TOUGH decisions ahead for European economies

Is Europe in an existential crisis? Yes, according to George Soros when he spoke at the European Council on Foreign Relations late last month. Five days later, I heard him elaborate on this view at the Trento Economics Festival in Northern Italy.
For an Italian city to celebrate economics as a science is remarkable at a time when the economics profession has lost considerable credibility and trust. This was brought more into focus when the Italians finally managed to form a government two months after the March elections. This is a government formed from the populist eurosceptic Five Star Movement and the right-wing League party – an unholy alliance that seems to want to have minimum wages, cut immigration, cut taxes and boost subsidies all at the same time.
Why is the Italian political fracas so threatening to the existence of the European Union and eurozone?
First, Italy is the third largest economy in Europe after the pending departure of Britain under Brexit.
Second, its debt stock, at roughly 160 per cent of GDP is the third largest sovereign debt in the world, and Italian banks have high levels of non-performing loans. Third, even the IMF admits that a decade after the global financial crisis, Italian real GDP per capita is still below what it was 1999, 8 per cent lower than in 2007, and falling behind other eurozone countries.
Suggestions that Italy is finally recovering (at 1.6 per cent per annum) are not good enough to address the growing debt, high unemployment and regional and generational inequalities. The electorate understandably rejected the old establishment and voted in very divergent populist parties. Surveys suggest that a third of Italian voters toy with the idea of exiting the eurozone – the second highest after Greece. But Italians and Greeks understand that a divorce from the European Union would carry devastating costs in terms of inability to repay their sovereign debt, plunging them deeper into crisis.
Italy’s problems stem from a combination of internal structural issues and its complex relations within the European family. The good news is that Italy does not suffer the property-related credit boom-busts of Greece, Portugal, Spain and Ireland. The government may be in debt but the people are actually quite wealthy, with a balanced net international investment position.
Because of fragmented government (with an average life of a year each since 1946), the short-sighted politics never addressed long-haul labour and productivity reforms even as Germany and the northern European economies powered ahead.
Nearly two decades after the formation of the euro monetary zone, Europe’s banking and capital markets are still fragmented. Because of Germany’s historical experience that rejects high debts, deficits and inflation, Europe cannot agree to mutualise its member countries’ debts.
In plain language, the largest and richest member of the family refuses to accept that the individual debt of each member is a family debt.
The cumulative result since the 2007 financial crisis is that the GDP numbers of Europe as a whole look good, but the southern people feel very bad. This is a family that is existentially rich, but unhappy, made worse by the threat of more immigrants from the war-torn Middle East and water-stressed North Africa.
Indeed, geopolitically, Europe has transformed from a roughly balanced current account trade zone to the largest trade-surplus region in the world, running a 121 billion-euro (Bt4.5 trillion) trade surplus with the United States in 2017. 

Fiscally cautious
Europe is now holding the largest part of the US trade deficits, replacing China and the oil-producing countries. Since exports make up 43 per cent of the EU’s GDP, compared with 12 per cent for the US, Europe is very vulnerable to trade friction with the US and cannot escape collateral damage from its growing protectionism.
The standard Keynesian argument in such a situation is for the winner country (especially Germany) to reflate, spend more and increase aggregate demand so that the southern deficit countries will also reflate.
Because Angela Merkel’s German government is fiscally cautious, this imposes a huge political strain within southern Europe. The solution to this high-debt situation was identified by economist John Maynard Keynes when he wrote “The Economic Consequences of the Peace” in 1919. At that time, Germany as the loser of World War I was forced by the winners to bear the high cost of war reparations, forcing Germany into huge deflation, excessive debt and later hyperinflation in order to get rid of that debt. This led to World War II.
Post-war Europe was reflated by the US Marshall Plan. In the aftermath of European debt crisis, where is the European Marshall Plan for Europe and its climate-stressed neighbours?
The irrationality of rational economics is that what seems reasonable to professional economists is unacceptably unreasonable when the debtor countries have to force even higher unemployment and loss of income to repay the debts to the rich. Rational economics leads to irrational populist politics.
Ironically, one century later, Germany is now the fastest growing creditor to the southern European debtor countries and increasingly the US.
Politicians who refuse to accept economic realities – that excessive debt is money already lost and unrecoverable except historically through war or hyperinflation – will be swept away by the tides of change.
From the long lens of history and a distant Asian perspective, the European existential crisis is not whether Europe will survive, but whether Germany’s leader will rise above a local perspective to become a regional and global statesperson.