Why the Euro Crisis Isn't Over

The economist who dared to predict Europe's mess, and was fired for it, says there is much more pain to come

By BRIAN M. CARNEY

Seventeen years ago, Bernard Connolly foretold the misery that awaited the European Union. Given that he was an instrumental figure in the EU bureaucracy and publicly expressed his doubts in a book called "The Rotten Heart of Europe," he was promptly fired. Mr. Connolly takes no pleasure now in having seen his prediction come true. And he takes no comfort in the view, prevalent in many quarters, that the EU has passed through the worst of its crisis and is on the cusp of revival.

As far as Mr. Connolly is concerned, Europe's heart is still rotting away.

The European political class, he says, believes that the crisis "hit its high point" last summer, "because that was when there was an imminent danger, from their point of view, that their wonderful dream would disappear." But from the perspective "of real live people, and families and firms and economies," he says, the situation "is just getting worse and worse." Last week, the EU reported that the euro-zone economy shrank by 0.9% in the fourth quarter of 2012. For the full year, gross domestic product fell 0.5% in the euro zone.

Two immediate solutions present themselves, Mr. Connolly says, neither appetizing. Either Germany pays "something like 10% of German GDP a year, every year, forever" to the crisis-hit countries to keep them in the euro. Or the economy gets so bad in Greece or Spain or elsewhere that voters finally say, " 'Well, we'll chuck the whole lot of you out.' Now, that's not a very pleasant prospect." He's thinking specifically, in the chuck-'em-out scenario, about the rise of neo-fascists like the Golden Dawn faction in Greece.

Mr. Connolly isn't just any Cassandra. When he predicted disaster, he was running the European Commission's Monetary Affairs Committee, the Brussels bureaucracy charged with ushering the euro into being. His public confession of fear that the monetary union would inevitably produce an economic crisis not only cost him his job, he says, it also cost him his pension, and he was barred from his office even before his dismissal was official. In the introduction to the paperback edition of "The Rotten Heart of Europe," Mr. Connolly describes how his photograph was posted at entrances to the commission's offices, as if he were a wanted criminal.

Mr. Connolly went on to a career as a private economist. His research notes while at American International Group's trading division showed the same flair for bold prognostication. In 2003, as then-Federal Reserve Chairman Alan Greenspan cut interest rates to an unprecedented 1%, Mr. Connolly described the U.S. economy as a debt-driven Ponzi scheme and predicted that interest rates would have to fall even further in the next cycle to keep the scheme going.

Today Mr. Connolly provides his research notes to clients who presumably pay a great deal for his thoughts. He generally doesn't talk to the press. And he doesn't make public pronouncements or market calls, lest he "agitate" his clients.

But with his book back in print, Mr. Connolly agreed to sit down in his publisher's office to explain why the euro went wrong, why nothing has been fixed, and what he expects to happen next.

Superficially, there is some basis for the official view that the worst of the crisis is over: Interest-rate spreads, current-account deficits and budget deficits are down. Greece's departure from the single currency no longer seems imminent.

Yet unemployment is close to 27% in Spain and Greece. The euro-zone economy shrank ever-faster throughout 2012. And—most important in Mr. Connolly's view—the economic fundamentals in France are getting worse. This week France announced it would miss its deficit-reduction target for the year because of dimming growth prospects.

It's one thing to bail out Greece or Ireland, Mr. Connolly says, but "if the Germans at some point think, 'We're going to have to bail out France, and on an ongoing, perpetual basis,' will they do it? I don't know. But that's the question that has to be answered."

The official view is that the bailouts of Greece, Ireland and Portugal—and maybe soon Spain—are aberrations, and that once those countries get their budgets on track, their economies will follow and the bad patch will be a memory. Mr. Connolly calls this "propaganda."

And here we get to the heart of Mr. Connolly's rotten-heart argument against the single currency: The cause of the crisis, according to the "propaganda," he says, was "fiscal indiscipline in countries like Greece and financial-sector indiscipline in countries like Ireland." As a consequence, "the response is focused on budgetary rules, budgetary bailouts and rules for the financial sector, with the prospect, perhaps, of financial bailouts through the banking union, although that remains unclear."

But even if the Greeks were undisciplined, he says, "both the sovereign-debt crisis and the banking crisis are symptoms, not causes. And the underlying problem has been that there was a massive bubble generated in the world as a whole by monetary policy—but particularly in the euro zone" by European Central Bank policy.

The bubble formed like this: When countries such as Ireland, Greece and Spain joined the euro, their interest rates immediately dropped to near-German levels, in some cases from double-digit territory. "The optimism created by these countries' suddenly finding that they could have low interest rates without their currencies collapsing, which had been their previous experience, led people to think that there was a genuine rate-of-return revolution going on," he says.

There had been an increase in the rates of return in Ireland "and to some extent in Spain" in the run-up to euro membership, thanks to structural reforms in those countries in the pre-euro period. But by the time the euro rolled around, money was flowing into these countries out of all proportion to the opportunities available.

"And what kept the stuff flowing in," Mr. Connolly says, "was essentially the belief, 'Well, yes, there is a high rate of return in construction.' " That in turn depended on "ongoing expectations" about house appreciation "that were in some ways not dissimilar to what was happening to the United States in the middle of the last decade. But it was much bigger."

How much bigger? "If you scale housing starts by population, then the housing boom in Spain and Ireland was something like three or four times as intense as the peak of the boom in the U.S. That's mind boggling."

That torrent of money drove up wages far faster than productivity improved, while cheap borrowing led to major deficit spending. After the 2008 financial panic, the bubble inevitably burst.

So what's needed now is not simply a fiscal retrenchment, or even a retrenchment along with banking reform. Wages and prices have to adjust to something like their pre-bubble trends, Mr. Connolly says, to make these economies competitive again. One way to accomplish that would be a massive depreciation of the euro—"really massive."

If that's not feasible, he says, Europe can try to "recreate the bubble" by bringing back the conditions that allowed Spain to borrow so cheaply. That is "essentially what [Mario] Draghi"—the European Central Bank president—"appears to be trying to do: to recreate a bubble." Mr. Draghi, by threatening to intervene in the sovereign debt markets, has driven interest rates in Spain down substantially. But because the banking system is distressed, and because house prices continue to fall, even these lower rates are not driving investment into the country the way they did before. And even if Mr. Draghi were to succeed, Mr. Connolly says, the ECB president would merely be "recreating exactly the dangerous, unsustainable situation that we had in the middle of the last decade."

Which leaves Europe with the last option: Germany pays. As Mr. Connolly puts its: "You can say to a country like Spain: 'No need to adjust your competitiveness, you don't need to have full-employment trade balance. You can still have full-employment current-account balance because we will give you transfers instead.' And by definition, if the point of that is to avoid adjustment, you have to do it this year, the next year, the year after, and every year, forever."

That is not how Brussels and Frankfurt see it. In their view, a little help now will simply ease the transition back to a stable future, when the transfers will cease. Of all the countries that have been bailed out so far, Ireland comes closest to realizing this goal. But Ireland, Mr. Connolly notes, "is a much more flexible and much more open economy than Spain, Greece, Portugal, France, Italy." The less flexible economies have been slower to adjust, with the consequence that wages, instead of dropping to a sustainable post-bubble level, remain high—resulting in mass unemployment.

Which brings us back to the politics of the euro crisis. At some point, the people in the affected countries presumably will call a halt to the pain and sweep in a government willing to think the impossible—leaving the euro, for example.

To avoid that, Germany could well agree to pay for a transfer union, either believing that the transfers needn't be permanent, or hoping they'd be less expensive than a euro break up. But, Mr. Connolly warns, once a mechanism is in place to transfer money from Germany to the current-account deficit countries, it's only a matter of time before Germany is faced with the question of adding France to its list of dependents—something even Berlin may not be willing or able to afford.

German reunification has cost the former West Germany about 5% of GDP a year, with no end in sight. The expense has proved politically tolerable, Mr. Connolly says, because there was a strong sense that "they were reuniting their country." But such solidarity does not exist within Europe.

"There is no European demos, and you're not going to create a demos by setting up a system in which you say, 'We will give you money, you will follow these rules,' " says Mr. Connolly. "It simply will not work."