The Euro Is Dead

But, if Europe's leaders play their cards right, it can rise again.

Europe is living in denial. Even after the economic crisis exposed the eurozone's troubled future, its leaders are struggling to sustain the status quo. At this point, several European countries will likely be forced to abandon the euro within the next year or two.  

European leaders tell us that this is impossible. There is no legal mechanism, they say, for exiting the euro. But the collapse of the euro is simple arithmetic: Once a country's debt-to-GDP ratio gets high enough, it becomes impossible for it to generate enough future taxes to repay its existing debt and interest costs. This week, Portugal became the latest country to threaten the integrity of the eurozone when it saw the yield on its Treasury bills soar, based on investors' fears that it would be unable to pay its debt.

The only way out of this conundrum is for countries with insurmountable debt burdens to default on their euro-denominated debts and exit the eurozone so that they can finance their continuing fiscal deficits by printing their own currency. Here's a hint for Europe's politicians: If the math says one thing and the law says something different, it will be the law that ends up changing.

The countries currently teetering on the precipice include "peripheral" countries -- such as Greece, Ireland, and Portugal -- as well as large countries, such as Spain, Italy, and France. It is extremely unlikely that all of these countries will still be members of the eurozone by the time revelers gather to ring in New Year's 2013. The most likely scenario is that the next two years will witness the departure of more than one peripheral country and at least one of the large countries.

Greece is at the top of that list. The country will soon have a sovereign debt-to GDP ratio of more than 150 percent and an economy that contracted approximately 4 percent in the past year. It has long suffered from the worst corruption and largest shadow economy in Europe, while also possessing some of the lowest labor participation rates, most generous pension systems, and highest consumption rates among its European peers. It is true that the Greeks have made heroic efforts in the past six months to cut spending and raise taxes, but it won't be enough to reverse the explosive costs of covering its debts. And yet, the story goes, Greece will somehow repay what it owes.

Following closely on Greece's heels is Ireland. During the so-called "Irish miracle," the country experienced a housing boom that saw twice the appreciation as did the United States. When this bubble popped, Ireland's banking system suffered a massive loss. The government's bank bailouts have added more than 20 percent of GDP to its budget deficit in the past year and will add a similar additional amount to its deficits in the near future.

The Irish case also shows the perils of EU intervention. Ireland was forced by its self-serving European partners to guarantee massive bank debts -- in order to forestall debilitating losses to German, Belgian, Danish, and British banks, among others -- as a condition for receiving emergency EU assistance. This Irish policy mistake has raised its debt to stratospheric levels, which the government will be hard-pressed to bring down. Thus, in effect, some of the largest EU countries proved their willingness to throw Ireland under the bus to postpone dealing with their own financial institutions' problems.

Now Spain is being pushed by those same European partners into making the same deadly mistake as Ireland. Spain's housing boom was similar to that of Ireland and was similarly financed by large external borrowings. The good news in Spain, however, is that most of the country's largest financial institutions appear to be solvent. If Spain shuts down its insolvent savings banks and allows closed banks to default on their external bond debts held by other EU countries' banks, Spanish sovereign solvency can be preserved.

A number of other European countries face similarly daunting fiscal challenges. Italy, for example, is running a debt-to-GDP ratio in excess of 125 percent. Although serious and immediate fiscal spending cuts could give Italy a reasonable chance of repaying its debts, the country seems so politically broken that it is unlikely to make the deep spending cuts that would permit it to stay in the euro. Its meager cuts this past year are an indication of how difficult it is for Italy's political system to confront its challenges.

The same failure of political will bedevils France, Belgium, and Portugal. The French proved that they are willing to riot over a two-year extension of the retirement age. They will need to reconcile themselves to far more drastic measures if they hope to get their dismal fiscal situation under control.

This partial collapse of the euro is inevitable, and Europe's leaders should focus on the next step: Their challenge now is to lay the groundwork for a sustainable currency union in the future, once exiting countries reform themselves enough to rejoin. To do so, however, they will need to take stock of the institutional deficiencies undermining the current union, so that the new eurozone is more crash-proof than the last one.

Europe must do far more to cut the growth of government spending -- the only credible path to preventing ballooning deficits. But it needs to go even a step beyond that: Europe must agree on measures that prevent countries from behaving irresponsibly to take advantage of their membership in the eurozone. One of the reasons that Italy and Greece spent so much is that their interest rates on debt fell dramatically when they joined the eurozone, making deficit finance more attractive. There is no substitute for the creation of a fiscal union, which would centralize enforcement power that could credibly control spending. A currency union cannot survive without a corresponding fiscal union.

But fiscal reform is not enough without measures to strengthen the competitiveness of southern Europe. Southern European countries, notably Spain, Italy, Portugal, and Greece, are finding it increasingly difficult to compete in global trade -- the result of restrictive union contracts and labor laws -- and have accordingly suffered from high current account deficits and high unemployment. If left unchecked, these dynamics will produce a political powder keg of widening interregional economic-welfare differences that would threaten the long-term cohesion of the union.

The only way around this problem is to make southern Europe more business-friendly. That means making it easier for businesses to fire workers and cut wages. It also means less generous welfare programs and credible efforts to reduce corruption and lower entry barriers to foreign competition. A reconstructed eurozone should make the implementation of these reforms part of the requirement for membership.

The European financial sector is also in dire need of reform. New regulations should be put in place that make banking collapse less likely, most importantly through the creation of credible means of measuring bank risks and requiring capital and liquidity commensurate with those risks. Europe should also put in place policies that transparently and predictably allocate authority across different national regulators in the event of a bank's collapse. Without a credible plan for resolving a large global bank crisis, politicians will tend to prefer bailouts as a means of avoiding unpredictable financial chaos.

Policymakers must learn that the "too-big-to-fail" problem is both dangerous and avoidable, and that choosing not to bail out banks is a viable option. Politicians today are frightened of transparency in the recognition of bank losses and are often unwilling to close insolvent banks out of a fear of "systemic risk." However, it is only by credibly recognizing banking-system losses that governments can put an end to uncertainties in the financial market.

The eurozone's problems are not going away. Whether these problems will eventually be seen as bumps on the road to a credible currency union or as symptoms of the irreconcilable conflicts within Europe depends on how the eurozone countries react. The good news is that Europe possesses the techniques of statecraft and financial engineering to build the institutional foundations of a long-lived, stable union. The lingering question, however, is whether it possesses the political will to do so.

Sean Gallup/Getty Images


10 Percent Unemployment Forever?

Why the good news about the economy doesn't necessarily mean that jobs are coming back anytime soon.

The U.S. economy finally appears to be picking up steam and headed toward recovery: several economic indicators -- including manufacturing and services output, and sales of cars and consumer goods -- have shown noticeable improvement over the last few months. Scan virtually any financial news website, and you'll see it's now a consensus that a sustained economic recovery has not only arrived -- it's picking up speed.

But there's good reason to believe that the labor market won't be keeping pace. Rather than an aberration, high unemployment may be an enduring feature of the United States' economy.

We are, sadly, in a very deep pit when it comes to the labor market. The recent private-sector estimate from ADP Employer Services announced the creation of 297,000 new jobs for December, but this is the first instance of a real dent in the jobless rate since the beginning of the recession. The November report from the U.S. Bureau of Labor Statistics pegged the unemployment rate at 9.8 percent, which translates to over 15.1 million unemployed. Over 40 percent of currently unemployed workers have been out of a job for over six months, the highest percentage of long-term unemployment since World War II. The numbers look even worse if we consider the underemployed, which includes potential workers who have given up looking for a job or the 9 percent of the labor force that is made up of part-time workers who would prefer to be working full-time. At least 2.5 million people gave up looking for work in the last year alone.

Even if the December rate of job creation continues, it will be 2014 before unemployment is down to 5 percent. But last month's good news may not last. At a more conservative estimate of 150,000 jobs added per month, it could be 2024 before employment is back to 2007 levels. Keep in mind that there are 100,000-plus estimated new entrants into the workforce each month. In November, a sum total of 92,000 new jobs were created -- but that didn't lower the unemployment rate.

So what happened? Why have American labor markets ended up in such a dire situation?

The simple Keynesian explanation for the initial unemployment is that aggregate demand -- the country's combined spending and investment -- has been too low. But it's unlikely that spending is the only problem, as unemployment is too high and too persistent relative to similar episodes of disinflation in recent history. If weak demand was the main problem, profits should be collapsing too, but they are not. Investment and corporate profits have been fine for some time now, and they are broadly within the range of pre-recession estimates.

There's a second problem with the Keynesian story, which relies heavily on the notion that real, inflation-adjusted wages are sitting at too high a level. If unemployment causes someone real suffering, why wouldn't he or she be willing to take a lower salary to get a job and ease the pain? But rather than falling, private-industry wages are currently on the rise -- up nearly 60 cents per hour since the end of the recession. There are plenty of good theories why it is hard to cut the wages of employed workers -- long-term contracts pose legal challenges, and fragile worker morale threatens to collapse under the stress of wage cuts. But it's harder to explain why unemployed workers can't find new jobs for less pay, especially if output is recovering, profits are high, and corporations are sitting on a lot of cash.

Many conservatives in the United States have placed the blame for high unemployment on the shoulders of President Barack Obama, arguing that his administration's liberal agenda has complicated the recovery. But the statistics suggest otherwise. Again, corporate profits and consumer spending are fine. Indeed, it's the sector in which the government has most directly intervened -- health care -- that has maintained the most robust job growth over the past two years, adding 20,000 new jobs in November alone. And don't go blaming job losses on illegal immigrants taking jobs from documented workers: Latino immigrants have left the country in large numbers since the start of the financial crisis.

As time passes, it is harder to avoid the notion that a lot of those old jobs simply weren't adding much to the economy. Except for the height of the housing boom -- October 2007 through June 2008 -- real GDP is now higher than it has been in the entirety of U.S. history. The fact that the United States has pre-crisis levels of output with fewer workers raises doubts as to whether those additional workers were producing very much in the first place. If a business owner fires 10 people and a year later output is almost back to normal, it's pretty hard to make the argument that they were doing much in the first place.

The story runs as follows. Before the financial crash, there were lots of not-so-useful workers holding not-so-useful jobs. Employers didn't so much bother to figure out who they were. Demand was high and revenue was booming, so rooting out the less productive workers would have involved a lot of time and trouble -- plus it would have involved some morale costs with the more productive workers, who don't like being measured and spied on. So firms simply let the problem lie.

Then came the 2008 recession, and it was no longer possible to keep so many people on payroll. A lot of businesses were then forced to face the music: Bosses had to make tough calls about who could be let go and who was worth saving. (Note that unemployment is low for workers with a college degree, only 5 percent compared with 16 percent for less educated workers with no high school degree. This is consistent with the reality that less-productive individuals, who tend to have less education, have been laid off.)

In essence, we have seen the rise of a large class of "zero marginal product workers," to coin a term. Their productivity may not be literally zero, but it is lower than the cost of training, employing, and insuring them. That is why labor is hurting but capital is doing fine; dumping these employees is tough for the workers themselves -- and arguably bad for society at large -- but it simply doesn't damage profits much. It's a cold, hard reality, and one that we will have to deal with, one way or another.

So how should we interpret the recent trickle of good news? Well, one positive note is that less-productive, laid-off workers are undertaking the needed adjustments. For instance, according to a survey by the Pew Research Center, nearly 70 percent of unemployed workers have already made dramatic changes in their career or job-field choice, or are considering doing so. There also have been migrations out of expensive urban areas and into smaller and less expensive ones, such as Austin, Salt Lake City, and northern Virginia, with relatively high-performing industries and more fluid labor markets.

In other words, the U.S. economy is going through some major structural shifts. It's not a question of getting back to where we were, but rather that the economy must solve a new problem of re-employing a lot of people who were not, in reality, producing very much in the first place. That's a steeper challenge than we had realized early in the stages of this recession -- and so far policymakers have failed at meeting it.

Analysts still disagree on how rapidly the U.S. economy will recover. But they're missing the point. The era of low unemployment may be in our rearview mirror for a long time to come.

Robyn Beck/AFP