Simon Johnson, the former chief economist at the International Monetary Fund, is the co-author of “13 Bankers.”
Official Washington was gripped last weekend by euphoria, at least briefly, as people attending the annual meetings of the International Monetary Fund began to talk about how much money it would take to stabilize the situation in Europe. At least one éminence grise suggested that 1.5 trillion euros should do the trick; others were more inclined to err on the side of caution, and their estimates ran as high as four trillion euros.
Perspectives from expert contributors.Today’s Economist
Perspectives from expert contributors.
Ideally, investors would also give Greece and Portugal some time to find their way to back to growth.
But this is the wrong way to think about the problem. The issue is not money in the form of external financial support, whether provided by the I.M.F. or other countries to parts of the European Union. The real questions are whether Italy will get complete and unfettered access to the European Central Bank, and when we will know.
The big-package approach to economic stabilization was most famously demonstrated in the 1994-95 Mexican crisis. With Mexico’s currency under great pressure, President Ernesto Zedillo and Finance Minister Guillermo Ortiz arranged a $45 billion loan, a large part of which came from the United States.
This may look small today, but it was then seen as a large amount of support. President Zedillo famously remarked that when markets overreact, policy should in turn overreact — meaning, in this context, put more money on the table than is needed. When the financial firepower made available is overwhelming, as it was in the Mexican case, it does not have to be used — in fact, the Mexican loan was repaid in about a year.
But this version of Mexican events skips an important detail. While the external financial support helped prevent the complete collapse of the currency, the Mexican peso did depreciate significantly, which helped immensely. Before the crisis, Mexico had a large current account deficit: it was importing more than it was exporting, and the difference was covered by capital inflows (mostly foreigners willing to lend to the Mexican government).
When the peso fell in value, exporting from Mexico became much more attractive; an export boom of this kind always helps close the current account deficit and stimulate the economy in a sensible manner.
Important parts of the euro zone, like Portugal, Greece and perhaps Italy, badly need a reduction in their real costs of production. If their currencies were independent, this could be achieved by a depreciation of their market value. But this is not an option within the euro zone, and it is within the zone that they need to become more competitive.
These countries could cut nominal wages — a course of action being pursued, for example, in Latvia. But Latvia is a special case for many reasons, including its desire to become much closer with the euro zone, which it aspires to join. It is unlikely that any Western European government making such a proposal would last long.
Unable to move the exchange rate and unwilling to cut wages, the Portuguese government is embarked on an innovative course of “fiscal devaluation,” meaning it will cut payroll taxes, to reduce the cost of labor, while increasing the value added tax, or VAT (a tax on consumption), as a way to maintain fiscal revenues.
Unfortunately, “innovative” in the context of stabilization policies often means “unlikely to succeed” — and the precise implementation of this plan, with some very complex details, seems fraught with danger.
Europe needs a new fiscal governance mechanism, to be sure. Why would Germany — or anyone else — trust Italy under Silvio Berlusconi with a big loan or unlimited access to credit at the European Central Bank?
Greece and some other countries have serious budget difficulties. Most of the European periphery also faces a current account crisis, and something must be done to increase exports or reduce imports, or both.
If the exchange rate can’t depreciate, wages won’t be cut and “fiscal devaluation” proves unworkable, activity in these economies will need to slow a great deal in order to reduce imports and bring the current account closer to balance – unless you (or the Germans) are willing to extend these countries large amounts of unconditional credit for the indefinite future.
And if these economies slow, their ability to pay their government debts will increasingly be called into question. Last week the I.M.F. cut the growth forecast for Italy in 2012 to 0.3 percent. With interest rates rising toward 6 percent, it is easy to imagine Italy’s debt relative to G.D.P. climbing even further than in the still-benign official projections.
If Italy or any other euro-zone country were in good shape and could pay its debts, the European Central Bank could provide ample short-term support, through buying up bonds to prevent interest rates from reaching unreasonable levels.
The euro is a reserve currency — meaning investors around the world hold it as part of their rainy-day funds — and all European debt is denominated in euros. In Mexico in 1994, for example, much of its debt was in dollars; in such a situation, a foreign loan can help stabilize a crisis, because it provides reserves to the central bank, and this removes the fear that the exchange rate will depreciate excessively. But even in such a case the right policies have to be put in place.”
If Italy cannot pay its debt, then the European Central Bank has no business lending to it. The Europeans have to decide for themselves: Is Italy’s fiscal policy reasonable and responsible? If yes, provide full support as needed — from within the euro zone. If not, then find another way forward.
But please get a move on with this decision.
