Henry Farrell and John Quiggin have a new Foreign Affairs article (ungated) arguing that the E.U. should pursue "Hard Keynesianism" in response to its recent crisis. What does that entail? In a nutshell, run surpluses and/or pay down debt during expansions, then deficit-spend during downturns. They argue that this policy needs to be firmly embedded in E.U. law, and there has to be a credible enforcement mechanism in order for it to be more successful than the Stability and Growth Pact. Here's a few snippets, but of course you should read the whole thing:
If the EU is to survive, it will have to craft a solution to the eurozone crisis that is politically as well as economically sustainable. It will need to create long-term institutions that both minimize the risk of future economic crises and refrain from adopting politically unsustainable forms of austerity when crises do hit. They must offer the EU countries that are the worst hit a viable path to economic stability while reassuring Germany, the state currently driving economic debates within the union, that it will not be asked to bail out weaker states indefinitely. ...
Hard Keynesianism would not solve all of the EU’s economic and political problems. But it would steer the union away from the disaster toward which it is now sleepwalking. A new set of rules based on this approach could form the basis of a solution that is politically viable for both Germany and its European partners most suffering from the crisis. With only limited fiscal transfers allowed, Germany could be further assured that it would not have to continually bail out its profligate partners. Such an approach would maximize the fiscal room that states in distress need in order to deal with economic shocks while ensuring the eurozone’s long-term fiscal sustainability. In the short term, hard Keynesianism, like enforced austerity, would impose real adjustment costs on the eurozone’s weaker economies; there is no cost-free path to fiscal balance. But if the costs were shared with bondholders and were alleviated by a one-off loosening of monetary policy, they could be politically acceptable.
By concentrating on its economic problems but ignoring their political consequences, the EU is setting itself up for failure. The case for austerity does not make sense. And if the EU fails to deal with the political fallout of its own institutional weaknesses, it is going to collapse. No political body can force voters to repeatedly shoulder the costs of adjustment on their own and expect to remain legitimate. During the gold standard, nation-states tried this and failed—and they had considerably more authority than the EU has today. Hard Keynesianism offers a means to combine fiscal discipline with flexibility in order to cushion the political costs of adjustment in times of economic stress. EU leaders must institute it in a hurry.
I think I agree with their general take that the Eurozone cannot muddle on as it is, although I frequently waver. Things often persist longer than they probably should, and something as slow-moving as this debt crisis lends itself to that approach. In fact, "muddling through" seems to be the default position of the EU leadership right now, and there are very good reasons for that, which I'll return to in a minute. For now let's take for granted that the EU must either move towards deeper political and economic integration, including some form of fiscal union as well as a broadening of the ECB's mandate, or it must contract membership. Neither option is especially appealing to the leadership of the EU countries, but increasing integration appears to be especially unpopular with the voting publics, so of the two I still think an exit of at least one or two of the PIGS is most likely in the short run.
I disagree that "the case for austerity does not make sense". Short of debt forgiveness, which won't happen, austerity must occur. It's only a matter of how it occurs. The alternative to an internal devaluation through wage cuts, tax increases, and reduction of social services is external devaluation (exit from euro) and default. Call it the Iceland Alternative (Iceland was never in the euro, but it did devalue/default, which is what we're talking about). In that scenario, the new drachma and Irish pound will collapse in value and the government will be unable to borrow from international capital markets. This is austerity too. The government budget will have to be balanced almost immediately, and unless there's a full default will likely need to run a primary surplus for many years.
Moreover, small open economies like Greece and Ireland are heavily reliant on imports to maintain standards of living. Ireland imported about 40% of its GDP in 2009; Greece about 1/3. For comparison, the U.S. imported about 14% of its GDP. If the post-euro currencies drop 50% in those countries (as Iceland's did, and it was never attached to the euro), then those imports become 100% more expensive. That's a big price increase. True, there will be some substitution into domestically-produced goods, but such a large adjustment will take time and cause pain. These are not large, diversified economies and there's a reason domestic production wasn't being consumed before; overall standards of living will have to drop if there's a currency devaluation. And while exporting industries may benefit from a cheaper currency, boosting employment in those sectors, the importing industries will suffer, contracting employment in those sectors. Even if overall employment goes up, it will be at much lower relative wages. This is why Iceland is applying for EU membership, including adoption of the currency, despite the sacrifice of policymaking autonomy that entails.
In other words, there will be austerity. The only question is how it's distributed.
Meanwhile, a debt writedown would have a large adverse impact on banks in the EU core (as well as the US). The banks are already undergoing stress tests -- which have been defined down, well below the bank obligations under Basel III -- that reveal potentially critical exposure to peripheral debt. Banks are quickly trying to recapitalize in order to be able to absorb some losses on these loans, and are also trying to reduce their exposure, but that process takes time. If the PIGS defaulted today, Germany and France would have to bail out their banks anyway, so why not do so indirectly by extending loans to the PIGS? In this way, the EU debt crisis is a lot like the Latin American debt crisis in the 1980s.
This is why, unlike Megan McArdle, I'm not convinced that probability of a euro split-up is better than 50%. The peripheral economies will have to suffer austerity in either case, but by staying in the union they can still get the benefits of the common market. The core economies will have to continue to support their banks in either case, so they may as well keep the peripheral economies in.
Here's where the muddling through comes in. The current bailout scheme only runs until 2013. That's not enough time for Ireland and Greece to get completely out of their straits, but it is enough time for EU banks to recapitalize. It may be enough for the PIGS to stabilize, and pass credible enough reforms that their bond rates fall a bit. With some luck, the confidence fairies might even show up. So that leaves us with an equilibrium whereby the current policy of muddling through is a best response in the short run, and there are three possibilities in the medium run: If, in 2013, the banks can handle it and the PIGS haven't credibly reformed, there will be defaults and exits from the eurozone. If, in 2013, credible domestic reforms have been made in the PIGS then there will likely be political space for the sort of EU reforms Quiggin and Farrell describe and the eurozone will remain intact. If, in 2013, the banks aren't fine, then replay until 2015.
Anyway, that's how I see it, and this holding pattern until 2013 seems to be the default position of the EU governments. It's certainly possible that domestic polities force their governments' hand before then, but considering that default isn't good for anyone I'm not sure that's especially likely either.