Feldstein Poised to Secure Victory Over Euro as Trichet Departs a Crisis
Harvard University Professor Martin Feldstein, who predicted in 1998 that the euro would prove an “economic liability,” said the single currency will survive for now, even as he bets Greece quits within a year.
“With the exception of Greece leaving, I don’t think the whole thing is going to fall apart anytime soon,” Feldstein said in a Nov. 14 telephone interview. “The Greek situation is impossible.”
Feldstein’s views on Europe carry increased weight as the region’s two-year debt crisis validates his warnings in the 1990s that uniting so many disparate nations under the same exchange and interest rates could backfire.
While he said he doesn’t like to “use the word vindicate,” Feldstein, who turns 72 next week, said he recently reviewed his euro-skeptic articles and “thought they were pretty much on target, even though they were written 20 years ago.”
His conclusions often left him at odds with now-former European Central Bank President Jean-Claude Trichet, who consistently rejected as “absurd” any speculation the euro area would shrink and warned that a member shouldn’t be allowed to default.
In the final months of his eight-year term, which ended Oct. 31, Trichet used three speeches in the U.S. to take on American economists such as Feldstein by arguing the euro is built to last and its economy’s strengths, including tame inflation, are “overlooked.”
Views similar to Feldstein’s once were dismissed by those who argued Europe’s political masters wouldn’t let the euro fail, so its economic weaknesses didn’t matter, said Julian Jessop, chief international economist at Capital Economics Ltd. in London. With leaders this month raising, for the first time, the prospect of the euro area splintering and economic pain deepening across the region, the debate is shifting, he said.
Skeptics like Feldstein, who is based in Cambridge, Massachusetts, once were “lone voices in the wilderness, but such views are more commonly heard,” said Jessop, a former U.K. Treasury economist. Capital Economics said in early 2010 that the euro would break up within five years.
A week after debt-strapped Greece and Italy lost their sitting prime ministers, Feldstein, who chaired President Ronald Reagan’s Council of Economic Advisors and has advised President Barack Obama, drew distinctions between the likely economic futures of the two nations.
Greece -- where Lucas Papademos took office Nov. 11 facing the need for budget cuts to secure international aid and avoid an economic collapse -- will exit the 17-nation euro-area to default and devalue its way back to growth, he said.
“Even if they wipe out the debt, they still have a current-account imbalance they can only resolve by leaving the euro so they can devalue,” Feldstein said. Asked if that would occur by the end of next year, he replied, “I think so.”
Not defaulting and devaluing would mean “negative growth rates as far as the eye can see,” he said.
Greece’s debt will reach 163 percent of gross domestic product this year, almost three times the euro-area’s supposed limit, according to the European Commission. Even so, Papademos said Nov. 14 that “membership of the euro is the only choice” because it “is a guarantee of monetary stability and creates the right conditions for sustainable growth.”
Italy, where Mario Monti is premier-in-waiting, is in better shape because its budget situation and economy are stronger and its current-account shortfall is smaller, Feldstein said. Investors still propelled the yield on its 10-year bond to a euro-era high of 7.48 percent on Nov. 9 amid concern its lawmakers will struggle to cut the region’s second-largest debt and boost expansion after a decade of lagging behind the regional average.
“The situation in Italy is much better,” Feldstein said. “I’m hearing an understanding in Italy that they have to stimulate growth. I’m thinking they can make it.”
The ECB still should resist the lobbying of some investors to increase its purchases of Italian bonds, because doing so may distort financial markets and reduce the urgency for the government to restore fiscal order, he said.
The Frankfurt-based central bank “ought to let the markets make judgments,” he said. “If the ECB artificially depresses rates, it will take away some of the pressure for significant changes. It would be a mistake.”
Confidence in Ireland
Feldstein expressed confidence in Ireland -- the recipient of 67.5 billion euros ($91.4 billion) in aid from outside sources --because its debt woes are related to its banking sector and the country remains an “attractive” place to invest.
“Ireland, I’m pretty confident about,” he said. “It will be able to finance itself.”
Germany, the region’s dominant economy, also “continues to be very strong” and is helped by the euro remaining intact and by the competitiveness of its companies, he said.
Even with Feldstein’s longstanding doubt of the euro, his forecast it will survive the loss of Greece for now may make him more optimistic than some other investors and economists. Pacific Investment Management Co. Chief Executive Officer Mohamed El-Erian in Newport Beach, California, is among those saying the euro’s guardians must choose between a smaller currency bloc or tighter fiscal union.
‘All Too Thinkable’
Nobel laureate Paul Krugman, who teaches at Princeton University in New Jersey, wrote on his blog Nov. 9 that “the unthinkable, a euro breakup, has become all too thinkable.” While he finds “it hard to believe that the euro will fail,” it “seems equally hard to believe that Europe will do what’s needed to avoid that failure.”
While Feldstein wrote in 1998 there was a “strong risk that the prevailing sentiment will be for higher inflation” at the ECB, he acknowledged Trichet had delivered price stability. The crisis and need to fight it by taking unorthodox steps such as buying bonds may mean Trichet “would have been happier if he’d left a few years earlier,” he said.
Even before the euro’s 1999 birth, Feldstein identified the flaws that have since become apparent, warning as long ago as 1992 that “economic analysis” didn’t justify a single European currency because divergent countries couldn’t fit under one roof. In his most-famous contribution to the debate, he wrote in Foreign Affairs in 1997 that “war within Europe itself would be abhorrent but not impossible” under the euro.
‘Very Strong Bias’
In 2005 he wrote that weak budget rules leave a “very strong bias toward large chronic fiscal deficits,” and by November 2008 he was warning that diverging bond yields within the region signaled investors “regard a breakup as a real possibility.”
As the euro was marking its 10th anniversary in January 2009, Feldstein said the currency faced an “important testing time” and countries may ultimately leave it to regain control of their economies. At the start of 2010, he was saying Greece eventually would default, perhaps with Portugal, and should take a “holiday” from the euro to regain competitiveness.
Feldstein, a former contender to chair the Federal Reserve, said in the interview that his work in the 1990s was aimed at “trying to understand what’s happening over there.”
“Not only did the economics seem wrong, but the politics was very difficult too,” he said. “They saw it as a way of creating harmony, when actually it was the opposite.”
Lars Jonung, a professor at Lund University in Lund, Sweden, criticized Feldstein and other American economists in a January 2010 paper for disparaging the euro before it began. Now he’s “less optimistic” about the region’s outlook because governments failed to obey rules meant to curb deficits and debt, he said in an Oct. 5 interview.
Jonung said his report “summarized the first period of the euro, and that was a fairly happy time.” The problem “is the good times were used as an excuse for not taking tough measures, and that is a threat today.”
Feldstein, who sits on the panel that dates U.S. business cycles, doesn’t limit his gloom to Europe. He sees a 50 percent chance of another U.S. recession by the end of next year, although, given that exports to Europe account for about 4 percent of America’s GDP, the region’s woes have a “very small” effect on the U.S.
“Our problems are our own problems,” he said.
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