Euro Crisis: Responses from the United States and Germany

Originally published by the Carnegie Endowment for International Peace in Brussels
Participants: Tim Adams, Carlo Bastasin, Uri Dadush, Matthias Sonn

Greece’s sovereign debt crisis has spread across Europe, forcing the European Union and the IMF to extend a massive support package to struggling Euro area members. Nevertheless, the European debt crisis could deepen, cause another global banking crisis, and cut short the global economic recovery.

Tim Adams of the Lindsey Group, Carlo Bastasin of the Peterson Institute for International Economics, Matthias Sonn at the German Embassy, and Carnegie’s Uri Dadush discussed the causes and potential ramifications of the euro crisis and the role of Germany and United States in it.

Causes of the Crisis

Dadush outlined the causes of the current crisis, which trace back to the introduction of the euro over a decade ago.

• Unwarranted confidence: The adoption of the euro led to a surge in confidence in Europe’s less stable economies, creating a domestic demand boom and credit expansion, particularly in Greece, Ireland, and Spain.
• Misallocated resources: During the boom, resources were directed away from more productive tradable sectors and into non-tradable sectors, including housing and construction, realigning these economies away from exports.
• Lost competitiveness: The boom, coupled with the move away from exports, induced rapid wage growth that outpaced productivity, eroding external competitiveness.
• Increased spending: Tax revenue rose with domestic demand, compelling governments to increase spending.
• The recession: The Great Recession exposed these weaknesses by halting growth. Debt levels surged, revealing government spending as unsustainable.

Though the European rescue package has stopped the bleeding, the crisis is still ongoing. Government bonds have lost value and banks have taken the hit. Dadush warned that the next phase of the crisis could come through them.

The German Position

Lacking a central economic authority, Europe relies on Germany, the region’s largest economy, for economic and political leadership. The adjustments now required of European economies will be extremely unpopular, and strong leadership is needed to ensure that those adjustments are maintained. As Sonn noted, however, asking for German leadership generally means asking for German money, and Germans have been reluctant to open their wallets.

• Finding public support to rescue Greece is understandably difficult in Germany; Sonn compared it to the trouble U.S. politicians would have trying to gather support for bailing out another country’s Wall Street.
• Bastasin added that Germany generally oppose all bailouts, even those for Germans.
• Germans fully support Europe and the euro, asserted Sonn. In their view, a failure of the euro is a failure of Europe.

While Germany has approved the European rescue package, some are now calling for Germany to expand domestic demand and raise wages in order to help support Europe’s troubled economies. Rather than asking Germany to impair its economy, these countries should take steps to enhance their own competitiveness, argued Sonn.

The U.S. Role

The United States has a vital interest in assuring that the euro crisis does not intensify and should use its influence to press for reform in Europe, argued Adams. President Obama has already played an important role, and Adams stated that he should continue to do so.

• Financial ties: The U.S. economy is linked to Europe not just through trade and financial markets, but also through employment—3.5 million U.S. workers are employed by European firms. Furthermore, the falling euro hurts U.S. competitiveness, especially in third markets (markets outside of the U.S. and Europe in which both compete).
• Recovery: The longer the crisis lasts, the more the recovery—which is still fragile—is imperiled.
• Provide support: The United States can support Europe by encouraging medium-term austerity and structural reform in the Euro area that facilitates private sector growth, Adams concluded.

Moving Forward

In order to resolve the crisis, Bastasin argued that fiscal adjustments—while necessary—are not enough; Europe needs to reform structurally to restore competitiveness.

• Restoring competitiveness: The true cause of the crisis was a structural misallocation of resources, stated Dadush. Correcting this imbalance will require a number of reforms, including wage cuts.
• Greece: Participants disagreed about the fate of Greece. Bastasin and Sonn claimed that Greece could stave off default through fiscal consolidation, competitiveness reforms, and wage reduction. Adams and Dadush disagreed, arguing that, while the reforms could work, they would be extremely painful and Greece would likely be forced into restructuring its debts.
• Contagion: If Greece does default, Bastasin noted that other countries could be dragged down alongside it.
• Banks: Banks’ problems should not be ignored and “stress tests” would be wise, commented Adams.
• Resolving the crisis: Adams and Dadush suggested ways in which other countries and financial institutions could help:
  • The European Central Bank should continue its bond purchasing program, suggested Adams.
  • Since adjustments in troubled economies are deflationary, Dadush called for a more expansionary monetary policy and greater domestic demand in surplus Euro area economies.

Participants agreed that the crisis in Greece should serve as a warning to other advanced countries, not just those in the Euro area. The United States, the UK, and other advanced countries face their own fiscal problems. Unless these countries make adjustments, Adams warned, they will soon face the same troubles as those plaguing Greece. The reforms Europeans are currently being forced to make are necessary outside of Europe, and the panelists concluded that other countries should begin making them now, rather than waiting for a crisis.