The new fiscal pact agreed to by the majority of EU countries (save Britain) on Dec. 9 in Brussels will do little to avoid a pending catastrophe. It neither addresses the main causes of the current eurozone crisis nor calls for the economic policies urgently needed to restore stability and increase employment and growth.
The dominant discourse of the pact places the blame for the crisis squarely on public-sector profligacy, yet the crisis did not begin in the public sector. It began in the private finance sector, where it was triggered by risky overleveraging by the unregulated shadow banking system of non-bank financial institutions, many of which were exploiting a dangerous housing bubble in the United States and Europe that went neglected by authorities. It quickly became a public-sector deficit crisis, however, as lavish bank bailouts were put together and tax revenues fell because of the economic recession. Yet the initial problems of the unregulated nature of the financial sector and its reckless use of derivatives and commodity market speculation, not to mention the "too big to fail" moral dilemma, have not been resolved at all, leaving the door open for the possibility of more financial crises in the future.
Another root cause of the eurozone crisis lies in the unwillingness of the European Central Bank (ECB) to modify its current rules so that it can act more like a proper central bank. Although the ECB's recent moves to cut interest rates for the second straight month and expand emergency financing for cash-starved banks are steps in the right direction, its continued unwillingness to buy the bonds of troubled eurozone countries will only deepen the crisis. True, there is a technical ECB rule prohibiting unlimited bond purchases, yet one would think staring into the abyss of a global depression might be a good enough reason to break this rule.
This fundamental failure to act with bond purchases reflects the eurozone's neoliberal architecture, which overtly seeks to diminish the role of the state and enhance the power of the market. This thinking is also reflected in the ECB's monetary policy, which is narrowly focused on maintaining low inflation over other goals such as promoting higher employment and growth. Because eurozone governments do not control their own national currencies and thus cannot devalue their way out of the crisis, the only other option for increasing their export competitiveness is to drive wages down and further weaken labor rights, a process referred to as an "internal devaluation" through the adoption of "labor flexibility" reforms.
In fact, the new EU plan to restrict deficit spending to 3 percent of GDP and have EU countries cut and starve their way out of this recession smacks of the misguided fiscal and monetary policy of 1937 and the same anti-growth, anti-worker, and anti–public investment toxic cocktails that have long characterized the IMF's approach in developing countries. These policies to drive wages lower and adopt budget austerity in the current context of a recession will surely fail as consumer demand falls further, unemployment worsens, tax receipts continue to decline, and public deficits rise anyway.
Also at fault in the crisis is Germany's long-standing beggar-thy-neighbor approach of using low inflation and low wages to out-compete its EU trading partners, which eventually created destabilizing imbalances within the eurozone. The approach worked so well over the last decade that it earned Germany a massive trade surplus while saddling the country's less competitive EU partners with large trade deficits. In so doing, however, it wiped out the purchasing power in these markets, which can no longer afford to buy German goods, thus killing the goose that laid the golden eggs.
So if these are the problems at the heart of the debt crisis, what are the solutions? European leaders could avoid eurozone imbalances in the first place by adopting sanctions against both deficit and surplus countries. Surplus countries could be required to provide countercyclical long-term financing to deficit countries during crises through a system of regional transfers, and adopt stimulus or even mildly inflationary policies at home to help boost the exports of deficit countries. But such steps to avoid imbalances in the future will require abandoning the current laissez-faire architecture of the eurozone.
Europe must also turn its attention to meaningful regulation. In the 1970s, the finance sector famously complained that too much regulation was constraining its animal spirits and amounted to "financial repression," prompting U.S. President Ronald Reagan and British Prime Minister Margaret Thatcher to set finance free with financial liberalization. But how free is too free, and at what point does a reckless and oversized finance sector become a problem? These are the questions that voices ranging from the Occupy Wall Street movement to Adair Turner, chairman of Britain's Financial Services Authority, are now raising, yet they are questions policymakers are still ignoring. Economic historians such as Hyman Minsky and Joan Robinson have noted that over the last 300 years, periodic financial crises have been preceded by exuberant speculative bubbles enabled by periods of financial liberalization, triggered by a crescendo of risky overleveraging, and followed by a period of re-regulation. Notably, however, there was no period of re-regulation following either the collapse of the dot-com bubble in the late 1990s or the more recent housing bubble in 2008. Finance may have avoided re-regulation after these recent bubbles because of the political power it has amassed over the years, as suggested by former IMF chief economist Simon Johnson in his Atlantic article, "The Quiet Coup."