Kemal Dervis, Vice President and Director, Global Economy and Development
February 17, 2012
It is now clear that the eurozone crisis will continue well into 2012, despite early Februarys recovery in stock markets. Negotiations between Greece and the banks over Greek sovereign debt may yet be concluded, but sufficiently wide participation by banks in the deal remains very much in doubt. Meanwhile, the International Monetary Fund has raised the issue of official-sector debt reduction, possibly even by the European Central Bank, sending the message that a haircut for private bondholders will not be enough to return Greece to financial sustainability.
The IMFs concerns are valid, but the Funds idea is being resisted fiercely, owing to fears of political contagion: other debt-distressed eurozone countries might press for equal treatment. Moreover, the promised increase in IMF resources that would allow it to build a stronger firewall against financial contagion has still not arrived. And all of the changes agreed upon for the European Stabilization Fund (ESF) and the European Stability Mechanism (ESM) have yet to be implemented.
Of course, some positive steps have been taken. The ECBs generous provision of liquidity to European banks at only 1% interest for up to three years has prevented a banking crisis from piling on top of the sovereign-debt crisis. But that initiative has not succeeded in reducing the problem countries longer-term borrowing costs to levels compatible with their projected growth rates: there is just too much long-term uncertainty, and growth prospects are simply too discouraging. Indeed, in mid-January Standard & Poors downgraded AAA-rated France and Austria, in addition to seven other eurozone countries Slovenia, Slovakia, Spain, Malta, Italy, Cyprus, and Portugal.
It now seems clear to almost everyone that one key challenge facing the eurozone stems from the fact that it is a monetary union without being an economic union, an arrangement that has no counterpart anywhere. As a result, divergences in production costs over time cannot be compensated by exchange-rate adjustments.
In the absence of somewhat higher inflation in the surplus countries, say, 4% a year, adjustment requires deflation in the crisis countries to bring about a noticeable relative decline in production costs over time. In practice, such deflation can be achieved only at the cost of high unemployment and social distress. It is therefore unclear whether the current strategy of combining austerity and deflation is politically feasible, which explains the huge uncertainty hanging over the entire eurozone.
Somewhat higher inflation in the surplus countries and larger cross-border resource transfers would give the deficit countries more time, allowing for structural reforms to produce results and reducing the need for deflation. But Northern European surplus countries reject such an approach, fearing that it would weaken the pressure on Southern European debtor countries to undertake structural reforms in the first place.
Beyond the specific problems of the monetary union, there is also a global dimension to Europes challenges the tension, emphasized by authors such as Dani Rodrik, and Jean Michel Severino and Olivier Ray, between national democratic politics and globalization. Trade, communication, and financial linkages have created a degree of interdependence among national economies, which, together with heightened vulnerability to financial-market swings, has restricted national policymakers freedom of action everywhere.
Perhaps the most dramatic sign of this tension came when Greeces then-prime minister, George Papandreou, announced a referendum on the policy package proposed to allow Greece to stay in the eurozone. While one can debate the merits of referenda for decision-making, the heart of the problem was the very notion of holding a national debate for several weeks, given that markets move in hours or minutes. It took less than 24 hours for Papandreous proposal to collapse under the pressure of financial markets (and European leaders fear of them).
Around the world, the stock of financial assets has become so large, relative to national income flows, that financial-market movements can overwhelm most countries. Even the largest economies are vulnerable, particularly if they are highly dependent on debt finance. If, for some reason, financial markets and/or Chinas central bank were suddenly to reject US Treasury bonds, interest rates would soar, sending the American economy into recession.
But being a creditor does not provide strong protection, either. If Americans appetite for Chinese exports suddenly collapsed because of a financial panic in the United States, China itself would find itself in serious economic trouble.
These interlinked threats are real, and they require much stronger global economic-policy cooperation. Citizens, however, want to understand what is going on, debate policies, and give their consent to the types of cooperation proposed. Thus, a more supra-national form of politics is needed to re-embed markets in democratic processes, as happened during the course of the twentieth century with national politics and national markets.
The scale of this challenge becomes apparent when one sees how difficult it is to coordinate economic policies even in the European Union, which has moved much further than any other group of countries in the direction of supra-national cooperation. Nonetheless, unless globalization can be slowed down or partly reversed, which is unlikely and undesirable in the long run, the kind of politics beyond borders for which Europe is groping will become a global necessity.
Indeed, the European crisis may be providing a mere foretaste of what will likely be the central political debate of the first half of the twenty-first century: how to resolve the tension between global markets and national politics.