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Tracing Europe’s Long Road to Economic Catastrophe

The economic crisis in Europe reached its latest crescendo last night, as Greece managed, through furious last-minute negotiations, to convince its creditors to give it some more breathing room. But if the Greeks have managed to stave off ruin for a few more minutes, nothing has essentially changed in their situation: Their economy is still in shambles. 

The burning question on most observers’ minds, and rightfully so, is whether the Greeks will ever manage to pay back their debts. But at this stage, it’s also worth considering how we ended up on the precipice of such catastrophe at all. Here are some reflections on the long road to our present disaster—and the possible paths out of it.

The economies of Europe are vastly divergent. The EU is much more variegated than commonly realized. It spans enormous economic disparities—great enough to cause problems for its functioning as a monetary union.

The Eurozone is comprised of countries that are more economically stratified and less economically integrated than the United States. Delaware is twice as rich as Mississippi measured by GDP per capita. But Luxembourg is almost eight times wealthier than Estonia. If you take the European Union as a whole, rather than just the Eurozone, the disparities are even starker, a multiple of over 16 between Luxembourg and Romania.

By way of comparison, let’s consider the North American Free Trade Agreement. Though it’s just a trade alliance, not a monetary union, the economic disparities it spans are much smaller: Mexico’s per capita GDP is about one-fifth of America’s. To match the gap between Europe’s poorest and richest countries, NAFTA would have to reach all the way from the United States to Guatemala.  

The European Union’s long-term goal has always been to integrate goods, capital and labor markets across the continent, bringing all of its members within a spectrum of acceptable differentiation. But the sheer magnitude of its current  differences has also set limits as to what can be done.

The Eurozone has taken corrective fiscal and monetary policy off the table. The Eurozone has few policy options at its disposal because it's the only monetary union in the world that lacks any of the institutions of a fiscal union. As a monetary union it has eliminated one of the most powerful tools of economic adjustment among its member nations: currency devaluations. Devaluing the local currency used to be the way that each EU nation lowered production costs, discouraged imports by making them more expensive, increased exports, and balanced trade relations. Now that the European Central Bank sets monetary policy for all countries using the euro, that option is off the table: The power of devaluation has been taken away from national capitals and given to the ECB, an institution clearly disinclined to use it.

But, because it is only a monetary union, there are few other tools that the European Union has to deal with economic shocks. Without a unified fiscal system, it has few monies to redistribute to regions in need. The EU’s own budget is some 120 billion euros annually, tiny compared to 800 billion euros of annual French expenditure or the 3.7 trillion dollar U.S. budget. The EU is essentially a regulatory union. It imposes rules whose cost are borne by its members. Insofar as it redistributes resources it is mainly through the Common Agricultural Policy, 40 percent of its budget.

Some money is channeled to public works, often with an eye to regional development. But it doesn’t compare to the sorts of stimulus that we’ve historically seen in the United States. Think TVA and interstate highways, NSF and NASA, or FEMA. It was not an accident that the federal government, in 1946, decided to locate the Center for Disease Control in Atlanta, a hub of a struggling region. In 2005, its European equivalent, the ECDC, was parked in Stockholm—not exactly needy territory.

Or consider the billions that course around the American economy with each financial crisis—from the 12 figure sums channeled to Texas alone during the Savings and Loan debacle of the mid-1980s,to the bailouts of Detroit and the financial industries of New York and Connecticut, to the hundreds of billions of dollars of new mortgages guaranteed by the Fed once the private sector refused to buy residential mortgage loans. (By effectively nationalizing the mortgage industry, Washington has channeled enormous sums to hard-hit markets in the west and southwest.) In the twenty years from 1990 to 2009, federal taxing and spending imposed a net transfer from New York state to the rest of the union of $950 billion, on average 47 billion annually.

By comparison, Germany contributes some 8 billion euro net to the EU. The Germans and the other EU nations do lots of internal redistribution, of course—but not through the EU to fellow members. As a recipient, Mississippi received twice its annual GDP from the rest of the union over this period. Were Greece to receive a similar share, the EU would have paid it $38 billion annually. In fact, its actual net receipts from the EU are about 3 billion. The practical effect of Europe’s lack of fiscal integration is that a poor nation like Greece would be much better off as an American state than as an EU member. And conversely, much less is asked of prosperous EU nations like Germany than of rich states like NY.

National cultures are a real barrier across Europe. Were the EU to become a fiscal—and not just a monetary—union, would that solve the problem? Probably not. Other reasons conspire to prevent Europe from achieving a sustainable economic equilibrium. Structural impediments hinder other means of regional adjustment that work in the United States. While labor mobility—the ability for workers to move where their efforts are most efficiently used—has facilitated inter-regional adjustment in America, that hasn't been the case in the EU. For linguistic and cultural reasons, Europeans don’t move for the sake of work. Housing market rigidities firm up such immobility. Waiting lists for social housing discourage movement anywhere. Even within their own countries, they move less than Americans. The result is that most foreigners within any member nation come from outside the EU.

Conversely, business investment flows freely—but it flows to where it can be put to best use, which isn’t Greece or other Mediterranean nations. Why would anyone build a car factory in Greece? Rather than a competitive advantage in the relatively low-cost areas of the Mediterranean, business finds low productivity, a barely passable educational system, corrupt politics, inept tax collection, stifling union rules and a labor market stitched up in a mass of corporatist regulation. The local labor force is unemployable and no one moves there from elsewhere in search of jobs. Thanks to the implicit subsidy of massive borrowing and the rigidities of their economies, the Greeks and other Mediterraneans have priced themselves out of their own market at the very moment citizens of the former Eastern bloc opened their arms to entrepreneurial capitalism. No prizes for guessing the outcome.

Cheap credit was used to paper over Europe’s differences (temporarily). The Greeks went on a borrowing spree effectively because no other tools in the EU workshop were at their disposal. No meaningful redistribution of resources is possible—neither directly through the EU budget, nor indirectly through the nonexistent EU fiscal system. That left borrowing. And borrow they did. Greece has debts of 160 percent of GDP, the fifth highest on the IMF list—right up there with Saint Kitts, Eritrea, and Jamaica.

Credit thus became the means by which Europe’s regions papered over their vast differences—just as it became the means by which America’s social classes papered over theirs. While the U.S. redistributes on a grand scale regionally, it is notoriously parsimonious in equalizing among social classes through direct government policy. But as firm believers in social engineering via the financial markets, Americans expanded credit dramatically. In hopes of mitigating the hardships of an ever more unequal society, and thanks to the liquidity made available by a Chinese working class that exports its savings, the American lower-middle and working classes were encouraged to borrow massively on a debt-fuelled consumption binge. From the misguided hope of leaving social policy to Wall Street came the housing bubble and its eventual implosion.

Something similar took place among the EU nations. Its political class having ruled out serious reforms that might stimulate growth, Greece helped itself to  the equivalent of huge "zero doc" loans. When anyone dared ask about collateral, their answer was essentially: Ask Brussels and Berlin. Though maxed out on their credit cards, behind on their car payments, facing foreclosure on their house and jobless, they borrowed at German rates thanks to the implicit assumption that the EU as a whole would back them. Issuing debt in the form of bonds was the only way that a nation like Greece could suck in resources. Had they put these resources to good use, reforming their tax system and bureaucracy, opening up closed professions, bringing their educational system back into a first world ambit, and improving their infrastructure, the problem might not have been so great. But instead they used borrowing as a replacement for taxation, designed sweetheart deals for favored professions, force-fed an already obese civil service, subsidized grotesquely inefficient public services, and topped up the troughs for the whetting of political snouts.

Europe needs tough love. What can be done? Though certain financial interventions are possible, they are resisted by the Germans, Dutch, and other members who refuse concessions without wholesale reform. The ECB is technically prevented from being a lender of last resort, but it can buy national securities in the secondary market, thus fulfilling some of the same functions. It has not, though. The ECB has bought up bonds to the tune of about 2 percent of Euro area GDP. In comparison, the Federal Reserve intervened with 11 percent in the United . and the Bank of England with 13 percent.

Some commentators have proposed EU bonds—that is, bonds backed by the EU as a whole rather than any single nation—as a solution, but they would only in effect continue the problem that created the mess in the first place. Allowing Greece to continue selling bonds at rates that reflect the financial state of health of the entire EU, rather than its own national predicaments, would subsidize Greek borrowing indefinitely.

The real issue is fiscal sovereignty. If Athens wishes to continue to be bailed out, as it already has been, Europe is within its rights to ensure that Athens is upholding its end of the bargain. Proposals that Greece shift its tax oversight and authority to centralized EU bureaucrats may seem like a political non-starter—the very suggestion has already provoked the Greeks to rhetorical excess, including the tediously predictable accusations of the Germans sending in their Gauleiter—but they are entirely reasonable given Athens’ poor record when it comes to financial discipline. And redistribution in a supranational union will inevitably come with a political price: It makes no sense for the Greeks to cry neo-colonialism and impugned sovereignty as they demand solidarity from Brussels. Indeed, it is hard to fault the Dutch, the Germans, and the Finns for refusing to pony up before getting reform in return. In the World Bank’s tables, Greece ranks 100 out of 183 for ease of doing business, alongside Paraguay, Yemen, and Papua New Guinea.

Greece will plead that the demands being made of it are impossible to fulfill. But they are very possible indeed, so long as Greeks muster the political will. Take a look at Estonia: The Estonian economy was devastated by the crisis of 2008, but Estonians responded by cutting wages, trimming public sector staff, recalculating pensions, slashing subsidies for agriculture, and upping the Value Added Tax.

But if Greece continues to resist European entreaties, the European Union may have to admit that deeper fiscal integration will never be possible. If Europe’s poorer countries refuse to reform their economies, the continent’s richer countries cannot continue to support them without seriously burdening their own economies. In that case, the most likely scenario would not be a deepening of fiscal integration—including significant redistribution—but a retreat from it, and an abandonment of monetary unity. The current crisis, then, will mark either the beginning of a new European Union, or a return to an older one. We'll soon know which it is.

Peter Baldwin is a professor of history at UCLA.