The recent news from Europe could hardly be more unsettling for those who desperately wanted to believe that the eurozone was finally finding its way out of the region's imbroglio. The collapse of the Dutch coalition government over budget cuts dramatically called into question the commitment of the staunchest supporter of the German hard line on the need for fiscal austerity. On the same day, the National Front, whose platform calls for an exit from the euro, gained a record 18 percent of the vote in the first round of the French presidential elections. And the results confirmed François Hollande, who wants to renegotiate the European Union's recent German-inspired fiscal pact to create room for growth policies, as a firm favorite to wrest the presidency from Nicolas Sarkozy. Not surprisingly, markets retreated and troubled countries such as Italy, Spain, and France itself saw their borrowing costs soar.
Indeed, every time Italy and Spain -- two of the world's largest economies, with a combined government debt that exceeds $3.5 trillion -- struggle to refinance their debt at acceptable interest rates, the eurozone and the global economy flirt with disaster. Yet while the commotion over bond spreads is entirely justified, it diverts attention from the main arena where the survival of the euro will ultimately be decided: the realignment of Europe's peripheral economies (Greece, Ireland, Italy, Portugal, and Spain, or the "GIIPS") toward exports and import substitutes (think Spaniards buying fewer Japanese cars and more Spanish-made cars). Since domestic demand in the periphery is declining fast as finance dries up and budgets shrink, trade is the only hope for reigniting sustained growth in the region. Without growth, unemployment will keep rising from its extraordinarily high levels, political resistance to the monetary union will escalate, and it will become more and more difficult to service debts, with the very real risk that countries will be forced into default and -- possibly -- an exit from the euro.
Until recently, improved global economic conditions and large-scale liquidity injections by the European Central Bank (ECB) into European banks under its long-term refinancing operation (LTRO) program had reassured markets and kept Italian and Spanish bond yields well below their terrifying peak of last November. Global conditions can change quickly, however, and the policies adopted, however necessary they may have been, are more palliative than cure.
For example, Greece's debt remains unsustainable, and a second round of restructuring -- this time to include forgiving official debt as well as private debt -- will be needed. And the ECB's LTROs, which have so far shored up banks and supported government bond purchases, may backfire if, as is already happening, risk aversion returns and the prices of government bonds that banks have acquired fall again. While the periphery cannot avoid cutting government deficits, it may ultimately have trouble hitting its deficit targets if austerity stunts growth.
More important still, it is vital to recognize that the periphery's fiscal mess is not at the root of the euro crisis. The crisis, in other words, cannot be resolved with a fiscal fix alone, although a fiscal correction must be part of the solution. For example, Ireland almost halved its debt-to-GDP ratio (from 48 percent to 25 percent) between 1999 and 2007 and Spain nearly did the same (62 percent to 36 percent). These ratios were much lower than Germany's at the outbreak of the current crisis and, in Spain's case, they still are. Nor are weak banking systems the cause of the crisis in the periphery. When the global financial crisis struck in 2008, for instance, the Italian and Portuguese banking systems were in much better shape than their British, French, or German counterparts. Fiscal and banking problems, dangerous as they are, are a consequence of the crisis -- not their primary cause.
Fundamentally, Europe's so-called debt crisis is really more of a competitiveness crisis -- one that divides the eurozone's core (Austria, Belgium, Germany, France, Finland, and the Netherlands) from its periphery. The misalignment began in the mid-1990s as interest rates in the periphery declined to the lower levels found in the core, and domestic demand and inflation grew more rapidly in the periphery than in the core. This, combined with highly inflexible labor markets and limited competition in sectors ranging from pharmacies to banks, led to an erosion of competitiveness in the periphery -- reflected in wages outpacing productivity and prices in the sheltered sector (comprising everything from government to construction to coffee and barber shops) rising relative to the prices of exports and import substitutes, whose prices are determined in world markets. There followed a progressive reallocation of the periphery's production capacity toward the sheltered sector, most visibly toward construction in countries such as Ireland and Spain, which went on to experience the mother of all housing bubbles. Measures and estimates of the competitive misalignment in the eurozone vary. Typical estimates suggest that, in the periphery, the cost of labor, adjusted for productivity, is higher by 15 to 30 percent relative to Germany.