Saturday, December 10, 2011
The Brussels Agreement: Why it will Fail
One response would be to point out the irrationality of the agreement itself—the minimal role that fiscal profligacy played in bringing on the fiscal crisis, the lack of any mechanism for rebalancing between surplus and deficit countries, and the unchanged charter of the ECB, which prevents it from behaving like a normal central bank. Those arguments have been made, are being made and will continue to be made, and will apparently have no effect on the course taken by European politics.
So let’s look at the realpolitik, past and future.
First of all, it is important to bear in mind that this is an agreement of the European right. The economic collapse of 2008 resulted in an electoral rout of social democrats throughout the continent (and in the UK). That’s a story that needs more explanation, but for now the point is simply that conservative parties have absolute control over Europe, and the agreement just reached represents their priorities. It is for hard money, austerity in the face of recession, full guarantees for creditors, and implicitly for reining in the costs of the welfare state, which must happen if the deficit targets are to be met under foreseeable conditions. This is why politics matters, after all.
Not liking a political program is not the same as predicting its failure, however. It could happen that the conservatives get their way and a socially regressive stability takes hold. Under this scenario, the fiscal crisis recedes and Europe enters a long period of slow growth which is favorable for those who acquired wealth during the go-go years: the value of their assets is protected, and labor is mortally weakened. For those who designed the Brussels agreement, and for those who bankrolled them, this would look like victory.
A clear-eyed view of the situation suggests, for me at least, that this outcome is unlikely. I believe that the fiscal pledge will buy time—at most a year—for German support for peripheral finances. It is essentially a quid pro quo: the countries of Europe make a (foolish) promise to bind themselves to a 3% deficit rule, and in return the main creditor country, Germany, softens its stance toward transfers. How much softer? From first appearances, it looks like about €250B net, with some financing moved forward from 2013 to 2012. (This assumes that the €200B directed to the IMF is returned to Europe without leveraging Chinese or other commitments.) Is that enough? It depends on whether the market response is favorable. If interest rates come down in Italy, Spain and the rest, debt can be rolled over until the economy subsides. This means something like a quarter or two. If interest rates shoot back up, the money is not sufficient. In that case, everything depends on the ECB and whether Draghi now has implicit German forbearance to monetize a portion of euro-denominated sovereign debt.
But this about whether the plan can make it through the next few months. I believe it is simply impossible for it to survive much more than this. Absent a miracle, Europe is sliding into a recession. This will affect Germany as much as the weaker countries, even more considering its dependence on Eurozone exports. (Germany suffered an exceptionally sharp contraction post-Lehman too.) The result will be a risk of debt deflation in all markets. The sovereign debtors will again face default as public revenue dries up. Speculative assets like real estate will resume their decline. Overleveraged financial institutions—and Europe is the world leader in overleveraged finance—will need to be bailed out. Of course, a rise in unemployment will trigger automatic stabilizers and increase the pressures for discretionary fiscal deficits as well. It is likely that there will be a wave of elections in which center-left parties take revenge for their defeats of the past few years—Germany could lead the way, in fact.
When it comes to whether European economies will simply collapse into a deflationary spiral, or whether the Brussels commitments will be abrogated, I’ll put my money on abrogation. This agreement has a ticking clock, and when the time winds down, it will be history.