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Financial markets have been fairly euphoric about Mario Draghi’s plan to purchase government bonds from euro area Member States. The markets correctly see that the plan reduces the likelihood of a default by Spain or Italy in the next few years and rules out one of the scenarios in which the euro area could have broken up.
This still leaves the euro area with many longer-term structural problems. In particular, most of Europe’s so-called peripheral economies are going through a prolonged slump. Both the public and private sectors in these economies are laboring under high levels of debt and it will be hard for them to stabilise these debts without a return to economic growth. And without such stabilisation, the long-term future of the euro is at risk.
To many of the citizens of Germany and other core members of the eurozone, the solution to the periphery’s problems are very simple but painful. If a government is living beyond its means, then it must tighten its belt and spend less than it is taking in as tax... This seemingly simple prescription turns out to be less simple when you examine it from a macroeconomic perspective.
The growth prospects for Europe’s periphery aren’t too promising. Spain, Portugal and Greece have gone into the crisis running sizeable current account deficits and they are still a long way from stabilising their combined public and private debts. The German recommendation to these countries is that they introduce “reforms” to become more competitive. Translated, this largely means large wage cuts that would boost export growth.
An alternative approach to adjustment in the euro area could feature countries that have a bit more room for manoeuvre, such as Germany, choosing to adopt a more expansive policy approach via fiscal stimulus and a faster pace of wage increases. This alternative approach could also see greater use of pan-European funding for structural investment in Europe’s slumping economies.
This alternative approach could provide the “carrot” for crisis countries to go along with the “stick” of wage cuts and structural reforms. Unfortunately, German economic policy-makers are dead set against any such policies. The message from a notorious speech by Bundesbank President Jens Weidmann earlier this year was that it was up to the countries with debt problems to do all the adjusting.
Time will tell whether a “stick only” approach is sufficient to save the euro.