Wednesday, September 26, 2012

This Could Get Ugly, Eurozone Edition

Well, here we are again folks, mere weeks after European Central Bank President Mario Draghi announced an unlimited bond-buying program, rioting has erupted across Spain and Greece over the drastic austerity programs that have been forced upon those countries. Ever since I started studying economics, I've come to realize what a clumsy contraption the Eurozone really is, with monetary policy being determined  for a myriad of very economically diverse nations by one central bank. On top of that, it lacks fiscal unity because, at the end of the day, nationalism still is still fashionable. 

As plenty of people have said before, the crisis in Europe isn't really about debt, when you get right down to it. As Brad Plumer aptly noted in a post today:
"In a country with 24 percent unemployment, those measures are already inciting protests and labor unrest. And now it turns out, according to reports from Germany, that those austerity measures won’t even be enough, because Greece’s economy is hurting so badly that its deficit keeps swelling anyway.

The same goes for Spain, where thousands of protesters have surrounded the parliament building in Madrid, incensed at perpetual budget cuts and tax hikes that never seem to get the country on pace for recovery. Ditto for Portugal, which has been the star poster child for austerity and yet keeps getting choked by poor growth and widening deficits."
Therein lies the rub: The more austerity these nations undertake, the more depressed their economies get, the more anxious the bond markets get about loaning money to them, the larger their deficits get, leading to more cuts in a vicious cycle. Ultimately, the problem isn't one of deficits. Yes, the PIIGS countries will have to get their budgets under control, but they're not going to be able to do that until they've recovered, which they can't do because they're so uncompetitive. 

What I mean by this is that these countries have high labor costs--that is, the costs of employing people in a business there have become wildly more expensive than in, say, Germany. For you visual learners, here's a chart I pulled from Krugman:



Anyway, the point I'm getting to is that countries usually can get around this problem easily--they just devalue their currencies, so that it gets cheaper to do business there. A notable example of this would be Iceland, which sharply devalued its currency and is now experiencing a robust recovery. The only way for the Eurozone to achieve something like this would be for the ECB to pursue a higher rate of inflation, such that Southern Europe's labor costs get back into line with Germany's. 

The Germans, of course, have an almost paralyzing fear of inflation, one which brings up images of wheelbarrows full of cash being used to buy bread, as well as the rise of Hitler and the Nazi Party. While the bit about wheelbarrows is true, the fact is that hyperinflation had little to do with the Nazi Party's rise to power. Hyperinflation ended in 1924 in Germany, and Hitler wasn't sworn in as Chancellor until January of 1933. Might there have been something happening during those nine years? Something of the "Great Depression" variety? Via Clayton White:
"Inflationary finance did not bring about the Nazis; mass unemployment did. Crushing debt burdens owed to foreigners did. Foreign mandates imposed in a beleaguered population did. THAT'S the kind of environment that leads to radical leaders whose messages of spite and hatred can take root."
Between 1924 and 1929, the German economy was pretty prosperous, by the way. So Germany ought to get its facts straight, lest the rest of Europe pay an even higher price just because the members of the Bundestag didn't pay much attention in history class.