9 WAYS THE EUROZONE IS MORE FRAGILE THAN THE U.S. / NOURIEL UNPLUGGED

January 05, 2015

9 Ways the Eurozone is More Fragile than the US

I may be best known for predicting the global financial crisis and the housing bust of 2008 — but I made another key economic prediction when I warned of major structural risks threatening the Eurozone in 2006.

My remarks proved as prophetic as I'd feared. The crisis I predicted then is still casting shockwaves through the world economy, and may do so for generations to come.

At the World Economic Forum in Davos, Switzerland that year, I said that imbalances in the Eurozone would come to a climax — which might lead to a disaster in Europe within 5 years.

I made my remarks at a panel discussion on the “Ups and Downs of EMU” (European Monetary Union). The panel included several key European finance officials — including Jean-Claude Trichet, who was then president of the European Central Bank (ECB).

In a nutshell, I explained that some countries within the Eurozone — especially Italy, Portugal, and Greece — would experience weaker growth than the economically strong countries at the core of the Eurozone, such as Germany.

This kind of economic divergence would be a major threat to a currency union like the Eurozone, where countries’ inflation rates and interest rates converge.

As I was explaining all this, the Italian finance minister threw a temper tantrum: He interrupted my remarks and began shouting, "Go back to Turkey!" (The minister was making reference to my being born in Turkey — despite having spent two decades living in Italy.)

Unfortunately, by the Spring of 2010, many of the concerns I expressed during that panel discussion in 2006 turned out to be well founded.

Let's take a look at some of the highlights — or, perhaps more accurately said, the low lights — of the last five years in the Eurozone to set the context.

 

"The Euro sculpture is partially reflected in a puddle on a cobblestone pavement in front of the headquarters of the European Central Bank (ECB) in Frankfurt January 21, 2012."
CREDIT: REUTERS/KAI PFAFFENBACH
Source: reuters.com

• In May of 2010, the Greek government was thrown into chaos by a debt crisis; ultimately, Greece was forced to accept a bailout from the IMF and EU, to agree to implement austerity measures in return, and eventually in 2012 to restructure in a coercive way its public debt.
   
• By June of 2010 the member states of the Eurozone were forced to create The European Financial Stability Facility (EFSF) a temporary crisis fund that had to lend over €100 billion to Ireland, Portugal, and Greece after those countries made formal requests for much needed assistance.
   
• In the autumn of 2012, the member states of the Eurozone created an additional fund called the European Stability Mechanism (ESM). The ESM lent nearly €50 billion to Spain and Cyprus to backstop their banking crises by recapitalizing their banks.
   
• Perhaps even more significant, earlier in the summer of 2012 Mario Draghi, the president of the European Central Bank, pledged to do "whatever it takes to preserve the euro." This was a very strong commitment on the behalf of the ECB to use the full force of monetary policy to save the Eurozone.
   
• By 2013 several Eurozone economies received various forms of bailouts from the troika (IMF, ECB and EU): among them on top of Greece were Portugal, Ireland, Cyprus and Spain.

As a consequence of these interventions and Band-Aids, the Eurozone has survived — but now, as we enter 2015, the Eurozone has a host of economic problems that emergency stopgap measures simply cannot fix.

* In this map, please note the differences between the members of the EU that are in the Eurozone, which is the currency union for which the euro is the official currency, and members of the European Union, like The United Kingdom and Sweden, which participate in an economic free trade zone.
Source: spiegel.de

The Eurozone: A Brief Timeline of the Troubles

So what, exactly, is happening inside the Eurozone now? The problems of the Eurozone are, of course, complex, but for the sake of brevity let's take a look at a few of the most disturbing facts that seem to highlight the key difficulties that now exist there:

• The overall inflation rate in the Eurozone now stands at 0.3% — which demonstrates insufficient demand for goods and services – and now the EZ is at risk of outright deflation.
   
• The overall rate of unemployment in the Eurozone is 11.5%.
   
• While 11.5% unemployment is shockingly high by American standards, it doesn't really give you a true sense of just how bad the problem is in the so-called PIGS nations (Portugal, Italy, Greece, Spain) of Europe. In Greece & Spain, for example, the unemployment rate is 25%; even more disturbing, though, the rate of youth unemployment in both of those countries is about 50%, which gives you some sense of the level of desperation and hopelessness among young people there.
   
• In Italy, the rate of youth unemployment is above 30%. Italy's output is 8% below pre-crisis levels, but industrial production has collapsed 25%.  In Italy, this is not just economic stagnation — it's industrial depression.

In fact, it would be fair to say that the Eurozone is just one shock away from outright deflation — a nightmarish state of affairs where a sustained lack of demand and economic growth causes prices to fall.

 

Some people say Europe is going to get 'Japanified' — a reference to Japan's dismal economic performance over the last twenty years, which is sometimes referred to as 'The Lost Two Decades'.

 

But, in fact, the risks in Europe are even worse. While the Japanese have stagnated, Japan has not suffered the sort of debt crisis that’s affected the Eurozone. This is because, unlike the Eurozone, the Bank of Japan has the flexibility and willingness to monetize debt and print money. It's much easier for a national, independent central bank to act to bail out one country than for Frankfurt to attempt to bail out the divergent economies of the Eurozone, where there is no easy one-size-fits-all monetary policy solution to save the day.

 

Rather than get lost in the wonky math of the Eurozone, as macroeconomists so often do, I’d like to tell you about the challenges the Eurozone faces in a slightly more interesting way: By comparing it to a familiar organization of states—the United States of America.

The Eurozone & The United States

1) Rise of Extreme Political Parties

SYRIZA rally. Photo by SYN Flickr
Source: links.org.au

If the 20^th Century has taught us anything, it’s that difficult economic times often lend themselves to political radicalism. Both the left and right seized this opportunity last century and wreaked havoc. The Bolsheviks rose to power after the Russian empire collapsed following economic decline and WWI. Enthusiasm for the National Socialists in Germany followed a prolonged and intense period of deflation and depression.

 

Seventy-five years later, we would be wise to worry if it might happen again. Among the most troubling concerns on the horizon for the Eurozone is the rise of Eurosceptic extremist parties. Most of these parties tend to come from the political right, but there are examples on the left as well, such as Podemos in Spain or—more worrisomely—Syriza in Greece, a well-organized left coalition that is leading in polls and poised to win a majority in the upcoming election late in January.

 

Marine La Pen’s National Front party in France is a perfect example of how such extreme national movements must be taken seriously. For decades, the National Front was merely a nuisance, a hotbed for rightwing cranks and malcontents. Suddenly, in 2014, the National Front won a significant number of mayoralties, and their national numbers continue to grow. (In fact, if presidential elections in France, which are scheduled for 2017, were held today, current polls show that the National Front would win the first round.) They're no longer fringe—they’re now players in a very dangerous game. But, just as we saw in the 1930s, stagnation and insecurity breed resentment.

 

 

When hard times hit, the public looks for someone to blame: foreigners, globalization, or budget cuts from Brussels.

 

Even in Italy populist anti-Euro parties of the right and left could beat moderate centrist parties of the right and left if the current prime minister Renzi fails in his reform drive.

 

We should not underestimate the potential power of these movements. The United States is not free of such disgruntlement, of course, but the Tea Party in the U.S. is now more of a nuisance and a political sideshow than a threat.

 

In short, Europe has a very different kind of history — one it ought to take seriously.

2) Europe's Aging Population

Not long ago Jared Diamond popularized the phrase “geography is fate.” I would pair a phrase of my own beside this wise remark: demographics are fate too.

Source: weknownext.com
Credit: Society for Human Resource Management (SHRM)

 

According to a recent article in the Economist, in the next fifty years the working-age population of Europe will drop considerably, from last year’s peak of about 300 million to 265 million. This will be a significant blow to nearly every aspect of the Eurozone economy.

 

At the same time, the old-age dependency ratio--a fraction or percentage expressing the ratio of residents over the age of 65 to those under that age--will rise from 28% (recorded earlier this decade) to a staggering 58% by 2060.

 

This situation is, in a word, unsustainable.  

 

The causes of this challenge are in Europe are manifold: declining fertility, advances in old-age care, the residue of baby-boom demographics. But the impact will be serious.

 

The United States has managed to combat many of those challenges of an aging population through immigration. In the U.S., Immigrants now make up more than 13% of the total. population. In 2013, the number of immigrants living in the United States, both legally and illegally, topped 40 million.

 

Immigration may help to mitigate Europe's aging challenge, as it has in the United States — and then again it may not. Immigration is a controversial topic in Europe — and it is one of the many issues that extremist parties in the Eurozone have seized upon to attempt to lend themselves legitimacy within their own cultures.  Foreigners, after all, have always made easy targets for extremist political parties seeking to scapegoat others for their domestic economic woes in times of high unemployment.

3) Susceptibility to External Shocks

One of the reasons the Eurozone is more fragile than the United States is pure geography. America is surrounded by huge oceans, with relatively stable and like-minded countries to the north and south. Europe, on the other hand, is only a peninsula off the much larger and much less stable continent of Eurasia.

 

And Africa and the Middle East are right there too, a short skip across the Mediterranean. Thousands of refugees drown in that sea trying to reach Europe each year. Pope Francis recently made reference to this tragedy when he described the continent as a “vast graveyard.”

 

The aging population of Europe grows resentful of the influx. And because of a wide variety of social and historic reasons, Europe does not function as a melting pot, the way America, at its best, can do. (We see this drive toward assimilation in President Obama’s recent executive action, removing penalties for undocumented residents who aim to attain citizenship.) Whereas Germany, by contrast, contains plenty of Turks who have lived in that country for fifty years and still cannot apply for a German passport. They don’t feel like citizens. They can’t own a part of the dream.

 

Europe still has not finished the task of absorbing the former  Iron Curtain countries of Central and Eastern Europe within the EU. Problems there still persist—as recent events involving Mr. Putin have made clear.

Source: russia-eastern-republic.com

 

Eurasia is not an easy neighborhood in which to live. And because Europe cannot make centralized decisions to the same extent that a country like the United States can, coordinating responses to these periodic crises is always a struggle.

4) Labor Mobility & Capital Mobility

There is less labor mobility in the Eurozone than in the United States, since cultural barriers exist between nations with thousands of years of independent history. In the US, workers may flee a recession in North Carolina to seek work in the Northern cities. If there’s a bad shock in Michigan, people can pack up and move to New York. The borders are open between US states and the language is the same. Benefits are often portable.  Whereas in the Eurozone, a number of obstacles prevent this.

  

While there are mechanisms to allow for free movement between Eurozone countries, such as the establishment of the Schengen Area, which allows people to travel without passports between 26 European nations, the Eurozone still has a number of constraints that aren't present in the US which make movement more difficult. The Eurozone is a motley collection of competing languages, cultures, and legal restrictions. In consequence, Europe lacks the crucial shock absorber of a truly open labor market.

 

Source: meristation.com

 

Since the time of Alexander Hamilton, the United States has had an integrated, federalized banking system which allows for the free flow of capital. This advantage has made the US a good deal more nimble and resilient than the Eurozone. While capital mobility exists in the Eurozone, there is not enough of it. Investing abroad in other Eurozone countries means navigating different tax systems, legal systems, often in different languages and cultures. As a U.S. citizen, if you live in Connecticut and want to buy stock in a California tech company, you don't even need to think about it.

 

 

You don't have to call a different broker.  You simply buy the stock. The absence of free movement of capital, in fact, is entirely alien to the American way of thinking.

5) Asymmetric Adjustment

Asymmetric adjustment is a wonky phrase but it’s fairly straightforward to understand. Basically, what it means is that there is an asymmetry between creditors and lenders, borrowers and debtors when it comes time to adjust to economic shocks to the economy.

 

In the Eurozone, this means that countries that tend to spend too much (for example, Greece and Italy) and those that tend to save too much (for example, Germany and The Netherlands) both get hurt when the flow of money ceases.

 

When a shock to the economy arrives, the lending tends to dry up. In this scenario, debtor countries are forced to spend less — but nothing forces the lending countries to adjust and save less. This is what is meant by the phrase 'asymmetric adjustment.

 

For both sides, though, an unstable equilibrium is thrown out of balance. The so-called PIGS countries bristle against austerity, while the core countries, on the other hand, are left in the position of someone playing tug-of-war when the other side suddenly drops the rope.

 

Source: mariashriver.com

 

In the U.S., such a scenario could never arise. We are one unified economy. It's difficult to even draw the same metaphor. New York may lend more money that West Virginia, as we know, but both are states are parts of the same union.

6) Great Recession Response

After the banking crisis of 2008, the United States did three crucial things that were required to fix the economy right.

Bank Recapitalization

First, The United States took the bull by the horns and recapitalized the banking system. The U.S. Treasury department committed trillions of dollars to support US banks and other financial institutions, such as investment banks, money market funds and credit unions.

 

(While trillions of dollars were pledged to help the banks, far less capital was actually committed, and the government has collected billions of dollars in dividends and fees for their investment.)

 

Once government capital was injected into U.S. banks, those banks could continue lending — as opposed to selling assets, deleveraging, or contracting credit. In addition, the Federal Reserve in the U.S. forced banks to engage in stress tests to determine their solvency. Five years down the line, the ECB eventually performed similar stress tests.

 

But even after the stress tests, European banks don't have adequate capital, which means that if the banks need to shore themselves up, they are going to start retrenching and contracting credit — which risks further damage to the Eurozone economy.

Monetary Policy

Second, the US did aggressive monetary and quantitative easing, while the ECB is now still thinking about doing quantitative easing. I've written before in Roubini's Edge about how monetary policy can help soften the blow of recessions and economic slowdowns but here I'd like to just focus on the big picture. By quadrupling the size of the money supply from its pre-recession levels, the Fed freed up desperately needed credit and helped keep the U.S. economy from crashing into a full-blown depression.

 

The Marriner S. Eccles Federal Reserve Board Building in Washington, D.C.
Source: blogs-images.forbes.com

 

Back-Loaded Fiscal Consolidation

Third, the US back-loaded its fiscal consolidation, meaning it postponed measures aimed at balancing its fiscal budget. (This is because, in the short run, raising taxes and cutting spending reduce disposable income and therefore reduce consumption.) In the Eurozone,  however, the decision was made to front-load fiscal consolidation, which put additional pressure on their already beleaguered economies. This front-loading, which amounted to imposing budgetary austerity, reduced the total demand in the economy — the last thing the countries of the Eurozone needed at the time of a serious recession.

7) The Eurozone isn't a Fiscal Union

Seat of the European Parliament in Strasbourg, France
Source: enar.dk

 

One of the key challenges to the Eurozone is a lack of fiscal union. A fiscal union is something Americans take for granted and rarely think about. In the US, when there is a shock to the output of one of our fifty states, fiscal transfers from the rest of the union help to cushion the blow.  As an example, let's say there is a negative shock to the economy of Texas, perhaps due to a fall in oil prices. Economic output in Texas would fall. But for every dollar in lost output, the fall in income in Texas isn't a dollar but only about 60-65 cents.

 

Because when there are bad times in Texas the federal government transfers economic assistance there — on the premise that when there are bad times somewhere else, booming oil prices in Texas might help out another state in the union. It's a kind of risk pooling and insurance. In the scenario we've been discussing, Texans who were laid off from their jobs would be eligible for unemployment benefits.

 

 

Those same unemployed Texans might also be eligible for federal welfare benefits. Also, when the earnings of Texans decrease due to bad economic times they would automatically pay less federal income tax.  Conversely, when Texans are doing well, their federal taxes automatically rise. This serves as a kind of automatic stabilizer for the economy. Finally, the federal government can decide to cushion an economic shock to Texas by spending more money on Texan infrastructure or by funding federal projects at, say, the Johnson Space Center in Houston.

 

In the U.S. those shock absorbers at the federal level are considerable, since the federal government accounts for 25% to 30% of our GDP. In Europe, where the EU government only accounts for 1% of GDP, there simply isn't capacity for it to lend substantive assistance when countries are in trouble . So what winds up happening in the Eurozone is that when you have a $1 shock to the GDP of one country, that country's income goes down, effectively, by $1.

 

Unless there is a full fiscal union in the Eurozone — on spending, taxation, and even common debt issuance —the funds that the central government will have to assist countries in trouble will remain just spare change. Of course there are many reasons why citizens of some countries in the Eurozone don't want a fiscal union, which is a topic I will take up in the next section...

8) Banking Union: The Eurozone's Stumbling Block

 

In the United States, we take for granted that every state in the union has banks that are insured by the FDIC. In Europe, however, German deposit insurance pays only for German banks, and Italian deposit insurance pays only for Italian banks.

 

Seat of the European Central Bank in Frankfurt, Germany
Source: Bloomberg

 

In the U.S., on the other hand, when a bank goes bankrupt in California, we use the same pool of money to fix the problem as we would for a bank that goes bust in New York. Furthermore, in the United States, we have a banking system where the Federal Reserve, at the central level, not at the state level, decides which banks are in trouble and need assistance, or in the worst case, require resolution.

 

A banking union, in fact, is an important kind of risk sharing — a kind of subset of a fiscal union.

 

What concerns the Germans about a fiscal union — or, for that matter, a banking union — is that it pledges German citizens to support peripheral Eurozone economies and banks that are at risk of outright collapse. The fear in Germany is that risk-sharing will become risk-shifting — and that a fiscal union will become a transfer union.

 

In short, Germany, and other core Eurozone nations like The Netherlands, don't want to get stuck in a transfer union where they might be forced to subsidize Portugal and Italy and Greece and Spain forever. Fiscal unions and banking unions only work when shocks occur randomly. (One day I have bad luck in Texas; the next day you have bad luck in New York. Sometimes I help you out; other times, you help me.) If the economies within a fiscal union are not balanced — it's not a two-sided risk-sharing alliance but, rather, a risk-shifting scheme where one side passes money to the other forever.

 

That is why the Germans, among other core European nations, have been saying, in essence, unless the PIGS countries do reform in the form of fiscal austerity, structural reform, boost their growth, and make progress on avoiding future debt crises, we’re  not going to sign on to a fiscal union or a banking union that may become an economic suicide pact.

9) Political Union — And Democratic Legitimacy in the Eurozone

Court of Justice, Luxemburg
Source: skynrg.com

 

While Americans are accustomed to political squabbling — such as the commentary we hear from talking heads every presidential election about Red States and Blue States — the fundamental democratic legitimacy of American politics is rarely questioned by those within the political mainstream in the United States.

 

Supranational unions like the Eurozone — at there very core — are about transferring national sovereignty to the center.

In the case of the Eurozone, decisions that were once made at the national level get made at the supranational level. What was once decided by national legislatures of countries gets decided at the European Parliament in Strasbourg, France, while the executive powers of the EU are in Brussels within the European Commission. Decisions that were formerly handed down by national supreme courts get judged at The European Court of Justice in Luxembourg. And monetary policy that was executed by national central banks gets made by the ECB in Frankfurt, Germany.

 

What impact does this have on the political legitimacy of democracies?

 

If you are transferring national sovereignty from the nation state toward super-national authority, then you need a political union where those decisions being made at the super-national level are done in a democratic way. Otherwise, there are great challenges: For example the EU tells you that your country's budget is not acceptable and needs to be cut, or the ECB informs you that several of your national banks need to be shut down.

 

Decisions on budgets and bank supervision have already moved away from national capitals to the central authority — but the risk sharing component of fiscal and economic union never arrived. You might say that countries like Greece have lost their sovereignty on supervision and regulation without truly receiving the benefits of solidarity, i.e. risk-sharing.

 

Bureaucrats that were never elected by Greek citizens have begun making decisions that most Greeks would prefer to be made democratically in Athens, and many have already begun to blame their woes on the EU and the ECB and the Eurozone.

 

The issue, of course, brings us back to where we began our list: The rise of extremist political parties within the Eurozone.

 

Beyond Greece — in Spain and Italy and France and The Netherlands — populist parties on the right and the left are rising. And their rage is being channeled toward many of the same targets that extremist politics railed against during The Great Depression: Against globalization, against immigration, against reform, against austerity. They are saying, "Enough is enough." So far, they have not come to power.

 

 

But after five years of recession, low growth, high unemployment, little job creation, little income creation, more and more people have begun to say, "Enough is enough."

 

As their voices grow louder, and the political legitimacy of the Eurozone is questioned in more places, those with a keen sense of history begin to worry about the causes that made Europeans feel powerless within the political order of the 1930s— economic depression, stock market shocks, the wrong monetary and fiscal policies leading to deflation — that led to Europe falling into the clutches of authoritarian regimes and culminating in the Second World War.

 

 

 

The Future of the Eurozone

Source: The Telegraph

 

As 2014 drew to a close, I started thinking about all the things I've written about the Eurozone over the last decade. One of the more provocative ways of summing up the challenges that the Eurozone faces would be to say that in this world, economies can grow either because they have lots of young people willing to work long hard hours, or grow because people are creative and innovate.

 

Barring a few exceptions, these are, essentially, the two different paths economies can take to growth. Asia, broadly speaking, has taken the path of working very hard. (Though Americans work quite hard, they don’t work as many hours as their counterparts in Asia do.) But, in many key ways, Americans continue to lead the world in innovation and technological advances.

 

Europe, at this moment in history, is “the worst of both worlds” in this respect. Leisure and vacation time are of paramount importance to Europeans, but there is a dearth of innovation to make up for those losses in productivity. (Only isolated elements in core Eurozone nations follow American-style work patterns.) What Europe does have—and what continues to drive the major engine of European tourism—is high culture. Rich Chinese and Indian vacationers flock there to soak up churches and concerts and ruins.
 

If Europe wants to avoid becoming the Florida of the world—a peninsula full of vacationers and retirees—then it must urgently consider radical reforms. All of the nine points noted above are worthy of serious action by policymakers. And all should be in the minds of investors considering taking a risk on the Eurozone and its future.

 

Cordially,

Nouriel Roubini
Chairman
Roubini's Edge