as we have known it for the past 20 years.

Eichengreen Is Right ...

... or at any rate I agree with him:
The collapse of the eurozone would, of course, be an economic and financial calamity. But that is precisely why the European Central Bank will overcome its reluctance and intervene in the Italian and Spanish bond markets, and why the Italian and Spanish governments will, in the end, use that breathing space to complete the reforms that the ECB requires as a quid pro quo.
To be sure, Europe will not be spared the pain of a recession. A botched bank-recapitalization plan and the cloud of uncertainty hanging over the euro mean that recession is already baked in. Moreover, the pro-growth reforms needed in countries like Italy will almost certainly make things worse before they make them better. The initial effect of reducing hiring and firing costs, for example, will be layoffs of redundant workers. But investors look ahead, so reforms that promise an eventual return to growth should reassure them.

Of course, O'Rourke is also right:

As many feared and most expected, the just-concluded European summit left much to be desired. Once again, Europe’s national leaders showed themselves to be in denial about what underlies the eurozone’s economic, banking, and sovereign-debt crises, and thus hopelessly unable to resolve them.
Durchwursteln: it sounds better in German. Europe will muddle through.