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The way out of Europe's volatile debt crisis is likely to involve painful belt-tightening, increased emergency aid, and eventually a restructuring of debt in the most troubled countries, according to finance experts at the W. P. Carey School of Business.
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"It is becoming obvious that the peripheral, high-indebted countries in Europe are not going to be able to work themselves out of this mess," Clinical Associate Professor of Finance Werner Bonadurer says. "Their growth prospects are very low given the necessary domestic austerity measures and their lack of competitiveness, as well as subpar global economic expansion."
For more than a year, the European Union has been in crisis over the huge debts faced by its weakest economies. Cutbacks in social programs and benefits have stirred unrest in those countries, as well as in better-off nations in the Eurozone. The specter of sovereign default looms across the continent.
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The European Union and the International Monetary Fund have orchestrated rescues of Greece and Ireland, but concerns about those two countries, as well as others, remain high.
"The worry is that Portugal might join them and also Spain," says Associate Professor of Finance Sreedhar T. Bharath. "And the big worry is that Italy might also go in."
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Europe faces difficult choices as it tries to navigate a crisis that shows no signs of easing, faculty experts agree. "In the long run, the only way out is very deep and maybe painful reform in their markets, as well as a weaker euro" Bonadurer says.
Roots of a crisis
The current woes of the 16-nation monetary and economic union can be traced to the terms of the agreement that established the common currency in 1999, according to scholars at the W. P. Carey School. Under the agreement, the countries have a common monetary policy carried out by the European Central Bank, but each follows its own fiscal path. Problems arise when a monetary policy that benefits one country harms another.
"When the euro was created life was good," Finance Professor of Practice Anand Bhattacharya says. "No one was worried that things could go bad. This was one happy family."
But in the past decade, sharp differences in the growth rates and fiscal policies among countries in the Eurozone have emerged. The common currency has prevented the less competitive members of the monetary union from taking the course typically used by countries faced with a debt crisis: currency devaluation.
"If they had their own currency, they could devaluate and make themselves competitive again," Bonadurer says. "This is not an option they have at this stage."
The euro abolished market-based nominal exchange rates but it has led to divergences in real exchange rates. Consumer prices and wages in weaker countries have risen at a faster rate than in Germany since the start of the euro in 1999. Firms in these countries cannot compete with Germany in foreign markets and with low-cost imports from Asia in their home markets. Leaving the euro would allow Italy, Spain and the rest to devalue and bring their wage costs into line with workers' productivity.
"If they could devalue their currency, their exports could again become competitive, and they could eventually prune wages to make them compatible with the productivity of their workers," Bharath says. "Now they cannot do that."
Many observers have cited the lack of fiscal budget discipline, and the generous wage and retirement policies in Greece and other countries as the cause of the fiscal crises that led, in turn, to the debt crisis. But these countries had limited options, according to Bhattacharya.
