The decline of Europe – where to from here?

Britain, like the US, has been a centre of both great wealth creation and a widening wealth divide over the past 20 years, thanks to the rise and fall of the markets and global economic growth. Now the UK is sharing the suffering of the rest of Europe by implementing deep budget cuts that are hurting venerable populations the most. As youth programs, education subsidies, and housing allowances are axed in a desperate attempt to get out from under crushing sovereign debt, it’s clear why the poorest populations in the most economically unequal European nation have taken to the streets.

The new reality is impossible to ignore: the West -and more immediately Europe- is in serious trouble. This is no blip but a crisis of the old order, a phrase once used to describe the failures of capitalism in the 1920s. It is a crisis that is shaking not only markets, jobs and growth prospects, but an entire way of thinking about how the world works – the assumption that life gets better and opportunities richer for each successive generation in the West.

As bad as things might seem in the US, the centre of the crisis is Europe. Volatile markets and angry demonstrations are signs of the desperate scramble by European politicians to contain the euro-zone debt crisis that threatens to unravel the single currency and destabilize the region. The European Union and the euro-zone were supposed to bring about economic stability and remove traditional barriers to growth. Instead it’s become a union in which struggling economies feed rising nationalism, angst over immigration and simmering distrust between rich and less affluent countries.

While the crisis may seem to be Europe’s problem, if it results in a break-up of the euro-zone or even a series of costly bailouts, it will reverberate the world over. Europe is the largest trading partner of both the US and China and is home to the world’s largest pools of wealthy customers: if they stop spending, everyone suffers.

Borrowing costs for Europe’s weaker economies have skyrocketed as measures to stabilise markets have failed to show a firm commitment from the richer countries to the monetary union.

Europe and the US are not experiencing a typical recession or even a double-dip recession. Such a problem can ultimately be corrected with the right mix of conventional policy tools like quantitative easing (printing money to increase market liquidity) and massive bailouts. Rather, the West appears to be going through a second contraction of economic growth, the first being the period after the Great Depression of the 1920s. It is a slow or no growth environment that happens after deep financial crises that require massive bailouts, leaving few resources to cope with a stagnant economy and high unemployment, and leading to populist politics, social instability and violence.

It is a very different era than the period of historical rapid growth from 1991 to 2008, the period in which the European Union, the Euro and the dream of European integration were born. The linchpin of this age of optimism was the US, which helped re-build Europe after WW2 and toppled its main ideological competitor, the Soviet Union. The dollar and US government debt, backed by America’s well-functioning democracy and strong growth prospects, remained the most liquid and safest investments on the planet. It was in this environment that the Euro began to gain strength.

The global picture has changed. It is a measure not only of America’s position in the global economy but also of just how bad things are in Europe and elsewhere that there hasn’t been a rush out of US treasury bonds. Following the recent S&P downgrade, investors piled into US treasuries as the market tanked. Although China, the largest foreign holder of US treasury bills, issued a stern warning to the US to cure its addiction to debt, it made no attempt to convert its dollar holdings to Euro, being the only viable alternative to the dollar as a global reserve currency. The British pound is history, and emerging market currencies are still too small, volatile and controlled. While many investors are fleeing to gold, this market is not big enough to accommodate adequate dollar diversification without massive inflation in gold prices, which are already at record levels.

It is unclear at this stage whether the Euro will even survive this debt crisis engulfing Europe. Although the average euro-zone deficit, as a percentage of GDP, and debt-to GDP ratio are not rising as fast as in the US, the difference is that the US has time and favourable borrowing rates on its side; Europe has neither. Also, the US can tackle its fiscal problems through its single political system.

The Euro-zone is essentially a union of countries with varying vested interests at play. Europeans want to benefit economically from their proximity to one another and want at all costs to avoid expensive and destructive trade wars with their neighbours. Beyond that, many of their political, cultural and social agendas diverge. At each stage in the development of modern Europe, from the creation of the European Union to the introduction of the Euro, it has always been difficult to get nations to agree to deeper political integration. That is why in 2005 voters rejected a European constitution that would have required member states to cede more power to the EU.

The result is a monetary union that can sometimes resemble a casino. The existence of a European Central Bank (ECB) means that countries like Greece, Belgium and Ireland are free to borrow from the credit window and take on more debt than they can handle. But the fact that there is no centralized political control or accountability means that more-prudent member countries like Germany or France have no way to stop weaker states from undermining the viability of their shared currency.

Even in good times, it is never easy to balance the fiscal needs of a high-cost exporter like Germany with those of cheap and cheerful service economies like Greece, Spain or Portugal. In bad times, it’s impossible. The poorer peripheral countries in Europe used to be able to devalue their individual currencies to maintain global competitiveness. Post Adopting the single currency, they have two choices: (1) they can make painful structural reforms that are unpopular with voters, including cutting welfare programs, tax reforms, trimming pensions and increasing competitiveness by working harder and longer, or (2) they can borrow from the ECB and hope to grow their way out of trouble. It’s obvious from current debt levels which road was chosen.

Europe can no longer afford to stand still: it needs to fix things and fix them now, and this is not an easy task on a continent with a currency and a monetary system underpinned by multiple political systems, economies and fiscal priorities. Figuring out how to bail out the euro-zone is a lot tougher than figuring out how to bail the US financial system. Europe does not have a single institution to put together a bailout program for indebted nations. The ECB has been trying to play that role buying up billions ‘worth of Italian and Spanish bonds. But even as Germany and France have been applauding its efforts, they have also been reluctant to commit more money to the euro-zone rescue fund. This indicated that the two strongest nations in the euro-zone were not yet committed to saving the common currency. Uncertainty led markets to react badly as investors concluded that the ECB’s efforts are just a band-aid, and that it simply did not have the firepower to stem the crisis.

Can Europe be bailed out?

There may be a way out. Germany, one of the strongest and most solvent economies in the world, could save the day by leading an effort to guarantee all Spanish and Italian debt as well as the debt of major European banks. This would calm markets. But it would be hugely expensive and politically contentious. After all, why should prudent Germans- who have their economic house in order- have to rescue their spendthrift southern neighbours?

The reality is that Germans are in for pain no matter what. Some sceptics may argue that Europe might be better off economically without the common currency – the Germans would enjoy privileges of a strong deutsche mark, and Greece could devalue the drachma enough that its hotels would be full of more sunburned German tourists. But if the euro goes under, experts believe this would cause unmitigated financial chaos. Higher borrowing costs for many of Europe’s slow-growth and highly indebted countries would result in a severe recession or even depression, which would not leave Germany unscathed, considering 40% of German exports stay in Europe. Meanwhile, competitors like Italy (which has a strong manufacturing sector) could nibble at Germany’s economic edge by offering lower prices thanks to their highly devalued currency.

Bailing out Europe would represent a huge economic and political cost. Assuming politically acceptable, Germany would need to make sure that the peripheral nations cleaned up their act. And this in turn would require a real political union in Europe, in which Germany, to an extent, had control of the purse strings and fiscal policies of the euro-zone. As difficult and politically improbable as it sounds, many politicians and economists now believe this will happen, and possibly soon. But this will only be the beginning of the hard work, as serious reforms will be required. Most important, it will require painful and deeply unpopular austerity measures that could lead to more violence among populations already struggling to cope with the downturn.

Rioting of the kind seen in London and Athens is just one side effect of the new age of austerity. Populist politics is another. Just as the economic downturn in the US helped fuel the Tea Party, Europe’s debt crisis is fuelling a resurgence of polarizing, right-wing politics. Xenophobia and anti-immigrant sentiment are rife. Even in mainstream politics, there’s a sense that unity is impossible. Over the past months, Sarkozy, Merkel and Cameron have all spoken about the end of European dream of multiculturalism.

The US is ultimately facing the same problem as Europe: how to grow amid a continuing downturn when the public sector cannot or will not spend more to jump-start the economy. It is clear that Americans still have a lot of work to do before that problem is solved. In the meantime, both Europe and the US will continue to struggle with the crisis of the old order. Populations will have to come to terms with no longer being able to afford the public services they want. Investors will have to cope with a world in which AAA assets are not what they used to be. Businesses will deal with stagnating demand, and workers will face flat wages and high unemployment.

All this will take place at a time that is in many ways the opposite of the optimistic two decades that preceded the financial crisis of 2008. It is arguably the end of an era in which the West and western ideas of how to create prosperity succeeded. The crisis in Europe and the challenges yet to come on either side of the Atlantic take us into a whole new era. The rules and risks of it are only just becoming clear.

Extracted in part from “The end of Europe” published in Time magazine, with reporting by William Boston, Bruce Crumley and Michael Schuman

All views and comments expressed in this article are those of the writers and are of a general nature. Consequently, they should not be construed as investment advice. Investors should always seek professional advice in relation to their financial and investment needs, and should not rely on this information to make investment decisions. AUGEO Pty Ltd accepts no liability for any views and comments expressed in this article.

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