STOCK MARKET WATCH - Wednesday, 1 February 2012

[Demeter]

37. United States of Europe? What it Will Take to Save the Continent from Economic Collapse

http://www.alternet.org/story/153951/united_states_of_europe_what_it_will_take_to_save_the_continent_from_economic_collapse?page=entire

The dilemma Europe now faces is complicated -- not least because the European Union comprises 27 separate sovereign nations and the euro area, where the chief problems lie, is a currency union that has 17 members itself. Beyond that, the euro is flawed both in design and in execution. It hearkens back to the gold standard and its fixed exchange rate system which necessitated a deflationary policy response to the deep downturn of 1929, ending in the Great Depression and World War II. Unless drastic action is taken, we will soon find ourselves in another Great Depression....the problem is this: no state can have a fixed exchange rate, free flow of capital and independent monetary policy at the same time. Therefore, fixed exchange rate systems always end in trade imbalances that can last for decades and across business cycles, creating so-called debtor or deficit states and creditor or surplus states. This is not a problem during an economic boom. However, if boom turns to bust, the debtor states will become distressed as cash flows supporting debts decline.

In a currency area with a national government like Canada or the United States, the central government alleviates these crises by making transfer payments like unemployment insurance to individual states. A state like Florida or California that is hit hard doesn't go bust easily. But in the euro area there is no fiscal agent making these counter-cyclical transfers; the individual states are on their own. And so the resulting crisis is more severe. The fact is the euro can't work across business cycles without fiscal transfers because some debtor state will always face crisis after each and every business cycle downturn. Put simply, the euro's institutional design was flawed right from the start. In fact, one of its chief architects, Tommaso Padoa-Schioppa, called the euro "a currency without a state." It gets worse because official euro budget policy virtually guarantees a deflationary response to every business cycle. The euro designers chose the Stability and Growth Pact, which sought to keep government debt below 60 percent of Gross Domestic Product (GDP) and deficits below 3 percent, to prevent large government deficits. And this is the thinking driving euro area policy now. Unfortunately, this approach means that the public sector must cut just when the private sector is cutting too, intensifying downturns, sucking money out of the economy and making the potential for national bankruptcy much greater.

Good Solutions v. Bad Solutions

Of course, the central bank could alleviate this problem by providing national governments with liquidity. Indeed, central banks were founded over 300 years ago specifically to finance budget deficits. The Bank of England was formed in 1694 to help England raise the funds to create a navy to rival France's after England's crushing military defeat by France ended the Nine Years' War in 1690. This kind of funding is out for the euro area. The Lisbon Treaty, the present European Constitution, forbids the European Central Bank from lending to governments, as the euro's designers believed that doing so would weaken the currency. Therefore, faced with a recession in which some euro nations invariably will have balance of payments deficits, those euro area governments must meet private sector cuts with public sector cuts or face insolvency. This guarantees crisis. Moreover, such an insolvency would boomerang back to the surplus countries which are the deficit countries' creditors. And so both debtors and creditors have strong motivations to make sure no insolvency occurs. This is exactly why we have seen bailout after bailout in the euro area; a national insolvency could end in a cascade of further national and bank insolvencies, creating a global Depression of untold magnitude. A global Depression is the scenario Europe's policymakers fear, and rightly so...However, the cutting solution -- so-called internal devaluation and austerity -- is not really a solution. This policy is politically unsustainable as unemployment mounts, economic output contracts and national insolvency threatens Europe nonetheless. For quite a while, I have been saying there are three options for the euro zone: monetization, default or breakup. That said, the political costs of breakup are still impossibly high. So I expect some combination of monetization (the creation of money by the central bank) and default.

Austerity Leads to Default, But Transfer Unions Give Stability


...I don't think the Europeans can keep this from spiraling out of control without creating the dreaded "transfer union" that so many are set against. A transfer union is simply an arrangement in which the stronger parts of a national economy subsidize the weaker parts, just like in the United States, where more economically robust states like New York transfer money to other states through higher taxes, for example, paid to the federal government. These funds can then be distributed in the form of unemployment benefits and other subsidies that help stabilize those weaker economies when they get hit by hard times. Can Europe accept a transfer union? I hope so. Everyone would win if they can. Transfers across nations would protect the credit rating and solvency of everyone. Germany and the Netherlands could continue to maintain economic growth through export and peripheral economies like Spain and Ireland can regain some measure of economic growth by foregoing drastic austerity plans. Most importantly, this generation now entering the employment market will not have to bear the tremendous social cost of high unemployment that would follow them and limit their earning capacity for decades into the future. Ordinary Europeans had no idea the euro would join countries at the hip this way and have every reason to feel tricked into the single currency. But this is done and cannot be undone. Let's remember as well that all national economies are transfer unions, even Germany, where there have been trillions of euros in transfers from west to east and south to north over just the past two decades. Despite the reality of transfer unions, many Europeans are not politically ready for a United States of Europe even though the euro's existence practically mandates it. Europe needs to get ready though. A transfer union means a mild loss to pay for a rainy day in the form of those vital economic stabilizers (again, things like unemployment benefits) that are needed during downturns. Defaults in Italy or Spain, on the other hand, mean the collapse of the entire financial system and a global Depression. The choice is clear.