Tuesday, September 13, 2011

Why the EU Has No Policy Options

Why has it been so difficult for the EU to resolve its sovereign debt crisis? Because it has no policy options.

Fiscal policy is limited by the EU's ostensible restriction of government deficits to 3% of GDP. Virtually all EU members, including powerhouse Germany, have violated this commandment. With deficits already exceeding 3%, EU members can't go Keynesian (more so than they already have).

The European Central Bank, guardian of the Euro, is constrained by its charter to promote currency stability, meaning that it is duty bound to keep inflation low. At 2.5%, inflation in the Euro zone is moderate. But the ECB can't take the low road of expediency and inflate the Euro in order to ease the burden of repaying the EU's sovereign debt and make the Euro zone more competitive internationally. Aside from violating its charter, the ECB would rile up the Germans, for whom inflation is anathema and perhaps cause enough to leave the EU.

Germany was the wealthiest proponent of the EU, and created the union in its own image. Fiscally prudent and indefatigably vigilant against inflation, the EU allows member nations to combat excessive debt only by enhancing the productivity of workers and elevating economic growth. A very German solution, but not all of the EU is German or inclined toward that persuasion.

So what's left? Right now, talk therapy is being offered. Rumors of Chinese interest in Italian bonds surfaced first. These preliminary discussions are less than first touted, focusing on strategic investments in Italian companies than Chinese purchases of Italian government bonds. In other words, the Chinese are trying to cherry pick the best of Italy's assets in a moment of Italian weakness. That ain't a bailout in anyone's book. The Chinese premier has also made noise about Chinese support for EU debt, but only if China gets improved trade access to Europe. That's just talk for now. Europe's immediate cash flow needs won't be served by this proposal.

Rumor mongers also proffer tales of Brazilian and other BRIC interest in Euro zone sovereign debt purchases. But these eager whispers appear to be just an agreement to meet and talk next week in Washington. The market has bobbed up and down the last couple of days. Its modest rises may be little more than short covering by hedge funds that don't want their butts fried in case some outside money actually wants to bet on Euro debt.

Outside money would appear to be Europe's only hope. It can't use fiscal policy, nor can it deploy monetary policy. But outside money may be far from a panacea. It can be profitably invested in EU sovereign debt only at a discount, something that by definition would preclude a bailout. And, even if the BRICs are willing to lend a helping hand, the hundreds of billions (and maybe more) of hinky Euro sovereign debt may defy the best of BRIC intentions. The BRICs are growing quickly, but don't by themselves have the sheer financial horsepower to haul Europe back from brink.

Europe remains a wealthy part of the world, with substantial economic resources. Europeans won't have to live on air. But the vision of living ever larger indefinitely into the future dangled by EU enthusiasts is as mythical as the chimera. The only way for the EU to survive is to endure a long, painful test of shared sacrifice and loss, leavened only by disappointment and disillusionment, before a true United States of Europe can be forged. And it's far from clear that Europeans will meet that test.

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