THE FALSE TRAIL OF AUSTERITY AND A WEAK EURO / THE FINANCIAL TIMES COMMENTARY & ANALYSIS ( VERY HIGHLY RECOMMENDED READING )

The false trail of austerity and a weak euro

By Wolfgang Münchau

Published: Last updated: May 30 2010 20:02

Want to hear the optimists’ case for the eurozone’s future? Austerity programmes coupled with a weak euro might just save it. The argument is that fiscal indiscipline has caused the crisis. Austerity must therefore solve it. A weak euro and a global recovery would cushion the impact of austerity. In addition, the financial guarantees and the bans on short sales would see off the speculators. End of crisis.

The optimists have not had a good crisis so far. This will not change. Here is why.

First, fiscal adjustment programmes will be necessary eventually but European governments are currently repeating their age-old mistake of cutting spending and raising taxes well before the economy has recovered. In the US there is a debate about another stimulus package to ensure the recovery does not prematurely run out of steam. The Europeans are choking off the recovery before it has even started. The premature austerity programmes will ultimately impede debt reduction, as nominal growth remains very weak.

Furthermore, Italy and Spain will both need to accompany fiscal adjustment with structural reforms. There are no such reforms on the horizon in Italy. Spain is about to decide a labour reform package. But it will almost certainly not deal with the fundamental problem of a divided and extremely inflexible labour market. Even in Germany, where domestic spending remains anaemic, the government coalition is discussing a tax increase.

Second, the euro’s exchange rate has indeed weakened, and may weaken further. But it will probably not do so sufficiently to solve southern Europe’s competitiveness problems. In Greece, for example, tourism is the main export industry. A slump of the euro against the dollar is not going to change the country’s relative competitive position against the eurozone nations of the Mediterranean Sea. It could improve competitiveness against Turkey and Croatia, for example, but only to the extent that the lira and kuna also revalue. For the euro exchange rate alone to do the heavy lifting in restoring southern European competitiveness, it would take a massive further depreciation – to about 60 or 80 US cents to the euro.

Assume this were to happen, and then consider the overall effects. The Organisation for Economic Co-operation and Development last week forecast that Germany’s current account surplus, which fell to 5 per cent of gross domestic product in 2009, would rise again to 7.2 per cent in 2011. That forecast is based on current exchange rates. An extreme further fall in the euro would have two effects: it would increase Germany’s surplus even further, probably to well over 10 per cent of GDP, and thus increase internal imbalances within the eurozone. It would also contribute to a deterioration of global imbalances, as the eurozone as a whole would turn a small current account deficit into a large surplus. Relying on the exchange rate would be the ultimate beggar-thy-neighbour policy.

Third, lingering doubts remain about the €750bn financial rescue package to help weaker eurozone countries. The German constitutional court has still to rule on the package and, while its rulings are difficult to predict, there are some legitimate reasons for concern.

I am not sure the court will accept the force majeure argument invoked by the European Council in deciding to permit the rescue package. The Council invoked Article 122 of the treaty on the functioning of the European Union, under which financial assistance is allowed “where a Member State is in difficulties or is seriously threatened with severe difficulties caused by natural disasters or exceptional occurrences beyond its control”, but I think there are legitimate doubts about whether the multiple policy failures that led to this crisis constitute an event beyond one’s control. I also fear the German justices will express misgivings about the European Central Bank’s decision this month to buy bonds.

Fourth, the assumption that the crisis was caused, or triggered, by speculation, is not just legally dubious. It may also deflect from the overriding need to reform the eurozone’s governance framework. If you blame speculators, it may be an obvious policy response to ban short sales and penalise hedge funds rather than reform the framework. I therefore expect little substantive reform. At most there will be a souped-up stability pact, to be announced in another pompous press conference at the next European summit in June. Governments are already watering down the European Commission’s sensible, though not very ambitious, proposals. This means European governments are very likely to miss the opportunity to fix the problems in the long run.

What the eurozone really needs is a consolidation strategy based on growth and a credible fiscal adjustment plan. It needs to encourage domestic demand in northern Europe to facilitate the adjustment in the south. And it needs a new and functioning system of economic governance.

But instead, governments have chosen to chase speculators and to impress each other with austerity packages. They are thus contributing further to the eurozone’s increasingly probable though still distant disintegration.

Copyright The Financial Times Limited 2010.