Monday, October 21, 2013

Everything You Need to Know About the Eurozone Crisis

With the onset of the global financial crisis of 2008, the U.S. economy took a steep nose-dive into recession. Similarly, the economy of the Eurozone, which was likewise dependent on a housing bubble, collapsed. However, the nature of Europe’s monetary union created a unique aspect to the region’s crisis. More specifically, the monetary union and unified currency of the area played a large part in creating what has now become known as the Eurozone Crisis, in which peripheral nations such as Greece, Ireland, Spain, Italy, and Portugal, (GIPSI nations) have found it increasingly difficult to finance their government deficits in global bond markets. While leaders on both sides of the Atlantic have sought to explain the Eurozone Crisis as a story of fiscal profligacy and overgrown welfare states, their narratives simply run counter to the available evidence.

Before attempting to explain the current crisis, though, I've always found it helpful to contextualize matters with a bit of history. In 2002, member states of the Eurozone gave up their independent currencies and adopted a single currency--the Euro. In so doing, these nations also effectively relinquished their respective independent monetary policies. The single currency fueled a false sense of security in the core Eurozone nations, leading French and German banks to lend large amounts of money to banks in the European periphery nations--because hey, it was all the same currency, so nothing could go wrong, right? This, in turn, created a large property bubble, similar to the one we had here in the U.S. This bubble, formed concurrently with its American counterpart, led to a period of rapid growth in the GIPSI nations. This rapid growth, which was financed primarily by rapidly increasing private-sector debt levels resulting from those massive core-to-periphery capital flows I just mentioned, led wages and prices in the GIPSI nations to rise substantially faster than those in core European countries:

Note the large gap between Germany and the periphery nations. In any case, these increased wages and price levels made these economies deeply uncompetitive compared to Germany, with their products being far more expensive on the world stage, driving their exports down. With the popping of the housing bubble, private spending sharply declined, and inevitable cyclical (recession-induced) deficits arose as governments found themselves with far lower tax revenues and far higher government expenditures, with no prospect of exporting their way to an economic recovery.

In response to this severe crisis, the European Central Bank (ECB), like most global central banks at the time, cut interest rates in an effort to increase liquidity in the markets and spur a recovery. While the downturn in the Eurozone was fairly ubiquitous across different nations, the subsequent recoveries across Europe spanned from fairly robust in Germany to nonexistent in the periphery nations. Germany, with its persistently large current account surpluses, traded its way to a vigorous recovery, with unemployment peaking just above 8% in 2009 and falling to 5.3% at last count. In stark contrast, the unemployment rates of the GIPSI nations remain well above any measure of full employment and show few signs of falling

Nevertheless, the ECB, which was (in theory) supposed to conduct appropriate monetary policy for all of the Eurozone, raised interest rates in mid-2011, sending the GIPSI nations' bond yields soaring and pushing the sovereign debt crisis into a much more acute stage.

What the ECB's actions indicated to the bond markets was that it sought to conduct monetary policy that was appropriate not for the whole of the Eurozone, but for Germany alone. In order for a government to be able to borrow at low interest rates, like America can, bond markets must have confidence in the ability of that government to pay back what is owed. What the ECB demonstrated is that Spain, Italy, Ireland, Italy, and Portugal lack a central bank willing to stand by their respective economies. As a result, the future economic prospects of these nations are correspondingly diminished in the eyes of the bond market. That's why they pay high interest rates on their debt. And it's precisely for this reason, for example, that the United Kingdom is able to borrow at a lower rate of interest than Spain while it simultaneously has larger debt-to-GDP as well as a larger deficit. 

Simply put, the bond market understands that the Bank of England will do what is necessary for England’s economy to thrive and produce the necessary tax revenues to pay off its debts. Spain—and indeed the rest of the GIPSI nations—by contrast, are left with a central bank that has demonstrated to bond markets that it is more concerned with Germany’s economy than with their own.

Ultimately, the critical lesson that ought to be drawn from this ongoing crisis is that its causes are largely not fiscal in nature, they stem from the flawed structure of the European monetary union itself. Unfortunately, leaders in both the United States and across Europe have subscribed to the theory that fiscal profligacy and overly large welfare states on the part of the GIPSI nations are the root causes of this crisis. 

An easy way to debunk this thesis is to compare the average public social expenditures (the size of the welfare state) in 2007 and average budget deficits among Eurozone nations between 1999 and 2007. It quickly becomes clear, looking at the chart below, that the size of the GIPSI nations’ welfare states is not a root cause of the crises, as Germany’s welfare state on the eve of the financial crisis in 2007 was larger than any of those found in the debtor nations:

The more widely cited theory among European policymakers is one in which the GIPSI nations partook in excessive government spending during the years leading up to the current crisis. However, in examining the average budget deficits between 1999 and 2007, this theory just doesn't stack up:

To be sure, Greece did run large deficits, but all other nations showed few signs of profligate spending. Italian deficits were roughly equal to those in France, yet France is not facing Italy’s current borrowing costs. Further discrediting this theory is the fact that Spain and Ireland both ran budget surpluses during the years leading up to the crisis, with their large budget deficits arising as a result of the economic crisis, rather than being its cause. 

This misdiagnosis on the part of the policymakers has led them into mistakenly demanding fiscal austerity in the face of high unemployment as the price of numerous bailout packages. However, as indicated before, the true problem facing many of the GIPSI nations is the fact that their labor costs and price levels grew wildly out of balance with those of Germany and other core nations, creating massive trade deficits:

Ordinarily, a nation would rectify this problem simply by having its central bank print lots of money to devalue its currency, thus making its exports competitive again. However, due to the monetary union, the GIPSI nations don't have the ability to devalue their currencies, and the ECB’s generally timid and ineffective policy responses have done little to this end.

At the end of the day, the Eurozone faces three choices: First, the ECB can opt to pursue a policy of slightly above-average inflation, such that prices and wages in the places like Germany rise to balance with those in the periphery. This policy option would be most likely to preserve the Eurozone and restore the periphery’s competitiveness. In general, it would also serve as economic stimulus to the entire Eurozone, because a continent of growing economies is a lot more beneficial to Germany than one made up of nations in crisis. In turn, GIPSI nations would be able to stage a more robust, export-led recovery, which in and of itself would restore confidence in the bond markets as well as improve their budgetary outlooks. With robust recoveries underway, these nations could then turn to balancing their longer-term budgets, rather than the other way around.

The second choice would be a Eurozone break-up or a peripheral nation’s exit from the union. This option, though politically disastrous, would allow the GIPSI nations to devalue their own currencies accordingly to restore competitiveness, but would also likely lead to bank runs in the exiting nation as well as cause turmoil across financial markets for some time after an exit. The likelihood of an exit is pretty hard to pin down, since you never really know how long a country is willing to put up with such unacceptably grueling economic conditions before doing something extreme.

The third option, which is currently being pursued by the Eurozone, is one of “internal devaluation,” as economist Paul Krugman dubbed it, in which nations would adopt structural changes and austerity measures and slowly suffer through deflation (falling prices) until their nation’s exports regained competitiveness. This option, due to the downward “stickiness” of wages (that is, workers are less willing to take pay cuts than pay rises) and in turn of prices, would be tremendously slow and painful, with the debtor nations facing years of catastrophically high unemployment and all of the associated human costs.

Indeed, while Mario Draghi has prevented the Euro from completely falling apart when he pledged to buy an unlimited number of GIPSI government bonds, there's a hell of a difference between staving off an acute crisis and staging a recovery. And he seems intent on keeping it that way. Even though Europe has faded from the limelight in recent months, it is very much still in crisis. For Spaniards and Greeks, 26% unemployment doesn't just fade away. For Italians, 12% unemployment isn't just something you forget about. Sooner or later, something's gotta give.