Europe, the euro and an unstable economic climate

11/7/2011 - The European debt crisis continues to grab headlines, turn markets and prompt many to question the world’s fiscal stability.

Eager to provide a behind-the-scenes view into Europe’s financial turmoil, Sergio Rebelo, the Tokai Bank Distinguished Professor of International Finance, recently offered a 75-minute presentation explaining the economic chaos to about 150 Kellogg students.

“What’s happening in Europe is at the center of the world economy, and whether there’s a controlled or uncontrolled resolution, the crisis will have major ramifications across the globe,” Rebelo said.

From the two World Wars to the Marshall Plan, Rebelo, a consultant to organizations such as the World Bank and the European Central Bank, guided students through the critical turning points that led to the formation of the European Union, the introduction of the euro and, finally, the current economic uproar.

When it was first introduced in 1999 (and later in currency form in 2002), the euro served a tangible symbol of a united Europe. It also simplified the administration of the European Union budget and put an end to competitive devaluations.

But Rebelo noted that this approach, as executed, was flawed from the start. For admission into the euro area, nations had to have low inflation, low interest rates, a fiscal deficit lower than 3 percent of GDP, and a debt-to-GDP ratio lower than 60 percent. Although very few nations met all of these criteria, the euro was adopted across Europe, tying very different economies to a common monetary policy.

“There were warning signs, but the old-guard politicians saw the Euro as a desirable major step toward the United States of Europe, so economic arguments didn’t matter much,” Rebelo said.

That early complacency laid the groundwork for the current crisis.

Today, the one-size-fits-all monetary policy presents difficulties as countries experience different business cycles, and language and cultural barriers impede the movement of workers across borders. On top of all that, Europe, unlike the United States, lacks a central fiscal authority and room to raise taxes.

Amid high unemployment and sputtering economies, Europe now rides an unstable course with no one willing to take the reins. Europe must refinance annually maturing public debt that represents roughly 20 percent of GDP. These funding needs, together with the half-measures taken by European leaders, are unnerving markets.

“Very little has been done to move Europe into a positive direction. The policy so far has been to procrastinate, to say that it will take time, that more will be done later,” Rebelo said. “Politicians are worried about how their countries will fare in the short run, as opposed to what is good for the whole of Europe in the long run.”

The veteran Kellogg professor then left students with a hearty plea.

“I know that many of you will go into the private sector, but I hope some of you head into government, because we need a new generation of leaders,” Rebelo said.