Europe's financial turmoil and the impact it could have on the rest of the world are the overriding focus of international financial markets. Will the euro survive? Would its failure spark a deep global recession? How would the fallout affect the United States—even the coming presidential election? To understand Europe's prospects, we must debunk several misconceptions that have emerged about the crisis. And we must understand that Europe's troubles may spark a deeper union—fiscal as well as political—that could protect the continent from similar crises in the future.
1. The Europeans will never get their act together.
The euro area will never be a United States of Europe, and the cacophony of voices on the continent will continue to spook the markets. But given this challenge, the euro area countries have responded to the crisis with impressive speed.
To defend against the financial collapse of the weaker members, they have created joint rescue funds approximating $1 trillion. The European Central Bank has lent trillions more, like the Federal Reserve, and has just reaffirmed that it will do as much as necessary to avoid catastrophe. The euro area countries have agreed on firm fiscal rules—with stiff enforcement penalties—to limit future budget deficits. They are moving toward a partial fiscal union, through which the strongest countries will help fund the weaker partners. They are working out a full banking union that will prevent bank runs by providing Europe-wide deposit insurance. The debtor countries are implementing politically difficult budget cutbacks and major structural reforms to promote growth, such as easing firing procedures and thus encouraging hiring as well as greater productivity.
The euro area's strong members, Germany in particular, cannot say they will provide unlimited bailouts; that would take the pressure off the debtors. Driven by the markets, however, the euro area seems on track to complete the economic and monetary union that was promised two decades ago and whose absence brought on the current difficulties.
2. Greece's departure from the euro area would doom the single currency.
If Greece, the weakest link, is forced out of the monetary union, that would actually strengthen the currency. The result would be so chaotic for Greece that the other debtor countries, observing the wreckage, would do whatever it took to avoid the same fate, cutting their deficits even more quickly and accelerating other reforms.
Moreover, to avoid the risk of fallout elsewhere in the euro area, the strong Europeans would couple “Grexit” with sharp increases in the size of their financial firewalls and would speed up banking and fiscal integration. By shedding Greece, the euro area could emerge stronger.
3. German taxpayers will never bail out Greek (or Spanish or Italian) pensioners.
Germany is and will remain the paymaster of Europe, complaining loudly and demanding austerity and reform, but coughing up however much is necessary to hold the euro area together. It has already provided the bulk of the rescue funds and financed most of the debtor countries' deficits through the European Central Bank.
There are many reasons for Germany's staying power. First, the entire European integration project of the past six decades, of which the euro is now the decisive symbol, arose from the devastation wreaked by Germany over the previous century. The Germans will not run the risk of destroying Europe again—something with which they could be fairly charged if they pull the plug. Moreover, Germany's export-based economic model rests squarely on the euro: The country runs the world's largest trade surplus, but it enjoys a highly competitive currency against the rest of the world because the exchange rate of the common currency reflects the economies of its weaker neighbors as well as the German powerhouse. And German banks are heavily exposed in the debtor countries, so German taxpayers would have to rescue them if Spain or Italy failed.
Smaller creditor countries, such as Finland and the Netherlands, may be reluctant to lend more. But in Germany, every political leader and most voters are fully aware of these political, moral and economic necessities, and pro-euro parties have won every major electionsince the crisis erupted.
4. If austerity measures continue, voters will revolt and extremists will take over.
One of the most amazing aspects of the euro crisis so far is that the political center has held in every debtor country. Incumbent governments have been rejected in all of them, but radical alternatives from both the left and the right have been rejected even more soundly.
Portugal and Ireland have stuck to the austerity commitments required as part of their bailouts, while Spain and Italy have gone beyond, with more spending cuts, higher taxes and major labor-market reforms. Only Greek voters flirted with a rejectionist party, but a bank run quickly forced them to reverse course.
The Europeans have now added a crucial growth dimension to their emphasis on austerity, adopting jointly financed infrastructure investments and pro-growth reforms that will further solidify political support.
5. The euro crisis will tank the US economy and could even swing the presidential election.
No doubt, the downturn in Europe has dampened exports and corporate profits in the United States, weakened employment and investor confidence, and cut perhaps 1 percent off our gross domestic product. Macroeconomic Advisers estimates that a collapse of the euro would produce a renewed recession here over the next year and an unemployment rate above 9 percent at least through 2013.
But the world's emerging economies, led by China and India, account for half of the global economy and will continue to expand at about 6 percent annually for the foreseeable future. This is slower than before, but such growth will keep the global economy—including the United States—churning for some time.
In addition, the United States derives important benefits from Europe's troubles because the crisis diverts global capital into the dollar, especially Treasury securities, keeping our interest rates low and thus fueling at least a gradual recovery of housing and consumer demand.
The likelihood that Europe will continue to muddle through will protect us—and our election—from major economic repercussions.