What should the Europeans do?
To repay the creditors in the core euro area countries, the debtors of the periphery must regain competitiveness. This will be neither easy nor quick.
A sustained process of relative wage adjustment will be necessary, implying large declines in living standards in one-third of the euro area.
A comprehensive adjustment is necessary. The burden cannot only be on increasing unemployment and falling wages in countries like Spain. Deflation in the peripheral countries will not likely prove any more tolerable than it did in the United Kingdom under the gold standard of the 1920s. An increase in German wages and private demand (and inflation) would ease the transition. It is striking that German real wages barely grew in the two decades before the crisis.
Moreover, it is essential that the structural reforms now under way across the deficit countries boost productivity.
With domestic incomes squeezed, some of the required investment will have to be financed abroad.
Unfortunately, the European financial system has aggressively renationalised in recent months. Intra-European cross-border lending —which had been growing by 25% per year in the run-up to the crisis—has been falling at a rate of 10% per annum since. While the European Central Bank (ECB) has adroitly stepped into the breach, reliance on central bank lending is not a recipe for robust private investment.
Bold steps are required to restore the single financial market. And bold steps are now under consideration. One example is the current European proposal to create a banking union. By centralizing bank restructuring, re-capitalizing banks with European rather than national resources, moving towards centralized (or federalized) supervisory oversight and harmonizing (or better still mutualizing) deposit insurance, Europe can break the increasingly toxic links between banks and sovereigns.
The recent agreement to recapitalize the Spanish banking system marks progress towards a greater financial and fiscal union that will reinforce the monetary union. It is further evidence of Europe’s resolve to address its problems.
If such measures are combined with swift implementation of the Financial Stability Board’s (FSB) financial reform agenda, which I will outline in a moment, there is a prospect of relaunching a deeper, more robust pan-European financial system.