It now seems almost certain that Greece will be subject to some kind of second bailout. Attention may then turn to Portugal and Ireland, the other countries being supported by the European Union and the International Monetary Fund. Both still face enormous difficulties, but their circumstances are very different.
The main problem Portugal faces is long-term economic stagnation. Growth averaged less than 1 per cent in the last decade. Vast EU subsidies have done little to stimulate business activity. Instead, they enriched special interests with close links to the political elite and enabled the government to ramp up welfare spending, which reached a massive 22.5 per cent of GDP in 2007.
Membership of the eurozone exacerbated the problem. Spending could carry on rising without the checks and balances that markets would have imposed in the absence of an implicit EU guarantee of government debt. At the same time, ill-fitting monetary policies created inflation that made Portuguese businesses uncompetitive. Enterprises were also burdened with expensive new regulations, both from the European Commission and domestic policymakers.
Like Greece – and also Spain – Portugal will have to undergo a very severe adjustment to regain its international competitiveness. But such necessary rebalancing will be hampered by these high levels of regulation. In particular, labour market controls make it more difficult to reduce wages, and instead mass unemployment may result.
While Portugal’s debts are not particularly high by international standards, the markets lost confidence in the government’s ability to undertake the necessary reforms. If economic stagnation continued it would prove extremely difficult for Portugal to cover the interest payments on its debts.
The bailout has staved off the prospect of default for the time being but there must be a serious question mark over whether the new Portuguese government will be able to push through liberalisations radical enough to transform the country’s prospects. Worryingly, a second Greek bailout may set a dangerous precedent that makes it even harder to gain political support.
The prospects may be rather better for Ireland. The government acted quickly to cut public spending. The country also boasts one of the freest economies in the EU. This means it can adjust more quickly than its southern European counterparts. Nevertheless, the size of the adjustment required is monumental.
The Irish crisis is perhaps the clearest illustration of the deep flaws in the euro system. Its government behaved relatively sensibly with low taxes, light-touch regulation and restraint in public spending. In 2007, Ireland’s national debt was just 19.5 per cent of GDP.
But the monetary deluge unleashed by eurozone membership swept away the benefits of such fiscal rectitude. Private sector credit increased by over 25 per cent in each of the years 2004, 2005 and 2006. Advances by credit institutions rose almost six-fold from €66bn in 1998, the last year before adoption of the single currency, to €392bn in 2008. One consequence was an explosion in house prices, with a 251 per cent rise from 1997-2007. Lending to the construction sector rose ten-fold in the same period.
Economic activity was thus severely distorted as a result of the credit boom. The European Central Bank set interest rates low to suit anaemic core countries rather than booming Ireland. The bad investments encouraged by cheap credit translated into toxic bank assets, which in turn precipitated the banking crisis and the Irish government’s disastrous decision to guarantee the liabilities of Irish banks.
Clearly, fiscal restraint and more flexible labour markets are essential for economic recovery in both Ireland and Portugal. But EU policymakers are deluded if they think such reforms will prevent future crises. Since the ECB imposes a one-size-fits-all monetary policy across the currency union, new bubbles will inevitably form and then burst, bringing instability to government finances and severe economic dislocation.
Peripheral countries are particularly vulnerable, as has been seen. Their geographical location means their economies are less synchronised with core Europe and centrally determined monetary policies are less likely to be appropriate.
It is very difficult to see a solution to this problem. In other large currency unions, such as the United States, some regions remain economically depressed for decades and adjustment takes place through mass migration. This option seems unlikely to be accepted in Europe given strong ethnic identities and traditions.
National currency regimes were very far from perfect but at least the more refined monetary policies could have avoided the economic depression and social unrest now facing the periphery of the eurozone. Competition among central banks also encouraged a process of discovery, emulation and evolution, with failing central banks copying the successful ones, such as the Bundesbank.
Rather than creating crisis after crisis, followed by bailout after bailout, EU leaders should now be considering less centralised monetary systems, even if this involves an orderly exit from the eurozone by some countries.