Heading for the wall

The common interpretation in Germany that it is essentially a sovereign debt crisis can only be explained by an ideologically constrained perspective.

Another wistful look back at the year 2011. It gave Germany strong growth, rising employment, falling unemployment and lower public deficits. It could have been called a good year if it were not also the year in which the Euro started to falter. In 2012, we will either run into the wall of a failed currency or we find a way to overcome this wall. The year 2012 will therefore be a year of crisis, hitherto a year of changes and turning points. What is needed is a political scenario to describe potential outcomes.

The year 2012 begins against the gloomy backdrop of a foreseeable recession in the Euro area. It is the result of a chain of incorrect decisions, supposedly saving the Euro as a joint currency. A way out of crisis is mainly seen in a more or less rigid austerity policy of all member countries of the euro area. The result of such an approach is a massive adverse impact on aggregate demand for the entire Euro area. The hope is that there is external help through exports to emerging countries like China, Brazil or India. Given their also weakening economies and their minor importance in comparison to European domestic demand, this is illusory. The same applies to the United States, which are likely to fail as the former powerhouse of the global economy due to their high public and private debt that urges people to save rather than to spend. The euro area has to solve its problems alone, without help from outside.

To save the Euro over the year 2012, the true nature of the crisis in the Euro area needs to be properly understood in the first place. The common interpretation in Germany that it is essentially a sovereign debt crisis can only be explained by an ideologically constrained perspective. Because it is forgotten, or rather should be obviously forgotten, how the national debt has actually arisen in recent years. There were no lavish social programmes or other sorts of spending sprees. Instead, the banking sector has been stabilised, which was expensive, but necessary. Through this the public sector debt almost everywhere was driven sharply upwards. Therefore a broader vision is required to get the crisis under control.

The Euro crisis is first and foremost a crisis of confidence in the institutions of the Euro area. It has its origin in the lack of clarity in dealing with trade imbalances and the resulting indebtedness or surpluses of individual Euro area member countries. It is also unclear how safe government bonds of the member countries actually are. Are they as safe as American, Japanese or English bonds, where both government and central bank have guaranteed bonds? Or are they as unsafe as the Argentine dollar bonds, whose value as a result of the insolvency of the Argentine state decreased drastically or even totally vanished. Here, neither the government nor the central bank could guarantee the debt, since they were listed in a foreign currency, the US-Dollar.

Finding the answer to these uncertainties is the economic policy challenge in 2012. It is primarily a loss of confidence in the institutions of the Euro area that caused the crisis and not a failure of some member states to reduce their public debt burden as is assumed by most governments. This false diagnosis led to the wrong conclusion that public household deficits should be reduced as quickly as possible entering a simultaneous crash course in all major countries in crisis. This, plus a restrictive fiscal policy stance in all major member states drags the euro area into a recession. However, recessions eventually produce no confidence but rather panic.

Against this background, a fundamental change in European and especially German economic policy is required. This means there must be a joint liability for at least part of the national debt burdens, given at most for a certain period of time. All this should be accompanied by a medium-term fiscal consolidation that avoids a recession in the euro area. Confidence can be gained only if both governments and the ECB credibly support the Euro. So far, there is not much to see of the economic policy turnaround that is necessary to achieve this. In this respect it is expected that the crisis will worsen initially. But as we have already seen in many respects, not sustainable policy options will be revised in due time. That happened to the refusal of giving any support to countries in crisis as it did to the idea to have another private sector hair-cut on public debt.

In the course of this year it is to be expected that other positions will be dropped. So it is quite clear that the ECB will have to signal that it continues to buy government bonds of countries in crisis. Already the ECB's liquidity supply for banks has been significantly expanded. So it will go on until all positions are cleared to save the Euro. And then confidence and stability will return to the Euro area. Then the crisis is over and the wall crumbles.

If I am wrong and things turn out quite differently, and all governments insist on the present course, then the wall will prove stronger than any ideology. The end of the euro would be certain, at least in its present form.

IMK (Macroeconomic Policy Institute) - Editorial  http://www.boeckler.de/imk_3401.htm