We’ve Got a Tough Decade Ahead

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Tyler Cowen points us today to a set of predictions from Michael Pettis that he thinks are “mostly correct.” Most relate to China, which Pettis thinks is going to enounter some heavy economic weather in the near future, and I don’t disagree. But he also has some things to say about Europe. Here’s his forecast for Germany:

Germany will stubbornly (and foolishly) refuse to bear its share of the burden of the European adjustment, and the subsequent retaliation by the deficit countries will cause German growth to drop to zero or negative for many years.

….If Germany does not take radical steps to push its current account surplus into deficit, the brunt of the European adjustment will fall on the deficit countries with a sharp decrease in domestic demand….For one or two years the deficit countries will try to bear the full brunt of the adjustment while Germany scolds and cajoles from the side. Eventually they will be unable politically to accept the necessary high unemployment and they will intervene in trade – almost certainly by abandoning the euro and devaluing. In that case they automatically push the brunt of the adjustment onto the surplus countries, i.e. Germany, and German unemployment will rise. I don’t know how soon this will happen, but remember that in global demand contractions it is the surplus countries who always suffer the most. I don’t see why this time will be any different.

Pettis has been bearish on the euro for a long time, and he’s even more bearish now. Here’s a bit more detail on his prediction that the eurozone is going to crack up:

Spain will leave the euro and will be forced to restructure its debt within three or four years. So will Greece, Portugal, Ireland and possibly even Italy and Belgium.

…The only strategies by which Spain can regain competitiveness are either to deflate and force down wages, which will hurt workers and small businesses, or to leave the euro and devalue. Given the large share of vote workers have, the former strategy will not last long. But of course once Spain leaves the euro and devalues, its external debt will soar. Debt restructuring and forgiveness is almost inevitable.

I don’t know if Pettis is right, but this sounds all too plausible to me. Leaving the euro seems impossible for a number of reasons, but the fiscal integration necessary to save the euro seems impossible too. That’s also Wolfgang Münchau’s take: “While I cannot see how Greece or Italy can remain in the eurozone indefinitely without a eurobond, I find it equally hard to see Germany, Finland and the Netherlands agreeing to it.” So I guess it’s a question of which one turns out to be more impossible. Or, perhaps, a question of which faction caves first.

If you held a gun to my head and forced me to guess, I actually think I’d guess that a eurobond and a massive bailout of the PIIGS is more likely than a breakup of the eurozone. At the same time, it’s easy to be too complacent about the integration of Europe states over the past 65 years. They’re not likely to go to war against each other anytime soon, but that doesn’t mean that all the old animosities are gone. They’re just lurking below the surface, and a prolonged crisis could create a climate of public opinion that simply doesn’t allow for a sensible solution. When the eventual crisis comes, and it’s not possible to shove it any further into the future, the euro may not survive

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