Following S&P’s downgrading of European debt in early January, German Chancellor Angela Merkel used her keynote speech at the World Economic Forum in Davos, Switzerland, to implore her euro zone colleagues to implement the budget austerity needed to secure their goal of a “fiscal compact.” While European interest rates fell in the wake of the European Central Bank’s (ECB) decision to provide a long-term funding facility for banks, unfortunately, the higher borrowing costs that will eventually result from lower credit ratings will make the goal of fiscal probity more elusive.

It may be a new year, but Europe faces the same malaise that plagued it in 2011. And, with the application of the same policy prescriptions, the prognosis, sadly, is unchanged.

Euro zone countries that have delegated monetary policy to a supranational authority have, of course, consciously limited their policy options. With monetary policy determined by the ECB, the full burden of country-specific macroeconomic adjustment falls on fiscal policy. In this respect, the old aphorism, “when a hammer is the only tool you have, every problem looks like a nail,” surely applies. For many, however, use of the fiscal hammer is problematic. As others have noted, authorities are trapped in a vicious circle — the more they apply austerity to reduce budget deficits, the more growth suffers.

Under the Bretton Woods system of fixed exchange rates, this dilemma was referred to as the problem of “internal-external balance.” A country with an overvalued exchange rate, and thus suffering from a lack of competitiveness, had two objectives — an external target for the current account balance and an internal target of full employment — and only one policy instrument (fiscal measures) with which to achieve them. Reducing current account deficits through higher taxes and lower spending implied moving further away from the internal balance objective of full employment. In Europe today, many countries face a similar situation, albeit with the added complication that they have run headlong into a debt wall.

In the Bretton Woods era, the solution to this problem was devaluation — an option euro zone members do not have. Instead, they must rely on “internal devaluation” — the euphemism for deflation or relative disinflation — to enhance their competitiveness. But unless wages are perfectly flexible, internal devaluation will entail a protracted, painful period of unemployment that induces workers to accept lower wages.[1]  In this respect, the enormous cost associated with Great Depression levels of unemployment already experienced by some countries is convincing evidence that wages in Europe are not flexible.

Structural reforms are promoted as a means of assuaging this cost by increasing the flexibility of labour markets and creating incentives for investment through product market reforms. Such measures will indeed reduce costs and improve competitiveness, but they take time to implement and even longer to pay dividends. As John Maynard Keynes observed, “In the long run, we are dead.”

Moreover, improved competitiveness would only help the European Monetary Union (EMU) if there is sufficient aggregate demand to absorb the increased supply. Regrettably, with countries outside the euro zone also undertaking fiscal adjustment or targeting current account surpluses, the global economy remains unbalanced; the problem, as Larry Summers, former US treasury secretary, and others have argued, is insufficient global aggregate demand.

Germany could help its EMU partners by providing additional stimulus and boosting aggregate demand, tolerating the resulting deterioration in its current account position in the process. To date, Berlin has ruled this out.

Instead, German officials argue that structural reforms will increase demand by raising future potential output. While such an outcome is theoretically possible, it must be judged unlikely. It is true that higher potential output from structural reforms can raise future expected incomes, but for higher future income to raise current demand, households must be both able and willing to borrow against this higher expected income. Neither condition applies in Europe at present. Banks are scrambling to de-lever, shedding risk in the process. Lending today against the uncertain results of tomorrow’s structural reforms is not a priority. At the same time, individuals are hoarding cash and firms are reluctant to invest, preferring to exercise the option value of waiting. In this environment, an increase of potential output will not translate into effective demand — however valid it may be in a primitive barter economy, Say’s law, or the notion that “supply creates its own demand,” does not hold in a modern monetized economy characterized by pervasive uncertainty and a generalized flight from risk taking and moving into cash.

This is not to say that fiscal austerity and structural reforms are unimportant or unnecessary. Countries that have exhausted their debt carrying capacity and cannot borrow have no choice but to implement austerity measures; meanwhile, a vigorous, successful program of structural reforms that raises potential output can improve long-term debt sustainability and thereby restore confidence. But any potential beneficial effect of higher future potential output on confidence could easily be outweighed by lower near-term growth.

In this regard, in an unbalanced global economy, and lacking the policy levers to raise domestic demand, the outlook for the EMU is bleak. Current actions by the ECB to assure funding to the banking system are not the solution — only a bridge to the solution. At best, members can look forward to a long period of weak growth and painful adjustment. But even this scenario entails risk. Past experience of highly indebted countries undergoing International Monetary Fund (IMF)-supported adjustment programs suggests that the likelihood of adjustment fatigue and policy slippage increases as the social consensus needed to support adjustment erodes. Indeed, as Italian Prime Minister Mario Monti recently warned, people have a limited appetite for exhortations of more austerity and more structural reforms. At some point, citizens will ask why they are bearing the adjustment burden on behalf of bondholders — especially foreign investors. It matters not a whit to them whether the policy has come from Brussels or Berlin, rather than from the IMF.

Euro zone policy makers are thus trapped between the demands of the bond market for fiscal adjustment and the expectations of their citizens for employment. Finding a way out of this dilemma requires the right diagnosis; in this regard, they should heed the lessons of history.

The problem is that Europe has, in effect, recreated the policy disciplines of the gold standard.  Unfortunately, the EMU is not the canonical textbook gold standard, which features the automatic and symmetric adjustment of current account imbalances, with both surplus and deficit countries bearing the burden of adjustment. Rather, the current crisis in Europe is reminiscent of the monetary disorder that characterized the dysfunctional gold standard of the inter-war period. During that time, the policy commitments prescribed by the gold standard came to be viewed as incredible; consequently, capital flows became a source of instability. In addition, given that the Bank of England lacked the resources to be an effective lender of last resort — in contrast to the pre-World War I experience — efforts to restore confidence through fiscal austerity were, ultimately, self defeating.

The inter-war experience suggests that policy commitments ostensibly designed to reduce uncertainty and support economic growth can, paradoxically, become a source of volatility and stagnation if they lack the necessary political and institutional support. History has shown that, in such situations, the “unthinkable” can quickly become the “inevitable.”

The simple fact is that the euro zone is neither an optimal currency area, in which economic shocks have similar effects on its members, nor is it characterized by a high degree of wage flexibility or labour mobility between members that would reduce adjustment costs. Absent economic or political incentives to persevere with austerity, either in the form of some degree of risk sharing across the euro zone, as the IMF has proposed, or through the promise of large future benefits, members in crisis may succumb to the temptation to defect. In this scenario, there is a risk that they will adopt policies that turn the positive sum game of economic union into a zero or negative sum game of “beggar-thy-neighbour.”

Abandoning the euro would, undoubtedly, be disruptive to the countries that exit. But sovereign governments with a popular mandate to protect and advance the interests of their citizens will weigh these costs against the economic, social and political consequences of adhering to the program of internal devaluation. While the potential long-term benefits from the use of the euro and participation in the European project may yet be sufficient to induce the citizens of countries in crisis to “stay the course” with internal devaluation, such considerations are surely less compelling today than they were a decade ago.

Berlin, in effect, wants the countries on the periphery of the EMU to emulate Germany’s experience with the unification of the former East Germany — that is, to transform Europe into an optimal currency area through structural reforms. That process took more than a decade to complete and, it should be noted, was supported by an unwavering political commitment backed by massive fiscal transfers and a national currency. In this respect, while the ultimate outcome of Europe’s current unification project of binding the periphery to the core is uncertain, recent German history suggests that, if the euro zone is to survive in its current configuration, Chancellor Merkel and the German people may have to be prepared to build a true fiscal union and not simply rely on exhortations to others to “do more.”

In the meantime, the uncertainty generated by the crisis in Europe hurts everyone.

History teaches that the international community has a critical stake in how the crisis unfolds. As Charles Kindleberger documented in The World in Depression, a key factor behind the stagnation in the 1930s was the widespread failure of European banks, many of which had accumulated large exposures to the nascent nation-states created at Versailles. The effects of those failures were magnified and spread through the dysfunctional monetary arrangements of the inter-war gold standard. Eighty years later, European banks are once again exposed to highly indebted sovereigns that are struggling to deal with fiscal and monetary crises. And, once again, global economic prospects hinge on the successful resolution of these twin crises.


[1] Irving Fisher’s “debt deflation” effect, in which deflation raises the real costs of servicing debt fixed in nominal terms, is also a risk for countries pursuing internal devaluation.

History has shown that the “unthinkable” can quickly become the “inevitable.”
Program