Does Europe Work?

"The Wizard of Oz" could be read as an allegory for our deflationary times. Written in 1900, its Scarecrow and Tin Man represent farmers and factory workers searching for a savior following the collapse of the U.S. railroad bubble, only to discover that the "wonderful wizard" in Emerald City is powerless to help them. A century later the world is again battling post-bubble deflation pressure. Only this time the tale unfolds in Europe, where residents who pray for a growth cure are finding that the leaders who just gathered in Evian, France, are largely powerless to help.

The grand experiment of Europe now faces its first serious test, and its institutions are failing to measure up. In the two years since the eurozone became a reality with the formal introduction of its currency, the world has changed dramatically. The threat of deflation has returned to the world stage after a half-century absence, just as Europe has forsworn the main weapons of war against it: sharp increases in spending or the money supply. The new European Central Bank is constitutionally unwilling if not unable to create easy money. The Stability Pact that binds governments to limit deficit spending forbids the priming of a broken economic pump, which could prove deeply destabilizing. "Their hands are tied," laments Nobel economist Joseph Stiglitz of Columbia University. "Europe has failed in that essential mission [creating stable growth]. Its framework is not well designed to address the problems of today."

The roots of this mess lie in Germany, the most powerful economy in the 12-nation eurozone. When the zone was under construction in the early 1990s, Germany was a model of austerity and demanded that others follow its example. Scarred by its experience of hyperinflation in the 1920s, the German Bundesbank's obsession with stable prices, reinforced by the inflation of the '70s and '80s, would become the obsession of Europe's new central bank, too. The irony is that now, no economy in the world is more at risk of deflation or in need of cheap money than Germany, yet the European Central Bank is institutionally incapable of providing it. "The ECB is still fighting the inflation wars of the 1970s and 1980s," says Barry Eichengreen, a financial historian at the University of California in Berkeley.

There is a global cottage industry devoted to blaming ECB chief Wim Duisenberg for Europe's straits, but he is merely carrying out the bank's formal mandate, says Thomas Mayer, chief economist with Deutsche Bank in London. The role of the U.S. Federal Reserve is to maintain stable prices and growth, while that of the ECB is to maintain price stability even when falling growth is a bigger risk. Worse, its board of 18 governors includes 12 from the former national central banks, which means they may not always vote the top priority of the continent--now, clearly, the growth revival of Germany. "No doubt Germany would be growing faster if the Bundesbank were still in charge," says New York University financial historian Niall Ferguson. "That's why the euro is slowly failing."

The problem is that when prices are measured across the eurozone, the result is an average that accurately describes neither the sluggish core of Europe (Germany, France) nor the fast-growing periphery (Ireland, Spain). By targeting an average inflation rate under 2 percent, the ECB winds up setting interest rates that, absurdly, favor the marginal over the major economies. Market players expect the ECB to cut rates by half a point this week, but AIG economist Bernard Connolly figures it would take an unheard-of cut of 1.5 points simply to counteract the rising value of the euro, which dampens growth by making European exports more expensive. "All this brings to a head things that were inevitable," says Connolly, who is also a former EU bureaucrat. "The current structure of the European Union is untenable."

The stability pact is another self-imposed straitjacket on growth. It provides for punishment of violators of the 1992 Maastricht Treaty, which created the eurozone and caps national-budget deficits at 3 percent of the GDP. Now its mastermind, Germany, is one of the eurozone members (along with France) that face billions in fines for violating the cap. And the Finance ministers who decide the fines show no sign of willingness to let one another off the hook. "Rigid implementation of the pact could be the end of the pact," warns Eric Chaney, an economist with Morgan Stanley in Paris.