The Magazine

Tough Times in EUtopia

The continent's politicians think the undemocratic character of the European Union is a virtue. They have miscalculated.

Mar 30, 2009, Vol. 14, No. 27 • By ANDREW STUTTAFORD
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In other countries, most notably a horribly in-hock Italy (public sector debt over 100 percent of GDP and expanding fast), low interest rates allowed governments to put off long overdue structural reforms. Instead of forcing the introduction of the badly needed discipline that was allegedly one of the principal reasons for its adoption, the euro (a hard currency when compared with shabbier predecessors such as the lira or drachma) was treated as a free pass. It has been anything but. Even before the current mess, Italy's crucial export sector was finding it difficult to cope with the brutal combination of rising cost inflation and a currency far stronger than the accommodating, and periodically devalued, lira. On some estimates, this latest recession is the fourth that Italy has suffered in the last seven years. Back in 2005 Silvio Berlusconi described the euro as a "disaster" for his country. He was not exaggerating.

Devaluations are to GDP what steroids are to sport. In the long-term they may be unhealthy, but in the short-term they frequently work miracles. The problem is that the option is no longer so easily available for the nations that adopted the euro. Italy, Ireland, and a number of other countries are in the grip of a one-sized currency that could never fit all, and the euro is now for them little more than a straitjacket or, more accurately, a noose. They have theoretically retained enough sovereignty to quit the euro, but for one of them to do so, especially if other states stick with the common currency, would be to risk something close to complete economic meltdown.

Money would pour out (so much so that capital controls would probably be required), interest rates would soar, and the reborn national currency would plummet. In the absence of a bailout from the eurozone it had just abandoned, the exiting country itself would probably be driven to renege (either de facto or de jure) on its foreign debt-as would much of its private business. In its consequences, this could be a Lehman-plus trauma with possibly devastating effects on already chaotic international capital markets. No less critically, it could set off a crisis in confidence in the credit of those weaker nations that had kept faith with the single currency, not to speak of feebler economies elsewhere. The cure, therefore, could well be worse than the disease.

In the meantime, in a damned-if-you-do, damned-if-you-don't spasm, the markets are fretting that the disease is turning ever more dangerous-and, in a process that feeds upon itself, ever more infectious. Spreads on sovereign debt yields within the eurozone (between German Bunds, say, and paper issued by Spain, Greece, Portugal, Italy, and Ireland) have widened noticeably. This is a warning that investors are beginning to think a once unthinkable thought: that one or more of the zone's less resilient members might go into default. On this logic these countries can neither afford to keep the euro nor to junk it. Rock, meet hard place.

These worries are made even more pressing by concern over the impact of Eastern Europe's spiraling economic woes on the already shattered finances of the western half of the continent. Contrary to some of the more excitable headlines, not all the countries of formerly Warsaw Pact Europe are, yet, in deep trouble, but the problems of those that are (notably Hungary, Ukraine, Romania, and Latvia) threaten to wreck confidence in those that are not. And those problems will not be confined safely behind the Oder-Neisse line: Two of Sweden's largest banks, for instance, are frighteningly overexposed to the faltering Baltic States, while their counterparts in Austria, seemingly lost in nostalgic Habsburg reverie, have reportedly lent out the equivalent of 70 percent of their country's GDP to once kaiserlich und königlich territories and parts nearby.

Eastern Europe's problems are Western Europe's and, given Eastern Europe's dependence on Western capital flows, vice versa, a state of affairs that neither side appreciates. Infuriated by the impression that they were being sidelined by the upcoming "G-20+" summit in London, nine of the EU's former Soviet bloc members held their own breakaway meeting earlier this month to discuss what to do. Meanwhile, led by Germany's indignant Angela Merkel in full prudent-Hausfrau, Thatcher-handbag mode, the Westerners have tried to damp down the East's increasingly aggressive demands for assistance. Good luck with that. Demonstrating a keenly cynical awareness of which buttons to press, the Hungarian prime minister warned that a severe slowdown in the East could lead to "a flood of unemployed immigrants traveling to Western Europe in search of jobs."