It’s déjà vu all over again. Three years on from the meat of the European sovereign debt crisis, and two years on from then-new ECB President Mario Draghi’s “whatever it takes” rescue program, which spurred across-the-board European asset price rallies, European economic data is showing strains again. France remains stuck in neutral. German GDP growth actually contracted last quarter. Unemployment rates across the Eurozone, especially in the periphery countries, remain disturbingly high; Eurozone-wide unemployment remains at 11.5%, but localized numbers can appear much more harrowing. Core and headline inflation remains dangerously close to stall speed. The latest annual CPI numbers for Europe in July showed overall Europe-area inflation below 1%, with outright deflation (the naughtiest of naughty economic terms) still observed in Greece, Portugal, and Spain. Italy is on the cusp.
A simple fact: potential Euro-area GDP remains upwards of 20% below potential and economic activity, unlike the US and others, is nowhere near pre-crisis levels. The way things are going, economic activity won’t make up significant ground anytime soon. As such, the blame game has begun ramping up again. On one side, the hawkish types continue to bemoan the fact that structural economic reforms haven’t proceeded as quickly as liked in periphery countries and that further budget cuts and reform are necessary to secure economic prosperity. On the other side, economists and policy-makers argue that current ECB measures are too timid and that aggressive monetary stimulus should be accompanied by aggressive fiscal stimulus to kick-start activity. In their eyes, European austerity policy, though softened somewhat over time, is a “penny-wise, pound-foolish” endeavor. Likewise, the Euro-currency-area structure can be equated, in their eyes, to the shackles of a gold system that undermined flexibility and exacerbated European economic problems during the Great Depression era.
There’s merit in both of these arguments. Without a doubt, closed, protected economies like Greece and Italy require much more work to achieve long-term competitiveness. On the flip side, while no one in the US is claiming economic victory, aggressive Fed action in conjunct with other aggressive moves by US policy makers helped keep the US on a growth trajectory, however uneven. Yes, policy-makers have made mistakes along the way in the US, but on balance our system found a path to a viable support structure. We in the US complain about the state of economic affairs, but the general state of economic affairs here is much better than experienced in the bulk of Europe, or even a number of former high-flying emerging economies.
While the issues at play on the European continent are far more detailed and complicated than could ever be examined in a simple blog post such as this, we tend to sympathize with those calling for a more aggressive European response and a move away from the shackles and restraints the Euro union place on the weakest nations. Frankly, we’re curious why peripheral nations have chosen to remain in a structure that allows them nearly zero flexibility in terms of monetary/currency policy response. Sure, economic growth has stabilized to a certain extent in the periphery during the years following the ECB’s 2011/2012 actions, but not enough to move the proverbial “needle” in any major way. Overall, it’s arguable that monetary stimulus remains woefully inadequate in these countries in terms of providing proper air cover for the demand destruction associated with the massive strides many have made in collapsing primary budget deficits. It’s not crazy to think that these countries could remain well below potential GDP for decades into the future. Again, what keeps policymakers (and citizens) beholden to a quasi-depression track?
A version of the “sunk-cost fallacy” remains in play among policy-makers and citizens alike. The sunk-cost fallacy is an economic problem under which individuals, organizations, or policy-makers make forward-looking decisions erroneously based upon the time, money, or other resources “sunk” into a project in the past. Time, money, and effort expended in the past should never be a consideration, only the future “profitability” or “viability” of an effort. What’s done is done. If a project is going to be a proverbial money-loser going forward, it should be stopped no matter what’s been invested in the past.
A version of the sunk-cost fallacy is playing out in the European sphere, in our estimation. For years, we’ve heard politicians, economists, and individual citizens across Europe express their commitment to a monetary union solely on the basis of the immense amounts of political effort that have been expended over the past six decades. This has been particularly true of politicians in the economically depressed countries. The structure of the EU can’t be significantly questioned because “We’ve dedicated so much time and effort to the project and the notion of European solidarity. If we change course, we sacrifice our significant past investment in a Pan-European identity.” Yes, there have been reasonable qualitative and quantitative economic arguments put forth to defend the status quo, but more often than not, the pursuit of the status quo is justified solely by the simple notion expressed above.
Just as in running a business, this can be a dangerous notion, and create much bigger problems down the road. Dumping the rest of one’s life savings into a money-losing venture to justify the past investment, for instance, would lead to full financial devastation and the even bigger problems associated with being completely wiped-out financially. Continuing this project in the periphery nations simply on the notion of a large historical investment in the European “project” without some serious soul-searching regarding future policy options could lead to devastating effects at the national level over the coming decade.
Already, younger generations entering the workforces in these countries face bleak future prospects. Despite progress made on budgets, debt-to-GDP ratios continue to rise because of stagnation. The best and the brightest continue to emigrate to other nations. Birth rates are down, exacerbating negative demographic trends. Extremism has increased, evidenced in recent years by organizations like Golden Dawn in Greece, as marginally attached individuals seek outlets for their discontent. If European growth at-large stalls out again meaningfully, and broader deflationary trends become a part of broader European economic life, there are few pathways for these countries to exit their depression-like conditions, especially if they remain in the currency union with its current slate of policy options and prescriptions. These problems will become significantly magnified. A blow-up of that pressure cooker down the road would make today’s dilemmas look like small potatoes.
Does this mean that breaking off portions of the currency union is desirable or fait accompli? Not necessarily. But with economic growth stalling again, it’s time for the periphery nations to break the shackles of sunk-cost thinking and engage in some serious self-examination in terms of what type of economic growth is achievable within or without the binds of the union. Band-aids and European solidarity proclamations are no longer acceptable or sufficient. Likewise, it’s in German and ECB leaders’ interests in the long-run to meet the periphery countries further in the middle before centrifugal forces move beyond their control. A broader Japan-esque “lost decade” experience with pockets of depression has dangerous implications on a fractured continent like Europe. Old solutions and old ways of thinking based on past investments in the European project will ultimately lead to violent economic problems. These countries must find sustainable economic growth. If that means a controlled exit, so be it. Exit and/or radical economic policy measures should be on the table.
