From Krugmania to Draghia: Five ways to save the euro zone

at 10:27 AM ET, 06/06/2012

So you’d like to save the euro zone from total annihilation, would you? Then it might be worth taking a stroll through this new report (pdf) from the analysts at ING, who outline six possible endgames for the euro zone.

The report starts with the premise that fiscal austerity has become, in author Mark Cliffe’s words, “too big to succeed.” At this point, most European countries only seem to be making things worse through big budget cuts and tax hikes. That’s paralyzing economic growth, which is making it harder and harder for countries to rein in their debts. “The required austerity to meet mandated budget deficit targets has become unrealistically large,” ING says.

Okay, so what’s the alternative? How can Europe start growing again? ING takes us through six scenarios, options ranging from “Austeria” (austerity!) to “Krugmania” (this is, we can only assume, Paul Krugman’s dream scenario). Here’s the graph, with an explanation for each scenario below:

Austeria: Europe sticks to its fiscal targets, with every country trying to get its debt-to-GDP ratio down to 60 percent. Countries like Spain and Italy focus on “labor market reforms” — for instance, making it easier to fire workers. If this sounds familiar, it’s because it’s the current course. And as seen in the graph above, ING’s not too sanguine about the ability of this strategy to work. Growth suffers miserably and countries like Greece could start defaulting.

Draghia: In this scenario, the central bank starts boosting the economy with interest-rate cuts and quantitative easing — a move that, ING suggests, could plausibly boost Europe’s growth by as much as 0.25 percentage points per year. Meanwhile, Europe moves forward with some sort of “banking union” where deposits are guaranteed by the entire zone and banks are supervised more thoroughly. The hope is that this would stop the bank runs that are plaguing countries like Spain and Greece.

The trouble with this option? There’d still be austerity, which means, ING notes, that “doubts about fiscal sustainability of the periphery, while less intense than in Austeria, would linger.” On the plus side, German officials have sounded receptive to elements of this approach.

Bondia: In this option, Europe moves toward some sort of common “eurobond,” so that rather than having each country borrow individually, all the countries pool their resources to borrow money together. This would ease pressure on the troubled countries. On the other hand, ING notes, this option would make further central-bank action unlikely, so the growth impact might be “relatively modest.”

Europhilia: This option could potentially be combined with Draghia and Bondia. Once the euro zone has a “banking union” and common bonds, the next step is to move to fiscal transfers. Basically, core countries like France and Germany would send money to struggling periphery countries like Portugal and Spain, paid for by borrowing. ING estimates that if the core countries provide a stimulus worth 1 percent of their GDP to the rest of Europe, that would boost growth in the periphery by 1 to 2 percentage points.

ING seems to be sanguine about this approach. “It would be seen as more sustainable than a mere funding union, and focus the markets’ attention on the fiscal and economic health of the Eurozone as a whole.” Of course, a lot depends on whether countries like Germany and France actually want to send that much money to countries like Spain and Italy.

Inflationia: This is a more radical version of Draghia, which involves the European Central Bank engaging in very aggressive monetary easing and boosting inflation. This approach could help periphery countries like Spain inflate their debts away. The euro would be devalued significantly, making Europe’s exports more competitive and boosting growth. That could solve a lot of problems.

On the other hand, ING says, there are some risks in this approach. Since core countries would be more likely to take advantage of the drop in the euro by boosting exports, this approach “could raise the risk of increasing intra-Eurozone imbalances.” Also, if the euro plummets too far, there’s the possibility that other countries could retaliate with protectionism measures.*

Krugmania: This scenario is a mix of lots of fiscal stimulus — focused on public investment — along with a more tolerant attitude by the central bank toward inflation, as well as a commitment by Europe to rein in its debts over the longer term. The drawback, ING notes, is that there’s “little sign of acceptance” of this scenario.

All told, the report suggests, these options run from politically plausible but ineffective (i.e., Austeria) to effective but politically unrealistic (i.e., Krugmania). “Roads to survival do exist,” ING notes. Whether Europe actually takes any of those roads, however, is really up to the policymakers in charge.

* This paragraph has been edited for clarity.

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