With substantial fiscal contraction in store over the next two years, banks deleveraging, and consumers and investors scared, there is simply no possibility of growth from domestic demand in the periphery in the foreseeable future. Indeed, with structural reforms incomplete and slow to produce results, recession -- in containing wages and inflation -- is the main instrument to engineer the competitive realignment. And in economies where both the private and public sector have become highly externally indebted and competitiveness hasn't improved, any recovery of domestic demand will quickly run up against borrowing constraints as current account deficits widen.
In these dire circumstances, can the trade sector come to the rescue?
This currently appears least likely in Greece because its export sector is small and mostly based on tourism. Portugal has a bigger export sector, but one that still confronts Chinese competitors directly in sectors such as footwear and garments. Ireland, by contrast, has high-tech exports that amount to 100 percent of GDP and are funded and operated by foreign multinationals. For these reasons, Ireland has a chance of reigniting growth, but it may be hit again by large banking losses.
Spain, meanwhile, has several competitive international firms and, unlike the other peripheral countries, has maintained its share of European exports over the past decade. But its export sector is small at roughly 26 percent of GDP, its private sector is heavily and externally indebted, its unemployment is already extremely high, and its fiscal and housing sectors still require enormous adjustments. Spain's capacity to steer through more austerity is therefore questionable.
While Italy's public debt is larger than Spain's, it has a more diversified export base and smaller fiscal, housing, and labor market imbalances. Italy's austerity and liberalization measures, however, are still very recent, and there is no sign yet of a trade-led recovery.
How should Europe address these challenges? As many economists are advocating, a €2 trillion firewall could be erected to protect Italy and Spain, the ECB could provide unlimited support to governments, and eurozone governments could even jointly issue eurobonds that would be less liable to attack than those of individual countries. Yet even if the resolute German political resistance to these measures could conceivably be overcome in the event of a market panic, none of these approaches would deal with the underlying competitiveness issue, and could instead delay its resolution.
In any event, the political stars are not aligned at present for these ambitious steps and there is little alternative but to accelerate the adjustment process in the periphery through small steps. These could include tax changes that incentivize production and exports (such as cutting payroll taxes) and discourage consumption and imports (such as increasing value-added taxes), and more far-reaching labor and product market reforms such as reducing severance payments drastically and attacking price fixing with more determination. A less ideological approach to policy by Germany and less insistence on blanket austerity measures even in relatively healthy economies could also stoke demand in the eurozone's core, increase eurozone inflation, and lower the value of the euro, all of which would ease adjustment in the periphery.
If, however, all this and fiscal cuts are not enough to restore competitiveness in the periphery -- as has so far been the case -- and unemployment keeps climbing, new approaches must be considered. Should failing countries be assisted by healthier ones in the core, the ECB, and the IMF to restructure their debt and leave the eurozone? The complexity of doing so is daunting and great collateral damage would ensue, but there would at least be a light at the end of the tunnel. The alternative -- depression, chronic unemployment, deindustrialization, and depopulation of the afflicted countries, plus even more concentration of industry in northern Europe -- is not what anyone signed up for, or what electorates will accept.