European Central Blunder

With America's debt-ceiling crisis resolved, the time is ripe for a brand-new set of financial calamities on the other side of the Atlantic. The "rescue" plan for Greece put forth by European leaders on July 22 is unraveling with surprising speed. The relatively narrow scope of the solution seems to underscore how little political will there is to resolve the underlying issues with the European economy.

Those structural problems are now wreaking new havoc. On Tuesday, the Italian government called an emergency meeting and Spain's prime minister canceled his vacation because the crisis is getting worse in bigger countries than Greece. Even France has the jitters, now needing to pay a 0.75 percentage point premium on its debt over Germany's. That's still a small number, but it's the highest spread since the introduction of the euro. The premium reflects, in other words, a growing sense that the euro project may collapse.

The problem is that Europe's leaders looked at a situation driven by inherent flaws in the architecture and responded with solutions narrowly tailored to Greece's unusual problems.

Greece is a small country and, relative to its European peers, rather unique. It's one of Europe's poorest in terms of per-capita gross domestic product, and, with its history of tax evasion and government fiscal shenanigans, it's been legendarily mismanaged. It now appears that Greece never actually met the criteria for membership into the Eurozone and basically skated in with fraudulent accounting. On the one hand, all this has meant that Greece's financial difficulties are unusually severe. On the other hand, though, they were manageable. Most of all, they were created by shady budgeting. If Greece's problems began and ended with irresponsibility that would mean the country's trouble only threatened the structure of the euro. Instead, it was a sign of a larger Euro problem.

Spain is a very different case. During the boom years, the Spanish government was a model of fiscal rectitude, balancing its budget with more rigor than Germany balanced its. But the Spanish private sector, like its American counterpart, borrowed huge sums of money, much of it to invest in real estate. Then, Spanish real-estate prices came crashing down from their bubbly peak, bringing the economy down with it. The ensuing recession, with unemployment soaring to double-digit levels, has created a huge budget-deficit problem.

While the deficit is a problem for the Spanish economy, however, the main story is that the Spanish economy is a problem for Spain's budget.

Spain's economic woes are intimately linked to the problems of the euro. What a country in Spain's condition desperately needs is loose monetary policy and currency depreciation. That wouldn't help the country avoid economic pain--the definition of currency depreciation is that the value of the Spanish people's money would decline--but it would avoid the current plague of idle resources. Spanish exports would be cheaper for foreigners to buy, the country would be a cheap vacation destination, and unemployment would be much lower than 21 percent. None of this can happen, though, since Spain uses the same currency as Germany, Austria, and the Netherlands, which are in very different shape.

Italy, meanwhile, is all the way at the other end of the spectrum from Greece. It's a major country, on the list of the world's ten biggest economies, and can't be bailed out. What's more, it's budgeting is fine. After a long period of excessive deficit spending, the country has managed to run what's called a "primary surplus." That means the country takes in more in taxes than it spends on programs. The deficit is caused by the need to pay interest on outstanding debts, and Italy has a lot of outstanding debt. The good needs to do is to keep running the primary surplus and then have its central bank commit to ensuring that nominal GDP growth runs high enough to make its debt-to-GDP ratio shrink.

Like Spain, though, Italy has no central bank. It's on the euro. The monetary policy consistent with keeping German inflation low is making Italy's national gross domestic product growth too slow to repay Italy's debts.

These deep structural flaws with the euro were foreseen at the time of its adoption. Both Spain and Italy are facing fears from investors that they won't repay their debts. These fears are driven by the deep problems with trying to run a single monetary policy for a continent whose economies are still very different. The countries either need to default, which will unravel the single currency, or abandon the single currency, which will lead to default. European leaders could try to make the status quo work, but doing so would require much deeper continental integration to turn the European Union into something more like a United States of Europe with substantial place-to-place fiscal transfers and linked labor markets. In theory, this could be done, and some major opposition parties have hinted they might like to go in that direction. Most observers, though, regard any such thing--German taxpayers subsidizing Spanish and Italian citizens--as politically impossible. As long as that's the case, the European monetary union is en route to unraveling much faster than many are prepared to admit.

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