Debt crisis: The eurozone will collapse without reform

At their meeting last night in Brussels, the task of the eurozone leaders was no longer simply to sign off on Greece's €120bn bailout. The pressing problem is how to stop the ongoing spread of panic across European and world financial markets.

Greece's fate now seems to be sealed – a belated bailout, coupled with savage public spending cuts that undermine the welfare state and dismantle core social standards. Athens is now a precedent, but it must not become an example for other heavily indebted eurozone countries.

Now that contagion is engulfing Portugal and Spain, the eurozone cannot afford to repeat the same mistakes of delaying intervention or failing to restructure debt.

The summit of eurozone leaders must conclude with decisive action – otherwise the entire euro edifice will collapse under the weight of its own internal imbalances. The Greek bailout will lock the country into a deadly spiral of debt deflation – spending cuts will keep Greece in recession, with lower state revenues and a growing budget deficits that require yet further cuts. Just as the economic costs of debt deflation are largely unnecessary, so are the social costs of soaring unemployment and unrest.

Nor is sovereign debt default and an exit from the eurozone a realistic or desirable course of action. That would leave all the "Club Med" countries exposed to international money market. They would have to finance their current budget deficit at extortionate interest rates of over 20% (in Greece's case perhaps as much as 38%).

Thus, the eurozone leaders can no longer dismiss debt restructuring, coupled with a new economic policy that promotes growth instead of simply controlling inflation.

First, sovereign debt restructuring involves pre-emptive rescheduling by offering to exchange short-term debt at high interest rates for long-term debt at lower interest rates. Creditors – including commercial banks bailed out by taxpayers – would only lose some profits but not their entire investment, as in the case of default. The ECB could support this process by continuing to accept "Club Med" bonds as collateral, which would avoid a run on their banks.

Second, this would enable the heavily indebted members of the eurozone to stretch the maturity of their liabilities and buy time. In this way, they can reduce the net present value of its debt. This alternative strategy also allows them to implement a wide-ranging economic reform programme to collect revenue (by reducing corruption and tax evasion) and boost competitiveness. All that is far better than IMF-imposed conditionality and structural adjustment which will induce deflation and a wholly unacceptable social recession.

Third, the eurozone also needs a new monetary and fiscal policy. This would benefit not just those countries that are in the line of global financial fire – Greece, Portugal and Spain – but also the rest that have also suffered from decades of low growth (on average less than 2% per year since the early 1980s).

The sole objective of the ECB's monetary policy is to keep down inflation – a relic from the era of monetarism that came crashing down during the global recession. Unlike the US Federal Reserve, the ECB does not seek to promote stronger growth – the best way to reduce public spending, cut budget deficits and invest a knowledge-based, green economy. Here eurozone leaders must set clear priorities and ultimately revise the ECB's constitution to include growth as a second objective.

Similarly, the eurozone's current fiscal rules that cap budget deficits at 3% and public debt at 60% of national output lack any economic rationale. They simply correspond to the average European levels at the time when they were agreed in the mid-1990s. Structurally different economies require differentiated levels, especially given the vast and growing trade imbalances between Germany and the other euro countries.

Worse, these artificial ceilings have a strongly deflationist bias, as they leave little room for counter-cyclical fiscal expansion. With a single monetary policy, fiscal policy the only adjustment tool available to national governments.

Reforming the eurozone's economic policy is especially urgent, as Germany plans to tighten its own fiscal stance even further. Indeed, a little-noticed amendment to the German constitution adopted last year to take effect in 2016 bars federal deficits in excess of 0.35% of Germany's national output (compared with the eurozone's upper limit of 3%).

That enshrines a deflationary policy into Germany's constitution and will perpetuate the structural imbalances within the eurozone. All this is a sure recipe of low growth or perhaps even stagflation (stagnation and inflation), caused largely by the fall of the euro which raises the costs of imports from China and the US.

Thus, the in-built deflationary outlook of the eurozone could lead to its own downfall. A failure of the euro will probably unleash centripetal forces of disintegration, undermining the political foundations of the entire EU – just when the union prepares to celebrate on 9 May the 60th anniversary of the Schuman declaration that inaugurated post-war reconciliation and political integration.

© Adrian PABST

Adrian Pabst is a lecturer in politics in the University of Kent at Canterbury. Since 1998, he also been a research fellow at the Luxembourg Institute for European and International Studies. He is a frequent visitor to Central and Eastern Europe, Russia and Asia. Currently he is writing The Spectacle of Paradox, a book on market-states, crisis capitalism and the coming ideologies. He is a regular contributor to the international press on geopolitics, political economy, Europe and religion.

* Originally published by "The Guardian" (08.05.2010) at: http://www.guardian.co.uk/commentisfree/2010/may/08/eurozone-collapse-without-reform