Euro dream threatens to become nightmare

ANALYSIS: LAST WEEKEND the world’s attention was on Washington DC as America’s politicians peered into the abyss of sovereign…

ANALYSIS:LAST WEEKEND the world's attention was on Washington DC as America's politicians peered into the abyss of sovereign default. On Sunday they stepped back. This weekend attention is on Rome and Madrid. Politicians in those two capitals are sliding towards the same abyss.

But there is a big difference between the US and the Mediterranean countries. In America, that country’s leaders walked voluntarily to the edge of the chasm for political reasons. They were not beaten to that point by the bond market.

Political leaders in Italy and Spain are in an altogether more difficult position. They are being propelled towards the precipice because confidence in their economies is draining away. They are clutching desperately for something to halt the slide. But it appears ever less likely that they can save themselves.

With each passing week it seems increasingly clear that Europe is coming to a fork in the road: one route leads to deeper integration, with very considerable political implications; the other leads down into the dark valley of disorderly disintegration. The decision on which way to go will be among the most important collective choices taken by Europeans in the post-second World War era.

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If a half century of integration ends in sudden disintegration, the European economic and political landscape will undergo huge upheaval. It is impossible to predict how it will look when the dust settles.

If, on the other hand, the euro zone countries bind themselves ever more closely together, the challenges facing the bloc will be enormous, but more predictable. For a closer union to succeed, a central issue – perhaps the central issue – will be whether the dangerous fault line that has opened up between the continent’s north and south can be closed.

While Greece looks destined to remain subject to intensive and intrusive outside intervention for many years to come, and Ireland and Portugal face tough, if shorter, journeys back to sustainability, they may be too small to make a closer union unsustainable, whatever happens to them.

But what happens to peninsular Europe’s big two – Italy and Spain – is different. If they cannot make themselves more like their northern neighbours a closer union might not survive.

What are their prospects?

The Italian state marked the 150th anniversary of its creation earlier this year. Its people did so with little celebration. Apart from Italy’s post-second World War decades of successful modernisation, most of this history has been one of underachievement and worse.

The Italian state’s first 50 years were marked by instability and weakness before two decades of fascist night descended over the country. Invasion, defeat and civil war in the 1940s left deep scars.

Now, the economy has been stagnating for almost two decades, with living standards barely rising and its once-vaunted industries – from textiles to autos – shrinking in the face of low-wage competition.

Italian entrepreneurialism and design flair succeeded in medium-tech industries when foreign competition was less intense, but success in high-tech sectors operating in a globalised context has been much harder to achieve.

One reason is schooling. Italy’s education system is ever more inadequate in preparing its young for the modern world of work and many of those who manage to do well are stymied in one of Europe’s least meritocratic societies.

Government influence on economies is often overstated, but it is important. Bad government in particular can have big negative effects on growth. The evidence that mismanaged public finances stifle growth is strong. And in this area Italy has long been a European leader – it is the only country to have a national debt bigger than its GDP uninterruptedly since the 1980s.

In the early 1990s the sweeping away of the cold war political parties and the jailing of many of the most corrupt politicians brought hope of better and cleaner government. Those hopes have long since been dashed.

The country’s long-time prime minister, Silvio Berlusconi, has dominated for most of that period. Even by the low standards of Italian politics, he has plumbed new depths. But however bad his actions, his inactions have been even more damaging.

Many of the reforms that could help spur the economy have gone unimplemented, despite his promises to shake the country up. Nor has he made much of a dent in Italy’s public debt mountain. His main appeal – that he could bring to the business of government the same get-things-done approach that made him one of Europe’s richest men – has proved baseless.

But Berlusconi will not lead Italy forever, and the country’s political class has shown that it can push through painful reform. Perhaps ironically, its biggest achievement in recent times was ensuring that Italy squeezed into the euro as a founding member. There is no such prize for taking radical action now. Instead, incentive comes from the need to avoid disaster. Italy’s politicians might yet rise to the challenge.

If Italy faces huge challenges, Spain’s are no less daunting.

Unlike the plodding Italian economy, Spain enjoyed a decade-long boom from the late 1990s. But the Iberian tiger, like its Celtic cousin, became engorged on credit. Property prices soared, construction boomed and competitiveness evaporated.

When the bubble burst the public finances went into a tailspin, the banks teetered and unemployment soared. It has suffered a much bigger shock than Italy and its economy is still on the floor, with consumers and households pinned down by huge mortgage debts.

Spain’s economy faces bigger challenges than Italy, with the exception of its government’s indebtedness.

With debts of 60 per cent of GDP in 2010, Spain has some breathing space (in Italy the figure was 120 per cent and in Ireland almost 100 per cent).

With such a manageable debt burden Spain does not look close to being insolvent, as the bond market has been moving towards concluding in recent weeks. So why the panic?

One reason for the recent loss of confidence in the country has been because fears are rife that its banks are not coming clean on their property losses. So far, those admitted to have been a tiny fraction of Irish banks’ losses, despite a property collapse there that is much more than a fraction the size of ours. Another suspicion is that the country’s 17 big-spending regional governments are keeping liabilities hidden.

If either or both of these suspicions have some basis in truth, Spain’s true debt levels are higher than officially stated.

But one reason to be optimistic about Spain relative to Italy over the long term is its more effective political system. This has been in evidence since the crisis erupted, with the government earning praise for undertaking some bold reforms and for reining in its budget deficit.

Although the Spanish are sometimes called the Germans of the south, the more likely explanation for their better governance is not cultural but institutional. Whereas in Italy the executive is weak and unstable – famously, the government has changed on average once a year since the second World War – in Spain, since the return to democracy in the late 1970s, governments have been stable and more effective.

This did not happen by accident but by design, and was informed by the lessons the two countries learned from their respective decades of dictatorship. While Italy’s 1948 constitution deliberately created a weak centre to avoid a repetition of the abuses in Mussolini’s time when power was highly centralised, Spain’s 1978 constitution created a strong and stable executive because weak government was seen to be a big factor in Franco’s seizing power in the 1930s.

Spain’s better political system gives reason to believe that it can manage its public debt problems, but no government can magic away a huge private debt burden or restore at a stroke chronic economy-wide uncompetitiveness. Even with lots of luck Spain faces a long and painful struggle.

Europe is in a bad place now. It looks increasingly likely that the euro zone countries will have to throw their fiscal lot in together in order to avoid cataclysm in the short term. But this brings its own risks.

Northerners will not like it. If they feel they will permanently foot the bill for southern profligacy they may rise up against it. That could get very ugly. The longer Italy and Spain remain in a slump, the greater the chances of that happening.

Southerners may not take their medicine lying down either. If their economies don’t return to growth, their peoples may reach breaking point. If they come to believe that an uncaring and alien force is imposing its will on them resentments could boil over.

The euro was designed to bring Europeans together and to crown decades of integration. It could end up causing deep divisions and, ultimately, disintegration.


DAN O'BRIENis Economics Editor