To Be or Not To Be?

European leaders face an acute existential migraine this New Year. If only AlcaSeltzer could help them.  

Gone are the days when “greek spread” referred primarily to tzatiki and taramasalata. The eurozone crisis is now generally regarded as a problem with a solution “technically and politically beyond reach”. The evidence certainly supports this dour viewpoint. Fifteen summits, seven changes of government and five master plans later, we are left with precisely zero in terms of substantive achievements. €457bn of European government debt must be refinanced by April, thus few grains remain in the hourglass. In the near term, ‘now’ in other words, European governments’ must acknowledge that contractionary fiscal policy is, yes, contractionary and revise the quack medicine of austerity that is currently prescribed to assuage our economic ills. In the longer term, the failure of the neoliberal underpinnings to the Euro must be acknowledged and institutions redesigned accordingly….if democratic support for a fiscal union is forthcoming.

What started as “the Greek problem” is now a fully fledged “Europe” problem. The credit rating of the entire European Union, not simply those of the pesky PIGS, is under threat of downgrade. Output and employment remain depressed. August witnessed the largest monthly decrease in eurozone industrial production since 2009 and many are predicting a slide back into recession in 2012. Unemployment in the region has soared to a new euro-era high, reaching 10.3% of the labour force in October. Joblessness has remained highest in Spain, where a staggering 22.8% (!!!) of workers are without jobs.

Rebalancing, not retribution, required

The strategies currently pursued by Eurozone institutions either do not go far enough or are opposite to what is required. Further, faster fiscal tightening continues to be dictated. Only yesterday, Spain announced plans to cut €8.9bn from public spending in 2012. Amartya Sen, a Nobel laureate in Economics, described austerity in the current climate as a “snake” within the wider metaphor of the game “Snakes and Ladders”. It is getting us further from where we want to be.

Austerity continues to be prescribed because fiscal profligacy is too highly stressed as an underlying cause of the debt crisis. Inexcusably poor financial discipline, in part a consequence of the moral hazard generated by Euro membership (see previous post), clearly played a role in the Greek debacle, however, fundamental imbalances in competitiveness across the Eurozone cannot be ignored as a salient causal factor.

The health of government finances pre-crisis provided little clue as to which countries would be sucked into economic chaos. As Martin Wolf notes, “fiscal deficits were useless as indicators of looming crises”.  Trade imbalances, on the other hand, correctly identify the countries at the heart of the problem. Estonia, Portugal, Greece, Spain, Ireland and Italy had the largest trade deficits over the period 1999-2007. A trade deficit occurs when the value of what a country imports exceeds that of its exports. In contrast to these tales of woe, Germany has experienced an increase in its trade surplus since 1999. The asymmetries in competitiveness and economic strength between Germany and the ‘peripheral’ states really are stark. Joblessness in Germany has been falling for the last 2 years and the financial market turbulence that is wreaking havoc in many European countries is said to have had “little impact” on the country’s economy. In Europe it really isn’t a case of ‘all in it together’.

It is an accounting identity that a country with a trade deficit must be a net borrower in order to fund that deficit. Within the Eurozone, surpluses in Germany and the Netherlands were previously channeled through the financial system to fund deficits in others, i.e. Greece Ireland, Portugal and Spain. The credit crunch caused these channels to seize up, eliminating this flow of funds, and also initiated a collapse in private borrowing, prompting government deficits to go through the roof.

Acknowledging that deep rooted differences in productivity and competitiveness have played a role in the crisis, leads one to the conclusion that reforms cannot simply be piled on debtor countries. Retributive justice, in the form of harsh spending cuts, is misapplied as reckless profligacy has had but a minor role to play. Rather, shifts in external balances across the eurozone are called for. As one country’s trade deficit is another’s surplus, this calls for adjustment and transfers on the part of surplus countries such as Germany. It is reckless to hold deficit countries to pro-cyclical austerity without countervailing measures to boost import demand elsewhere in Europe. In the absence of demand and credit expansion in healthy eurozone nations, fiscal tightening will continue to have the same impact that it has had up to now: to prolong and intensify the downturn.

Furthermore, not only does ‘more austerity’ inadequately deal with the root causes of the crisis, it is also aggravating our woes and is thus ultimately self-defeating. The Keynesian “Paradox of Thrift” is relevant here. To reduce the size of a budget deficit, a government must increase the size of tax receipts relative to its spending. Governments’ have focused their energies on fashioning large reductions in government spending as opposed to playing around with tax receipts. Public sector layoffs and pay freezes, cuts to departmental budgets and welfare bills are thus the name of the day. However, such coordinated, fierce austerity across the Eurozone is hampering growth and recovery, reducing tax revenues by more than the cuts in spending. Thus, paradoxically, the current austerity measures are ultimately making it harder for governments to repay those dreaded debts .

Eurozone countries are facing an even harder time of it than the UK as, for these countries, there is no exchange rate mechanism through which austerity and low domestic demand can boost exports to their main trading partners. Further, as implied above, credit and demand expansion among creditor nations has not been sufficiently boosted to provide any countervailing force to the cuts made in the peripheral countries.

ECB to the rescue?

In short, the fiscal policy of eurozone countries is a disaster zone: off target and self-defeating. What of monetary policy, that concerned with interest rates and money supply? The ECB has raised its game in the last few weeks but, by only offering credit to commercial banks, has not done enough to pull Europe back from the brink. Basic interest rates have been lowered to 1% and unlimited cash offered to commercial banks for up to three years. These actions will help to alleviate short term liquidity problems in the banking system but will not have any noticeable impact on the real economy or the debt crisis. Banks are adding this additional cheap funding to their capital buffers, compensating for the losses they face on their holdings of government bonds and household mortgages. Therefore, very little of this additional cheap capital is being devoted to easing the funding pressures on households, firms and their governments.

The hope was that, despite only offering credit to commercial banks, these banks would in turn buy the bonds of European governments, thereby easing the sovereign funding crisis. This has failed to occur as commercial banks are unwilling to purchase further government debt. The European Banking Authority recently announced that European banks still need to raise €115billion in additional capital to offset the falling value of government bonds they currently hold. Unsurprisingly, it is the Spanish, Greek and Italian banks with the biggest capital shortfalls. Thus, the banks in the most financially fragile countries are likely to go to their governments for assistance rather than with fresh funds. The ECB’s current actions are thus unlikely to do much to ease the debt crisis: banks are still turning to governments to bail them out, rather than the banks bailing out the governments as was hoped.

Sideshow Summit

The last Europe wide effort to produce a grand plan was, sadly, another grand waste of time. It was attention grabbing for the wrong reasons, bringing the continent no closer to a workable resolution. The fallout between the UK and its European peers may have some unpalatable consequences for us but is really a minor pothole in the road to Eurozone recovery. David Cameron’s actions did nothing positive to protect the City, it will now be harder for EU rules to be negotiated in our favour, and served to marginalise us within the European Union.

However, Mr Cameron’s mistakes are a mere sideshow. Of much greater importance was the failure of European leaders to acknowledge the arguments above that imply the need for reform that is balanced across creditor and debtor nations. Rather tougher controls on budget deficits, written into individual country constitutions, were focused on, with no countervailing measures to boost demand and credit availability at the eurozone core. It was agreed there is to be no fiscal union, only greater fiscal discipline. Therefore, Europe remains decidedly doomed. This summit got leaders no nearer to a credible cure to the continent’s troubles.

A New Year’s Resolution?

A tourniquet must be quickly applied, and life support machine turned on, to prevent the death of the Euro. Leaders must immediately acknowledge that further harsh austerity is wrongly targeted and self-defeating. The focus must be on growth and reducing unemployment. Public sector layoffs must be put on hold and tightening strategies rebalanced to put more weight on tax rises. Effort should be focused on designing a stabilisation strategy that expands import demand and credit supply among those eurozone countries that can afford it, i.e. Germany and the Netherlands.

More fundamentally, the failure of the neoliberal underpinnings to the Euro must be acknowledged. The existence of pervasive market imperfections implies the need to transform the design of eurozone institutions, promote greater fiscal integration and change the role and mandate of the ECB. A single currency eliminates a number of stabilisation mechanisms for individual economies, creating the need for much larger wage and price movements to prevent recessions, especially given that labour and capital are far from perfectly mobile (see my previous post). In this imperfect world, fiscal union is the essential counterpart to a monetary union. Fiscal transfers can then provide a counter-cyclical mechanism to support regional economies in tough times. This is what occurs in the United States, with Virginia playing the role of Greece.

Further, the ECB’s role and mandate must be reviewed. The ECB is not simply independent of European governments, as the Bank of England is to our own, but is ‘detached’. There is full separation of central bank and government finances, with the ECB legally forbidden from buying large amounts of government debt. This again reflects the euro’s neoliberal birthright, subordinating fiscal policy and the role of the state to the market. The neoliberal school of thought sees the sole role of central banks as inflation control. In the future the ECB must be mandated to target wider aggregates than just inflation, unemployment a key indicator. Further, the full detachment of the ECB from the governments it is supposed to serve must end. One potential institutional solution is given by Thomas Palley, who suggests the creation of a European Finance Authority that issues collective Eurozone debt on behalf of member governments which the ECB could then buy.

However, it must be noted that closer European fiscal integration requires the mandate of European citizens. In the short term, the advantages of installing technocrats and making executive decisions outweigh the cost of temporary infringement of democratic rights. However, these rights must not be continually subordinated, especially when it comes to thinking about the future of Europe more generally. It is far from clear that the necessary support for a more integrated Europe is there. Populist parties are increasingly sceptical of the Europe project and extremist politics appears to be making a comeback in a number of nations.

I remain sceptical that there is sufficient support for the extent of fiscal integration required to sustain the Euro. In my opinion, a common European identity is insufficiently forthcoming to motivate popular support for a United States of Europe, especially given the build up of anti-Europe and anti-Germany sentiment currently occurring. The unbalanced prescription of austerity and the stark asymmetries in adjustment pain across the continent is fuelling resentment and riots. Without adjustment by creditor nations who have benefited enormously from Euro membership, unemployment will continue to rise and times toughen in peripheral countries. Without a fiscal union to accompany the monetary union, wage falls and large variation in growth will continue to be the norm. This is a far from ideal backdrop to popular debates on the future of Europe.

In conclusion, we end 2011 with no end in sight to the eurozone debt crisis. Proposed solutions will continue to be off target and inadequate so long as fiscal mismanagement is stressed as the root cause of our woes. Although the consequences of a eurozone break-up will surely be enormously damaging, so too is the continued, futile application of austerity. Especially given that, if leaders continue in 2012 as they have done up to now, a disorderly disintegration looks inevitable. Happy New Year!

10 responses to “To Be or Not To Be?

  1. Great post Abi, I think your economic analysis of our unbalanced currency union is spot-on. However it seems to me that the eurozone crisis is the same as the ‘debt ceiling debacle’ – fundamentally a political crisis in which actors use a looming economic crisis as an opportunity to engage in brinksmanship so as to get their way.

    Just a few quibbles: “keyensian”, “David Cameron’s actions did nothing positive to protect the City, it will now be harder for EU rules to be negotiated in our favour, and yet served to marginalise us within the European Union.” (the second clause would be better in parantheses) “A single currency PLACES ELIMINATES a number of stabilisation mechanisms” “Without adjustment by creditor nations who HAS benefited enormously”

  2. Hi Abi! Insightful post as always, especially the part on the apparently minor role played by (and predictive power of) fiscal deficits as a cause of certain countries’ failure, as opposed to differences in historic trade imbalances which have more predictive power, but seem to be underrecognized.
    I did however wonder at one point:
    “However, such coordinated, fierce austerity across the Eurozone is hampering growth and recovery, reducing tax revenues by more than the cuts in spending.”
    Is there already any hard evidence that the crowding-out (or is it disincentive?) effect will be so large that the auterity measures will actually do more harm than good to the budget deficits? Just wondering.
    Cheers, and happy New Year to you too (non-ironically this time)!

  3. Interesting, and I definitely agree with your/Wolf’s point that fiscal deficits aren’t really the issue. But I’m not sure I’d be so quick to assume banks borrowing at 1% from the ECB won’t turn around and give that money to sovereigns (at least for the short term rollovers that you mention up front). The spreads are just too wide, it will be irresistible. The bigger problem with the ECB move is not that it won’t work (in the sense of staving off sovereign default, at least for a little while), but rather that it entrenches and props up a dysfunctional and inefficient financial system. Europe has now hit the ridiculous point where it accepts (non-democratic) creative destruction for national governments (see Greece, Italy), but not for its banks. Because even in this economy, if you can’t make money when you can borrow unlimited funds at 1%, you really shouldn’t be in the financial industry…

  4. Thanks for the typo spotting! Frantic typing in Nero’s, combined with my general poor grasp of grammar, didn’t make for a polished post. All changed now.

    I tend to agree with you that this is at heart a political crisis. However, could you be a bit more specific when you say ‘actors’ and ‘get your own way’?

    In the debt ceiling debacle, it was pretty clear who was up against who and the motivations and arguments (largely ideological) behind the different camps positions. It was also clear what the direct target of reform was: the debt ceiling. All of this is much less obvious in the eurozone crisis. The scene is dominated by ‘Merkozy’, with the other 25 EU member states marginalised from the decision making process (and not making too much noise about this fact), with little challenge to the prescription of greater austerity or neoliberal paradigm. Further, the main target of policy of reform is ill defined. For these reasons, the eurozone crisis seems to me to be a much more complex beast. I’d be really interested to hear more of your thoughts as my insight into the politics of it all is woefully poor!

  5. Hey Ewout! I don’t think there’s any hard evidence (yet) showing that the Paradox of Thrift is empirically relevant for the current crisis so, urm, yes, may have just be blindly making an empirical claim without the relevant backing 🙂 BUT there are strong arguments to think that this is the case.

    I’m sceptical of the strength of the mechanisms through which austerity is supposed to stimulate private demand. It is argued that austerity should help reduce investor fear of default, lowering the interest rate on public and private debt, stimulating consumer and investment spending. ECB base rates have no where left to fall really and there is so much uncertainty regarding the economic climate, and concern over the harm of austerity measures themselves, that I can’t imagine this impact being large in practise as the risk premium must be massive. However, I guess we won’t ever know how successful austerity has been at preventing debt spirals in more countries as don’t observe the counterfactual and all…. Anyway, also, austerity measures appear to be targeted at/affecting groups with particularly high marginal propensities to consume (low income groups and the young) so we can expect the fall in demand being particularly large….Thus, it’s by no means clear that government spending will fall by more than tax revenues….I wrote a more detailed response to a similar comment on my first post in August which is a bit more formal and convincing!

    Finally, Happy New Year to you too! What do you mean non-ironically? Does this refer to the fan mail?!

  6. I totally agree with the last point that if you can’t make money borrowing at 1% then you shouldn’t be operating in the financial industry. However, permitting bank failure doesn’t follow from this if one’s goal is to minimise medium term economic pain and turmoil. The havoc prompted by Lehman’s collapse is evidence of this. The financial system is horrifically inefficient and dysfunctional but, unless accompanied by regulatory and institutional change, allowing big bank failures now will make matters worse. The past few years suggest that CURRENTLY the costs of creative destruction in the banking industry disproportionately fall on the vulnerable and low skilled (this isn’t a necessary relationship) and, as bank failure does not imply system reform, it is unlikely that efficiency will be born from the ashes. In my opinion, efforts to promote greater competition, ring fencing and tighter regulation of risk calculation must be operative for creative destruction to contribute to a healthier banking system and the economic outlook must be a little more calm and stable to prevent contagion to solvent firms and governments.

  7. I’m not particularly saying I *want* to see massive bank failures (well, I kind of would, though I do admit the downsides to this). But at some point we need to stop coddling the banks. While there’s obviously still a lot of uncertainty out there, it’s a different situation from early on in the crisis when there were genuine unforeseen surprises that snuck up on otherwise healthy financial institutions. Lehman collapsed 3+ years ago, Greece has been a mess for 2 years – if not now when? I guess I’d be a lot more comfortable with the “free money for banks” policy if it were presented as a temporary necessary evil to keep stability while we waited for the real policy solution to work (which seems to be the argument you’re making), rather than being presented *as* the solution, which is how it seems to be being sold. In any case, I agree there’s a rather urgent need to review the ECB role/mandate. If the ECB is going to actually step up and provide some sort of solution, rather than cheap loans to banks I’d prefer to see (in increasing order of preference) it just give money directly to sovereigns, temporarily accept a little higher inflation, or switch to price level targeting, or even NGDP targeting, as the Fed seems to be (maybe? hopefully?) inching towards (though I haven’t really thought through if/how the latter might work for the Eurozone…).

  8. Pingback: Budget and Trade Deficits 101: Two Sides of the Same Coin | Abi Adams

  9. Thanks, good comeback! I believe you’re perfectly right about the large risk premium offsetting most of the intended positive impact of the policy measures… In Draghi we (should) trust?

    And of course not! I was referring to your concluding sentence; wishing us a happy new year when obviously things won’t go too smoothly in many countries… Hence your irony (a bit like goldy or bronzy, I believe), whereas my wishes came straight from the heart.

    Hope the project with Richard, Ian and Martin went well last semester! I’ll probably hear from you this semester on a work-related basis… Take care!

  10. Pingback: Understanding Eurozone Imbalances II: Talking TARGET | Abi Adams

Leave a Reply