Monday, December 12, 2011

They Fiddled While the Eurozone Burned

It seems that everywhere you look, there's a crisis. The unemployment crisis in the United States, the debt crisis (that still isn't one, but the talking heads would have you believe otherwise), and much more troubling for a number of reasons, the Eurozone debt crisis. As some of you may have heard, last week EU leaders came together and passed a fiscal pact that failed to restore confidence in the Eurozone. They then proceeded to pat themselves on the back as their nations crumbled. If that's not a "nailed it!" moment, then I don't know what is. Now, I'm hardly an expert on this topic, so I'm probably going to be heavily outsourcing to Paul Krugman and Brad DeLong for some of this post, seeing as how they're actual economists and all.

Anyways, here's a quick recap of the Eurozone woes by Krugman:
"In the years leading up to the 2008 crisis, Europe, like America, had a runaway banking system and a rapid buildup of debt. In Europe’s case, however, much of the lending was across borders, as funds from Germany flowed into southern Europe. This lending was perceived as low risk. Hey, the recipients were all on the euro, so what could go wrong?
For the most part, by the way, this lending went to the private sector, not to governments. Only Greece ran large budget deficits during the good years; Spain actually had a surplus on the eve of the crisis.
Then the bubble burst. Private spending in the debtor nations fell sharply. And the question European leaders should have been asking was how to keep those spending cuts from causing a Europe-wide downturn.
Wait, there’s more. During the years of easy money, wages and prices in southern Europe rose substantially faster than in northern Europe. This divergence now needs to be reversed, either through falling prices in the south or through rising prices in the north. And it matters which: If southern Europe is forced to deflate its way to competitiveness, it will both pay a heavy price in employment and worsen its debt problems. The chances of success would be much greater if the gap were closed via rising prices in the north.
But to close the gap through rising prices in the north, policy makers would have to accept temporarily higher inflation for the euro area as a whole. And they’ve made it clear that they won’t. Last April, in fact, the European Central Bank began raising interest rates, even though it was obvious to most observers that underlying inflation was, if anything, too low."
So right there at the end, Krugman is calling for the European Central Bank (ECB from now on) to do a number of things. First, he's calling for them to embark upon a bond-buying spree on a much larger scale so as to raise inflation expectations. Now, some of you may, as I once did, think that inflation is always a bad thing no matter what. That's not actually true. Inflation can be useful, especially in combating depressions in that it reduces the real value of debt burdens, while deflation does the opposite. Right now in Europe, the expected inflation rate in Germany, the strongest of the zone's economies is about 1 percent for the next five years. Inflation increases when a nation's economy is pushing at or above its potential GDP, so generally speaking, the weaker the economy, the lower inflation is likely to be. 

Since all of the zone economies are operating under the same monetary policies, that means that the countries that have much weaker economies are going to be experiencing deflation in the next few years. This means that debtor countries like Italy, Greece, Ireland, and Spain are going to have the real value of their national and private debts go up. If anyone's studied the Great Depression, you ought to know that this is very, very bad. Moreover, increasing the real value of national debts for these countries while at the same time savagely cutting government spending to try and reduce their debt is a recipe for a much deeper depression. You're doing it wrong, policymakers.

So what's the recipe for growth that the Germans have in mind for the indebted countries? They'll trade their way out of it, don't worry! This would only work if the more successful economies in Europe increase their overall spending and embark on expansionary policies. But what are they doing? Cutting spending. You're already seeing this in slowdowns across northern Euro countries. So their plan is that the debtor countries will trade their way out of this with northern countries who are also adopting austerity measures and likely pushing the whole of Europe into recession? Who's going to want to buy these debtor countries' goods? The unemployed people in the north? Or perhaps the Germans who are running giant trade surpluses? I'm dubious.

On a slightly different note, the ECB certainly isn't doing anything to foster confidence either. Mario Draghi, the new kid on the block, has taken a hard stance against additional bond-buying or allowing the ECB to become a lender of last resort. Instead, it has taken a hard line against any kind of inflation, raising rates this past year which probably sent this debt crisis into its most severe phase. So far, the unified monetary policy set by the ECB in Frankfurt serves to cater only to what Germany wants, rather than what would be best for the union as a whole. Furthermore, the bank's bond-buying that it has embarked upon was done with about as much enthusiasm as this guy and a whole lot of, "I GUESS I'll buy your bonds, if I really HAVE to..." Real confidence booster, that one. I think Paul de Grauwe puts it best:
"There is no sillier way to implement a bond purchase programme than the ECB way. By making it clear from the beginning that it does not trust its own programme, the ECB guaranteed its failure. By signalling that it distrusted the bonds it was buying, it also signalled to investors that they should distrust these too."
I hope I didn't lose too many of you in that diatribe. If I did, feel free to leave questions and I'll do my best to address them. I think the most frustrating thing about the crises we face today, not just the Eurozone crisis, but the problems with the economy in the U.S. are really not that hard to solve.

Also, as an addendum, a friend of mine just finished covering the woes of the Eurozone in a much more in-depth multi-post blogging spree, which can be found here for those interested.