“The Eurozone in Crisis: Origins and Prospects”

Time to breathe a sigh of relief, with resolution of the Greek bailout? Not so fast. Greece is likely to need re-adjustments to its plan [0] Plenty of challenges remain in the eurozone; PIMCO's El-Erian says Portugal is next [1]. In fact, as Jeffry Frieden and I argue, the resolution of the problems facing eurozone policymakers is likely to be contentious and prolonged. From an article forthcoming in the Spring issue of the La Follette Policy Report, by me and Jeffry Frieden (since the article is not yet published, the working paper version is here):
The financial crisis gripping the eurozone countries seems incredibly complex, and although the reasons why their finances have come to grief are quite simple, the solution will not be easy. For the eurozone to resolve its crisis requires the political will to undertake painful measures, with serious distributional effects. As long as certain groups seek to avoid those costs, resolution of the crisis will be elusive.

The European financial crisis and the ensuing recession are of critical importance. The euro area is the world’s largest economy; its trajectory has a powerful impact on the fortunes of Asia and even the United States. This effect is even stronger at a time when the world economy is so fragile.

The eurozone crisis is the result of at least two key weaknesses in the original project of European monetary integration. First, the common currency and its monetary policy were applied to a set of economies that were very different one from the other. In the lingo of economists, the original group of 12 nations—Austria, Belgium, Finland, France, Germany, Greece, Ireland, Italy, Luxembourg, Netherlands, Portugal, and Spain—did not constitute an “optimal currency area.” (Greece joined in 2001 between the euro’s establishment and introduction.) The countries were subject to too diverse a set of economic shocks. They were not sufficiently integrated, and they lacked a fiscal union that could smooth out those shocks, compensating hard-hit economies with transfers from better-performing economies. Further, with the euro in place, the monetary policy of the new European Central Bank proved to be too loose for some countries and too tight for others.

The second weakness is that investors interpreted the creation of the union as an implicit guarantee of member countries’ government debt. It seemed clear that if a serious financial crisis erupted in one eurozone member country, the risks of contagion to the rest of the zone and of a negative effect on the euro would force other countries to bail out the member in crisis. Investors believed this interpretation even though no such formal guarantees were made. These implicit guarantees were problematic because they pushed interest rates lower, which, in turn, gave governments, businesses, and households incentive to borrow more than they would have had they properly understood the risks. In other words, risk was underpriced due to the perception of an implicit guarantee. The result was that Europe, particularly Southern Europe, which experienced unnaturally low interest rates, borrowed far more than was sensible, and is now suffering from the resulting debt binge. And in certain countries, this problem of over-borrowing is compounded by a long-term problem of public spending on pensions and health care that has exceeded what the rate of economic growth made possible.

The impact of the implicit guarantees asset prices is clear when one looks at sovereign debt spreads over the (risk-free) German rate, depicted in Figure 1 from the paper.

Figure 1: European Sovereign Interest Rates, 10-Year Maturity. Source: ECB via Chinn and Frieden (2012).

Lest we Americans feel too smug, the apparent disappearance of risk, as manifested in the shrinkage of spreads against German bunds, is similar to the apparent disappearance of risk for US asset-backed securities during the mid-2000's. After all,

[t]he new financial managers assured policymakers that their modern,
computer-assisted methods had relegated risk to the dustbin of history, who in turn reassured themselves that all that was necessary was for the wizards of finance to take good care of themselves and their financial institutions, and that this would in turn take good care of the rest of the country. These fables have been put to the test, and by now put to rest. (Chinn and Frieden, Lost Decades, p. 220)

(Libertarian prescriptions to remove the onerous burdens of Dodd-Frank ignore the recent experience with financial markets self-regulation.)

The implementation of the eurozone was problematic insofar as it was subject to asymmetric shocks. This was well understood, but proponents argued that a combination of currency union and a program of economic liberalization could mitigate this shortcoming. Increased labor mobility was one key prerequisite, and certainly this increased in the wake of Economic and Monetary Union (EMU). However, it wasn’t anywhere near sufficient; as a consequence, the other great deficiency -- the absence of a fiscal union -- came to the fore.

We highlight another point: not all of the debt-burdened countries were fiscally profligate:

When the global recession of 2008-09 struck, most eurozone governments went further into deficit, as social welfare and unemployment benefit payments increased and tax revenues collapsed. In some cases, the problem, which the recession aggravated, was a structural deficit associated with overgenerous social spending and insufficient tax collection. This scenario applies most profoundly to Greece. To a certain extent, it applies also to Italy, although a slow trend growth is driving the debt dynamics there. However, the characterization of excess public spending does not pertain to all the problem eurozone countries.

For instance, Ireland, in contrast, was a paragon of fiscal rectitude on paper. In the midst of a boom in financial and housing markets, the Irish government ran budget surpluses. With the financial crisis, the government implemented a complete bank deposit guarantee and subsequently bailed out major banks, resulting in massive increases in the government’s debt. Similarly, Spain was running a budget surplus —until the collapse of its housing market.
The phenomenon of hidden government liabilities suddenly showing up at the onset of a crisis is not new. In fact, the East Asian crises of the 1990s brought to the fore the concept of “contingent liabilities.” A government can look like it’s in an enviable fiscal situation, when in fact the government is on the hook for massive debts, because it cannot allow a banking system to become insolvent.

This graph from a presentation by James Bullard highlights the fact that contingent liabilities were of importance for Ireland and Spain.

Figure 2: Government debt and deficits as a share of GDP. Source: Bullard, “Death of a Theory” (2012).

In other words, credible precommitment to no-intervention when a massive and systemic financial crisis strikes -- the libertarian prescription -- is not feasible. That means running small budget deficits is not a sufficient condition for avoiding a debt crisis; effective and smart financial regulation is also essential.

What’s our prognosis for the eurozone? From the article:

...While we hope for the early recognition of the need for North-South transfers, recapitalization of the banking system, and accelerated inflation, our observation of the political process makes us pessimistic. Thus far, electorates in the creditor countries do not seem to be convinced that transfers are necessary. As long as this characterization holds true, progress toward a true solution will be elusive.

Much more likely will be a process of lurching from one crisis to temporary palliative to the next crisis. In that scenario, recovery will be years off.