The wider problem in the EU
Background
The West German constitution of 1948 gave anyone who can establish German heritage the absolute right to claim German citizenship. When the Berlin Wall came down in 1989, the Federal Republic was faced with the prospect of making good on that promise for millions of Germans who had been trapped behind the wall.
Thus the merger between the former BRD and DDR. The terms were more political than economic, and were designed to minimize migration from east to west: massive financial aid from west to east, and exchange of Öst-marks into D-marks at the rate of one to one (the real exchange rate would have been more like seven or eight to one).
The economic result of the reunion of east and west into one Germany was stagnation for the next ten years. Since Germany is the largest economy in the EU, money policy was set to lend support to the struggling giant.
This policy stance had a downside: it sent massive stimulus into faster-growing countries on the periphery, like Ireland and Spain. Overabundant money not only spurred overall economic activity and raised wage levels, but it also funneled energy disproportionately into domestic demand activities like residential construction and commercial property development. In many ways, the peripheral countries experienced a variation of the “Dutch disease,” with the difference that it was money policy and not a natural resource development that spurred the one-sided development.
The financial crisis
The financial crisis popped the speculative property bubbles that had grown up over years in Ireland and Spain. It has also focused attention on the way Italy has been abusing its EU membership to fund excessive government borrowing. So the EU had three problem cases.
Recovery of all three economies will likely be drawn-out affairs. For Italy the question is one of political will. For Spain and Ireland, the short-term issue is that export-oriented manufacturing has been supplanted by domestic demand-related businesses, especially those linked directly to housing and commercial construction. Given that housing and construction aren’t going to be such hot businesses in the next year or two, growth will have to depend on export-oriented activities.
The outlook there? Looking within the EU, Germany has a labor cost advantage and is a net exporter, in any event. Outside the EU, the competition is China. Spain and Ireland will gradually return to health, but the emphasis in that thought should probably be on gradually.
And then there’s Greece
Greece is the weakest link in the EU. As best we know, the country has debt equal to 110% of GDP and a budget deficit of 12.7% of GDP. These are really bad numbers. Why the “as best we know” qualification? Greece had an election late last year that produced a change in the ruling party. The new government discovered and announced that the prior administration had been falsifying the national accounts for years. Who knows whether the accounts we now have are correct or complete?
We know, qualitatively at least, that Greece is the Ireland/Spain problem on steroids, but with a gigantic government sector (over half of GDP) and rigid product and labor markets thrown in. There’s also a bit of the Italy question mixed in–does a country that cooks the government books so it can act imprudently a while longer have the political will to do the heavy restructuring needed to restore fiscal and trade balance?
Recent developments
Rating services have downgraded Greece to a level below which the country would effectively be barred from issuing euro-denominated debt.
The euro has dropped several percent against other currencies on the worry that Greece will not be able to fix its own problems and will have to be rescued by the rest of the EU.
Speculation has also begun that Greece will seek to leave the EU instead, so that it can devalue its currency and thereby get some quick relief from its economic woes.
Finally, some have extended the thought that Greece will flee the EU to wonder if, say, Italy might not be next on the list of defectors.
My thoughts
None of the “easy” solutions for Greece are likely to bring any resolution to the crisis. The EU is unlikely to bail Greece out, for fear this would send a signal to, say, Italy that its borrowing can go on unchecked and will ultimately be repaid by more responsible EU members. Bailout also couldn’t occur, I think, before the EU welded itself into a more cohesive political/economic whole, something member countries and their citizens have shown themselves, in voting on the proposed EU charter, loathe to do.
Leaving the EU would not come without difficult consequences. Would Greece accept responsibility for its euro-denominated government debt, even though a presumably immediate and large depreciation of the currency would make the burden that much heavier? or would it default on its obligations and lose access to world credit markets?
“Muddle through,” the current watchword for the US and the UK, will likely become the EU strategy for Greece. There may be some covert help from stronger EU members or from the EU as a whole. But the key question will be the level of Greek resolve to set out on the difficult road to economic healing. We won’t know the answer for several years, I suspect.
Another problem the world didn’t need.