Last month Pedro Sánchez Castejón was chosen to be the new leader of Spain’s center-left Socialist Party (PSOE). El Pais called his appointment a “renewal” of the PSOE, although Sánchez seems to have been chosen mainly because he is too young and unknown to suffer from the revulsion most Spaniards feel towards the political establishment.

But as the PSOE’s new leader, and without much of the baggage carried around by the older generation of leaders, Sánchez has an important choice facing him. If he expects to lead Spain and his party out of its current crisis, he must recognize that the crisis is fundamentally a conflict between the interests of Europe’s bankers and of Europe’s workers, and he must reengineer PSOE’s policies in favor of the Spain’s very anxious working and middle classes. If not, he will watch wistfully as Europe’s extreme right eventually takes control of the debate, either directly, or indirectly as the center-right parties absorb their arguments.

Michael Pettis Pettis, an expert on China’s economy, is professor of finance at Peking University’s Guanghua School of Management, where he specializes in Chinese financial markets. More >

Throughout Europe, no less than in Spain, policymakers have refused to acknowledge the fundamental contradictions created by the euro just as, in the 1920s, they refused to acknowledge the fundamental contradictions created by the gold standard. Currency flexibility is one way an economy adjusts to volatility in growth and relative prices changes. When a country gives up control of its currency, however, volatility doesn’t disappear. Instead the adjustment accommodated by changes in the currency must now occur in some other way.

One common way is in the form of wage adjustments. Under a strict gold standard, countries with overvalued currencies usually adjusted by having wages fall relative to that of their trading partners, and of course the strongest impetus for falling wages was the unemployment caused by the expansion of foreign tradable goods sectors at the expense of the domestic. The volatility that could have been absorbed by the currency, in other words, was resolved mainly at the expense of workers.

Barry Eichengreen argued in Golden Fetters that the gold standard lasted so long during the 19th Century probably in part because the connection between the exchange rate and unemployment was not fully understood and, more importantly, workers were not sufficiently organized and enfranchised to protect themselves from the adjustment process that resolved currency imbalances. Because these conditions have changed, especially the latter in liberal democracies, this, he argued, is why we are unlikely to see a return to the gold standard.

But within the euro area, adjustment must take the same form as adjustment under the gold standard. Within Europe currency adjustments are not possible, and as a result Europe is forced into the classic gold standard adjustment when prices and wages are misaligned internally. With Germany having effectively devalued its euro during the decade after it was created relative to countries like Spain, for whom the euro is consequently overvalued, a misalignment of wages and prices must be resolved primarily in the form of wage and price adjustments, and this has meant, not surprisingly, that these countries would be forced into high unemployment until wages adjust.

The “correct” way to resolve internal misalignments would be for Germany to reflate domestic demand and raise domestic wages, but for a variety of reasons, at least some of which have to do with Germany’s determination to protect its banks from loan decisions made in the last decade, this is unlikely to happen without much greater pressure exerted by the peripheral nations. In order to protect the banks, who want a strong currency and for all debts to be either fully repaid or to be subsidized with transfers from the household sector, the brunt of the adjustment clearly will be borne by workers and an anxious middle class.

Put another way, Europe suffers from structurally weak demand largely because of structurally weak demand in its largest economy, Germany, and the result is that for many years Germany relied on excess demand from peripheral Europe to balance supply and demand. The 2008 crisis put an end to this form of balance by making it impossible for peripheral Europe to over-consume. Rather than resolve the problem by boosting demand in Germany, Europe’s solution is to reduce demand in the rest of the region (lowering wages reduces consumption). If Europe were a small economy, a surge in its current account might make up for this increasingly weak domestic demand, but Europe is too big to rely on external demand. It must rely on unemployment to “resolve” weak domestic demand.

Protecting the value of the currency and of international debt is usually characterized as behaving “responsibly”, but it comes with a cost. The policymaking elite, both on the left and the right, have been reluctant to make explicit the connection between the German policies, the euro, and domestic unemployment, preferring instead to blame misguided domestic labor polices, even though these labor policies long predated the euro crisis. This confusion affects not just Spain. Mario Draghi for example recently blamed “a lack of labour market reform and excessive business regulations” for Italy’s current failure to grow, as if these only became problems after 2008.

The rise of the fringe

Not surprisingly, this failure to address the root cause of the crisis has left European politics once again vulnerable to fringe parties. But while the extreme left does little more than act out publicity-garnering ways to express outrage, the extreme right has mounted a skilled and consistent attack on Europe’s monetary structure and on the banking establishment. Their attacks are not always rational – blaming foreign immigration, or the US, or China, for Europe’s problems suggests a pretty high level of confusion – but they have clearly taken sides.

This is why the extreme right has done so well throughout Europe, and will continue to do so, even eventually in Spain, at the expense of the major parties. Neither the PSOE nor the PP (the center right party in Spain) will revive Spain’s economy by behaving “responsibly”, given the intractability of the forces behind the economic crisis. Except in the very unlikely case that Germany vigorously reverses the wage- and income-suppressing policies implemented in the past two decades, Spain really has only two policy options, both very difficult.

Madrid can confound elite consensus and move aggressively to restructure Spain’s external debt while redefining its participation in the euro, for example by leaving the euro while committing credibly (i.e. with German support) to rejoin the currency union at some specified future date. In this case Spain will suffer a year of chaos before the reforms implemented, ironically, by Mariano Rajoy generate a return to rapid growth.

Alternatively Spain can continue to suffer many more years of high unemployment and, with it, a rising debt burden. The recent anemic improvement in the Spanish economy, announced with great fanfare, will do almost nothing to resolve either problem, especially with Germany and France weakening. Unemployment will stay high for many years and the combination of prolonged unemployment, emigration of many of the country’s best and brightest, weakened infrastructure, and a deterioration in the political landscape will ensure that Spain will be one of the sick men of Europe for decades.

For the PSOE to avoid irrelevance Sánchez must formally recognize that the policy failures accumulated over the past four decades, including labor rigidity and out-of-control corruption, although very real, are not the cause of the crisis. Spain’s high unemployment, excessive debt, and stagnant growth stem indirectly from policies implemented by Germany that forced down the GDP share of German wages while also reducing domestic investment. These policies created for Spain the same set of problems that simultaneously affected Portugal, France, and the rest of peripheral Europe.

Since 2001, with both consumption and investment declining relative to Germany’s production of goods and services, the only way Germany could avoid a surge in unemployment was with a surging current account surplus. The constraints imposed by the euro, which ensured massive German capital exports to the rest of Europe, allowed Germany to run this surplus, while its European neighbors, no longer in control of monetary policy and unable to prevent German capital imports which forced up asset and consumer prices, were forced to run the obverse deficits.

These countries had only two possible responses to German imbalances. First, low interest rates and surging capital imports from Germany could set off an unsustainable consumption boom and raise domestic costs relative to that of Germany, which they did before 2008. Second, Germany’s newly created manufacturing competitiveness would force German’s European neighbors to absorb the unemployment that should have afflicted Germany, which they did after 2008 once the consumption boom ran out of steam.

Their real commitment to Europe made it hard for policymakers to acknowledge that the crisis was caused by many of the policies, including the establishment of the euro, that seemed fundamental to European unification, and so they blamed domestic distortions, and especially high wages, for the crisis. Once the ECB declared its readiness to provide unlimited liquidity, and in spite of high and growing debt burdens and debilitating unemployment, Brussels declared that the euro crisis was largely behind us.

The crisis is not about bond prices

But while investors may be forgiven for thinking so, the European crisis is not about the price of bonds. The collapse in bond prices in 2008-09 reflected the very real fears of insolvency, and the fact that the European Central Bank has decided to provide unlimited liquidity to prop up bond prices has not resolved the insolvency risks at all. What is more, historical precedents suggest that the ECB’s resolve will only last until European banks, and especially German banks, have been sufficiently recapitalized (at the expense of households, of course) to recognize that many European countries will never repay their debts. Once they have the capital to absorb sovereign defaults, the appetite of Germany and other countries to continue funding unrepayable debt will fade away.

A recent piece by Barry Eichengreen and Ugo Panizza makes this contradiction clear. The authors show that countries like Spain can repay their debt only under implausible assumptions about the size of the fiscal surpluses needed to do so. As they write in a summary:

For the debts of Europe’s problem countries to be sustainable, absent restructuring, foreign aid or an unanticipated burst of inflation, their governments will have to run large primary budget surpluses, in many cases in excess of 5% of GDP, for periods as long as ten years. History suggests that such behaviour, while not entirely unknown, is exceptional. Countries that have run such large surpluses for such extended periods have faced exceptional circumstances. On balance, this analysis does not leave us optimistic that Europe’s crisis countries will be able to run primary budget surpluses as large and persistent as officially projected.

At some point, in other words, either the suffering countries of peripheral Europe will have to squeeze their citizens far more than is likely to be possible in a democracy, or these countries will have to restructure their debt with significant debt forgiveness.

The extreme right, and especially Marine Le Pen’s Front National, has engineered a frontal attack on the real source of the euro crisis. They recognized that policies that forced down German wages created the collapse in demand, and that the euro forces the rest of the region to compete with Germany by forcing down domestic wages which, paradoxically, will reduce overall demand in Europe even further. By leaving the European Union and regaining control of monetary policy, France will almost certainly see a decline in unemployment, a sharp improvement in its current account, and faster GDP growth.

French elites insist that Le Pen is not a threat because were she ever to become too powerful, the left and center would unite against her and prevent her party from winning any election. But even if they are right, they miss the point. The only way for the centrist parties to prevent a victory for the Front National may be by adopting most of its policies. As a recent article in Le Mode Diplomatique put it:

However the main reason [for earlier failure of the FN to take power] may have been Sarkozy’s adoption of staple FN policies: the promotion of a French identity; national preference in work, welfare and public service access; hostility towards low-income immigration; special crime laws for foreign-born migrants. Voters sympathetic to the FN saw Sarkozy as a more viable vehicle for their politics. As Le Pen Jnr put it: “The only thing that weakened the Front National was Sarkozy’s strategy of presenting himself as a kind of double of the FN.” Sarkozy saw that “the French people were turning more and more towards the option of the Front National. He managed to harness the force of that river and divert it to his own advantage.” She laughed. “But now the river has returned to its own bed.”

Europe’s policymaking elite refuses to acknowledge what is pretty obvious. Monetary union, as it is currently structured, forces imbalances in one country to affect neighbors within the union, and there is no mechanism for resolving the imbalances at the place of origin. Countries like France and Spain have no way to deal with policies in Germany that forced up the country’s national savings rate (by forcing down wages) while lowering domestic investment except by themselves lowering their own national savings, either in the form of an unsustainable consumption boom or a surge in unemployment.

Responsible bankers versus hungry workers

In this split between the “responsible” policymaking elite and the “irresponsible” anti-euro right, Europe is replaying one of history’s classic battles between bankers and workers. Throughout the 19th and 20th centuries (and indeed much earlier) debt and monetary crises have pitted one against the other. Sometimes the bankers win, as they did during Latin America’s Lost Decade of the 1980s, and the US in the late 1970s, and sometimes, although never without a struggle, the workers eventually win, as they did in the 1930s both in the US under Roosevelt and Germany under Hitler.

Whether the bankers are right about the long-term benefits of maintaining the course or the workers are right (and history makes clear that neither side is always right), by defending the currency and the sanctity of debt, elite policymakers throughout Europe have taken the side of the bankers. In order to protect the current monetary structure they have allowed worker unemployment to soar and uncertainty and fear to spread through the middle class.

But even if over the long term they are right to do so, the historical precedents suggest that the votes of the disaffected will go to whichever party, left or right, most vigorously takes up the cause of the workers against the bankers. If the center parties do not do so, as Roosevelt did in the 1930s, the extremists will. While Europe’s centrist policymakers refuse to address the root cause of the European crisis, and the extreme left expends its energy on theater and rage, the extreme right’s share of votes has risen and will continue to rise.

Pedro Sánchez has a choice. He can maintain the policies of “responsibility”, in which case he will cede leadership of the struggling working and middle classes to the racist and xenophobic right, with all the awful long-term consequence for Europe that this will entail, including a very low likelihood that the European Union will revive. Or he can seize leadership across Europe by demanding a meaningful debate across the continent on European debt and on the euro. This means among other things discussing ways of introducing currency flexibility as a more efficient way for relative costs in Europe to adjust, and it means recognizing very explicitly that much European debt can only be repaid in the form of a massive and unacceptable transfer of wealth from European workers to German banks.

Contrary to alarmists who see any step backwards as an existential threat to Europe, this debate would not mean the end of the dream of a unified Europe. It would simply mean conceding that Europe does not yet have the institutions needed for the currency union to survive, and that the capital, labor, banking and fiscal frictions that remain in place ensure that the flexibility eliminated by currency union will re-emerge in more destructive ways. There can be a successful European Union, and many of the changes that are needed to ensure success are likely to be relatively easy to implement, especially if they are part of an overall package that includes significant debt restructuring and forgiveness, but the current structure is not in place.

By undermining the irresistible pull of those who wish to destroy the union, a serious debate that recognizes the unbearable cost to European workers of the current structure might actually be the best way to save Europe. To insist that the current Europe is the only possible Europe does not make sense, and even many of Europe’s strongest proponents understand this, but to argue that the current version of Europe can evolve gradually in spite of the tremendous costs that must be borne by workers, especially in countries like Spain, may overstate the popular appeal of Europe and understate the extent to which political elites have overcommitted themselves to their creation.

The PSOE’s party elders did not choose him for this role, but if Pedro Sánchez takes the lead, in Europe as much as in Spain, and reopens the debate about the euro, acknowledging that the current structure does not work and defining with the help of hindsight what vulnerabilities must be addressed in a reformed European Union, the party’s new leader can halt the decline of the PSOE at home and reverse the ugly nationalism spreading through Europe. Spain and other countries suffering from high unemployment should unite and jointly put pressure on Germany to resolve its structurally weak domestic demand, and their excessive debt.

If however he continues to pretend that the crisis has been resolved by the ECB’s willingness to roll over Spain’s debt, which it will probably do only as long as German banks are insufficiently capitalized to recognize the obvious, he may find himself presiding over Spain’s and Europe’s swing to a nationalist right. In the battle between workers and the bankers, ultimately the workers will decide on who will determine policy.

This article was originally published by China Financial Markets.