What Would It Take To Save Europe?

By Simon Johnson

Last weekend official Washington was gripped by euphoria, at least briefly, as people attending the IMF annual meetings began to talk about how much money it would take to stabilize the situation in Europe.  At least one eminence grise suggested that 1.5 trillion euros should do the trick, while others were more inclined to err on the side of caution – 4 trillion euros was the highest estimate I heard.

This is a lot of money: Germany's annual Gross Domestic Product (GDP) is only about 2.5 trillion euros, and the combined GDP of the entire eurozone is about 9.5 trillion euros.  The idea is that providing a massive package of financial support would "awe" the markets "into submission" – meaning that people would stop selling their holdings of Italian or Spanish debt and thus stop pushing up interest rates.  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 – provided by the IMF or other countries to parts of the European Union.  The real questions are: will Italy get complete and unfettered access to the European Central Bank, and when will we know this?

The big package approach to economic stabilization was most famously demonstrated in the 1994-5 Mexican crisis.  With their 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 like a small amount today, but at the time it was 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 is overwhelming, as was the Mexican case, it does not have to be used – in fact, the Mexican loan was paid back in about a year.

But this version of Mexican events skips an important detail.  It's true that the external financial support helped prevent the complete collapse of the currency, but the Mexican peso did still depreciate significantly.  Prior to the crisis, Mexico had a large current account deficit – meaning it was importing more than it was exporting, and the difference was covered by capital inflows (mostly foreigners being willing to lend to the Mexican government.)  With the exchange rate depreciation, exporting from Mexico became much more attractive – an export boom of this kind always helps close the current account deficit and also stimulate the economy in a sensible manner.

Important parts of the eurozone, such as 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 the market value of their exchange rate.  But this is not an option within the eurozone – and it is within the zone that they need to become more competitive.

These countries could also cut nominal wages – a course of action that is being pursued, for example, in Latvia.  But it is unlikely that any government making such a proposal would last long in Western Europe.  Latvia is a special case for many reasons, including its desire to become much closer with the eurozone – to which it aspires to join.

Unable to move the exchange rate and unwilling to cut wages, the Portuguese government is embarked on an innovative course of "fiscal devaluation," meaning that they will cut payroll taxes – to reduce the cost of hiring labor – while also increasing 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 scheme, 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.  But most of the European periphery also faces a current account crisis – something has to 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 down 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 them large amounts of unconditional credit for the indefinite future.

And as these economies slow down, their ability to pay their government debts will increasingly be called into question.  Last week the IMF cut the growth forecast for Italy in 2012 down to 0.3 percent.  With interest rates pushing up towards 6 percent, it is easy to imagine Italy's debt relative to GDP climbing even further than in the still-benign official projections.

If Italy or any other eurozone country is in good shape and can pay its debts, the European Central Bank (ECB) can 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 their debt was in dollars; in such a situation, a foreign loan can help stabilize a crisis – although even there the right policies have to be put in place.

But if Italy cannot pay its debt, then the ECB 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 need – from within the eurozone.  If not, then find another way forward.

But please get a move on with this decision.

An edited version of this post appeared on the NYT.com's Economix blog; it is used here with permission.  If you would like to reproduce the entire post, please contact the New York Times.