Get Used to the EMU as a Source of Problems

Macroeconomic problems in the EMU are quiescent now; don’t get used to that — this is going to be in the news for your adult life (kind of like racism in the U.S. or violence in the Middle East).

A good primer on this is the interview entitled “Why the Euro Crisis Isn't Over” in the February 23 issue of The Wall Street Journal.

In macropolitics, there’s always a lot of fingerpointing about why people didn’t forecast this or that. The thing is, they usually did:

… Bernard Connolly foretold the misery that awaited the European Union. Given that he was an instrumental figure in the EU bureaucracy and publicly expressed his doubts in a book called "The Rotten Heart of Europe," he was promptly fired. Mr. Connolly takes no pleasure now in having seen his prediction come true. And he takes no comfort in the view, prevalent in many quarters, that the EU has passed through the worst of its crisis …

The first solution is the one used in the U.S., the second one is what Italy is leaning towards:

Two immediate solutions present themselves, Mr. Connolly says, neither appetizing. Either Germany pays "something like 10% of German GDP a year, every year, forever" to the crisis-hit countries to keep them in the euro. Or the economy gets so bad in Greece or Spain or elsewhere that voters finally say, " 'Well, we'll chuck the whole lot of you out.'

Maybe he knows what he’s talking about:

In 2003 … Mr. Connolly described the U.S. economy as a debt-driven Ponzi scheme and predicted that interest rates would have to fall even further in the next cycle to keep the scheme going.

As per usual, politicians and the media focus too much on the symptoms:

… "both the sovereign-debt crisis and the banking crisis are symptoms, not causes. And the underlying problem has been that there was a massive bubble generated in the world as a whole by monetary policy—but particularly in the euro zone" by European Central Bank policy.

…

"And what kept the stuff flowing in," Mr. Connolly says, "was essentially the belief, 'Well, yes, there is a high rate of return in construction.' " That in turn depended on "ongoing expectations" about house appreciation "that were in some ways not dissimilar to what was happening to the United States in the middle of the last decade. But it was much bigger."

How much bigger? "If you scale housing starts by population, then the housing boom in Spain and Ireland was something like three or four times as intense as the peak of the boom in the U.S. That's mind boggling."

And here’s what I want you to think about. Several times this semester I’ve pointed to the problem with long-term unemployment in the U.S. In Europe, the problem is countries that aren’t competitive, in the U.S. the problem is groups within the labor force that aren’t competitive. So, consider this quote, and draw an analogy between how it talks about countries within Europe, and how we should talk about some workers in the U.S.

That torrent of money drove up wages far faster than productivity improved, while cheap borrowing led to major deficit spending. After the 2008 financial panic, the bubble inevitably burst.

So what's needed now is not simply a fiscal retrenchment, or even a retrenchment along with banking reform. Wages and prices have to adjust to something like their pre-bubble trends, Mr. Connolly says, to make these economies competitive again.

If it’s correct to draw this analogy, then the U.S. is doing fiscal retrenchment (and it won’t be enough) with banking reform (which won’t be enough) because the bubble was in the real wages of people tied to the construction, housing, and real estate finance sectors.