Saturday 6 August 2011

Euro dream threatens to become nightmare‎

Europe has dramatically scaled up its efforts to stanch its sovereign-debt crisis since the start of last year, but to no apparent avail as the turmoil threatened this week to overwhelm Spain and Italy.

Yet, governments still have some unused weapons in their armory—though the political cost of firing them will be high.

As the common currency of 17 nation states, the euro isn't like national currencies. Governments borrowing in their own currencies don't usually need bailouts, because, as a last resort, national central banks stand behind their banks and their governments.

The euro zone is different. The European Central Bank is prevented by treaty restrictions from lending to governments and has been a reluctant buyer of government bonds in the secondary market. Willem Buiter, chief economist at Citigroup, argues that this creates a "black hole" at the center of the euro zone that constitutes "a fundamental design flaw" of the currency union.

Euro-zone governments have tried to patch over this flaw by setting up bailout funds. Over the past 18 months, they have rescued Greece, Ireland and Portugal after they were shut out of financial markets.

But these steps haven't been enough to stop the much bigger economies of Spain and Italy from drifting into the debt vortex. One reason for this, according to analysts, is that the bailout funds haven't been big enough or flexible enough to handle large liquidity crises.

Euro-zone leaders made big strides boosting the tools available to the main rescue vehicle, known as the European Financial Stability Facility, at a summit July 21, which also set new aid for Greece.

The Italian state marked the 150th anniversary of its creation earlier this year. Its people did so with little celebration. Apart from Italy’s post-second World War decades of successful modernisation, most of this history has been one of underachievement and worse.

The Italian state’s first 50 years were marked by instability and weakness before two decades of fascist night descended over the country. Invasion, defeat and civil war in the 1940s left deep scars.

Now, the economy has been stagnating for almost two decades, with living standards barely rising and its once-vaunted industries – from textiles to autos – shrinking in the face of low-wage competition.

Italian entrepreneurialism and design flair succeeded in medium-tech industries when foreign competition was less intense, but success in high-tech sectors operating in a globalised context has been much harder to achieve.

One reason is schooling. Italy’s education system is ever more inadequate in preparing its young for the modern world of work and many of those who manage to do well are stymied in one of Europe’s least meritocratic societies.

Government influence on economies is often overstated, but it is important. Bad government in particular can have big negative effects on growth. The evidence that mismanaged public finances stifle growth is strong. And in this area Italy has long been a European leader – it is the only country to have a national debt bigger than its GDP uninterruptedly since the 1980s.

In the early 1990s the sweeping away of the cold war political parties and the jailing of many of the most corrupt politicians brought hope of better and cleaner government. Those hopes have long since been dashed.

The country’s long-time prime minister, Silvio Berlusconi, has dominated for most of that period. Even by the low standards of Italian politics, he has plumbed new depths. But however bad his actions, his inactions have been even more damaging.

Many of the reforms that could help spur the economy have gone unimplemented, despite his promises to shake the country up. Nor has he made much of a dent in Italy’s public debt mountain. His main appeal – that he could bring to the business of government the same get-things-done approach that made him one of Europe’s richest men – has proved baseless.

But Berlusconi will not lead Italy forever, and the country’s political class has shown that it can push through painful reform. Perhaps ironically, its biggest achievement in recent times was ensuring that Italy squeezed into the euro as a founding member. There is no such prize for taking radical action now. Instead, incentive comes from the need to avoid disaster. Italy’s politicians might yet rise to the challenge.

If Italy faces huge challenges, Spain’s are no less daunting.

Unlike the plodding Italian economy, Spain enjoyed a decade-long boom from the late 1990s. But the Iberian tiger, like its Celtic cousin, became engorged on credit. Property prices soared, construction boomed and competitiveness evaporated.

When the bubble burst the public finances went into a tailspin, the banks teetered and unemployment soared. It has suffered a much bigger shock than Italy and its economy is still on the floor, with consumers and households pinned down by huge mortgage debts.

Spain’s economy faces bigger challenges than Italy, with the exception of its government’s indebtedness.

With debts of 60 per cent of GDP in 2010, Spain has some breathing space (in Italy the figure was 120 per cent and in Ireland almost 100 per cent).

With such a manageable debt burden Spain does not look close to being insolvent, as the bond market has been moving towards concluding in recent weeks. So why the panic?

One reason for the recent loss of confidence in the country has been because fears are rife that its banks are not coming clean on their property losses. So far, those admitted to have been a tiny fraction of Irish banks’ losses, despite a property collapse there that is much more than a fraction the size of ours. Another suspicion is that the country’s 17 big-spending regional governments are keeping liabilities hidden.

If either or both of these suspicions have some basis in truth, Spain’s true debt levels are higher than officially stated.

But one reason to be optimistic about Spain relative to Italy over the long term is its more effective political system. This has been in evidence since the crisis erupted, with the government earning praise for undertaking some bold reforms and for reining in its budget deficit.

Although the Spanish are sometimes called the Germans of the south, the more likely explanation for their better governance is not cultural but institutional. Whereas in Italy the executive is weak and unstable – famously, the government has changed on average once a year since the second World War – in Spain, since the return to democracy in the late 1970s, governments have been stable and more effective.

This did not happen by accident but by design, and was informed by the lessons the two countries learned from their respective decades of dictatorship. While Italy’s 1948 constitution deliberately created a weak centre to avoid a repetition of the abuses in Mussolini’s time when power was highly centralised, Spain’s 1978 constitution created a strong and stable executive because weak government was seen to be a big factor in Franco’s seizing power in the 1930s.

Spain’s better political system gives reason to believe that it can manage its public debt problems, but no government can magic away a huge private debt burden or restore at a stroke chronic economy-wide uncompetitiveness. Even with lots of luck Spain faces a long and painful struggle.

Europe is in a bad place now. It looks increasingly likely that the euro zone countries will have to throw their fiscal lot in together in order to avoid cataclysm in the short term. But this brings its own risks.

Northerners will not like it. If they feel they will permanently foot the bill for southern profligacy they may rise up against it. That could get very ugly. The longer Italy and Spain remain in a slump, the greater the chances of that happening.

Southerners may not take their medicine lying down either. If their economies don’t return to growth, their peoples may reach breaking point. If they come to believe that an uncaring and alien force is imposing its will on them resentments could boil over.

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