[Viewpoint] The global future of Europe’s crisis

It is now clear that the euro zone crisis will continue well into 2012, despite early February’s stock market recoveries. Negotiations between Greece and the banks over Greek sovereign debt may yet to be concluded, but bank participation in the deal remains 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 IMF’s concerns are valid, but their idea is being resisted fiercely, owing to fears of political contagion; other debt-distressed euro zone 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 and the European Stability Mechanism have yet to be implemented.

Of course, some positive steps have been taken. The ECB’s generous provision of liquidity to European banks at only 1 percent 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 too discouraging. Indeed, in mid-January Standard & Poor’s downgraded AAA-rated France and Austria in addition to seven other euro zone countries: Slovenia, Slovakia, Spain, Malta, Italy, Cyprus and Portugal.

It now seems clear that a key challenge facing the euro zone stems from the fact that it is a monetary union without being an economic one, 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, 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 euro zone.

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 Europe’s 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 Greece’s then-prime minister, George Papandreou, announced a referendum on the policy package proposed to allow Greece to stay in the euro zone. 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 Papandreou’s 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 China’s central bank were suddenly to reject U.S. 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 U.S., China itself would find itself in serious economic trouble.

These interlinked threats are real, and they require 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 supranational form of politics is needed to re-embed markets in democratic processes, as happened during the course of the 20th 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 EU, which has moved much further than any other group of countries in the direction of supranational 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 for 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 21st century: how to resolve the tension between global markets and national politics.

Copyright: Project Syndicate, 2012.

by Kemal Dervis

* The author, a former minister of economy in Turkey, is vice president and director of the Global Economy and Development Program at the Brookings Institution.