March 19, 2012
“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  Plenty of challenges remain in the eurozone; PIMCO's El-Erian says Portugal is next . 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.
Posted by Menzie Chinn at March 19, 2012 09:35 PMdigg this | reddit
You are inverting the economic logic here. The fiscal crisis is not the outcome of a monetary union crisis (as it couldn't be, after all it doesn't happen in other equally dissimilar large monetary national unions around the world). The fiscal crisis is *revealed* as what it is, a fiscal crisis, once you give up *FOR REAL* your monetary powers and adopt rules instead of monetary discretion.
So much better then for Greece that it's being forced *by its own choices* to deal with its heritage of fiscal indiscipline. So much worse that the US has no real independent central bank to do the same to its Treasury, creating the conditions for a fiscal crisis to develop into a full-blown monetary crisis -- as it has happened many times before in other equally dissimilar large monetary unions.
Posted by: Badger at March 20, 2012 02:38 AM
The main problem wasn't fiscal profligacy (at least not in every eurozone nation), but the current account deficits, the euro (as you have shown with the sovereign debt spreads - the euro esentially made each country's debt risk free), and finally the contagion form the US that ruined confidence and started a typical credit stop to the peripheral economies (as explained by Reinhart and Rogoff).
Posted by: Vuk at March 20, 2012 03:41 AM
In other words, credible precommitment to no-intervention when a massive and systemic financial crisis strikes -- the libertarian prescription -- is not feasible.
Are you familiar with the phrase: "First do not harm."
How about: "The cure is worse than the disease."
"...we hope for the early recognition of the need for North-South transfers,"
Transfers of wealth from the productive to the unproductive.
"recapitalization of the banking system,"
Transfers of wealth from taxpaying citizens to tax revenue consuming wealthy bankers.
"and accelerated inflation..."
Transfers of wealth from those who hold currency to those who hold assets.
The "cure" impoverishes productive citizens through confiscaition for socialist redistribution.
Posted by: Ricardo at March 20, 2012 06:23 AM
"Time to breathe a sigh of relief, with resolution of the Greek bailout?"
What Greek bailout?
Posted by: Ricardo at March 20, 2012 06:27 AM
There is nothing surprising in knowing that banking crisis and currencies crisis are followed by long protracted loss of output and sluggish growth.The IMF sampling 140 years of such events found few exceptions to the rule and more consistency in its confirmation Japan and Thailand among others.It may be assumed the same is likely to occur in Europe with uneven patterns within the European zone.As several times written, when borrowing from F. Braudel "A civlisation is not one economy but several economies" The ambition of the European community is to maintain the existence of several civilisations and several economies all to gather and that is a must.
"The romance finishes when the finance starts",prosaically consigned in the European treaty a country may take a leave of absence at its own will,so far none did.
Protracted will be this crisis and long the social predicaments within or without the Eurozone.There is no such thing as an implicit guarantee, the Romans were prompt to say "verba volant scripta manent" "the words fly,the writing stay", unless a guaranty is written in a formal document the above charts are as mysterious than ever.The countries risks were as little respectable than now,in 1992 the total amount of money owed by governments were 100% for Greece,123% for italy.Note that when the USA current account was deteriorating the long term yields were driven down,note as well when the USA public debts (primary and secondary deficit) were increasing the US dollar was appreciating.Is it a pattern that foretell a third party guaranty?
More puzzling is a situation with an asymmetry in rewards and achievements.Rogue banks dealers have been sanctioned,when public servants have not and could for instance enjoy US academic recognition.For the others, a mute response from the European community and the preservation of their benefits.
Bloomberg "Italy Said to Pay Morgan Stanley $3.4 Billion to Exit Derivative"
no cause and causation,but a possible correlation.
Bloomberg Bini Smaghi is going to teach at Harvard
Posted by: ppcm at March 20, 2012 07:38 AM
I recently spent a lot of money removing and replacing our lake cottage with a nice, maintenance-free home [because I really don't want to have to work on it].
Of course, I don't like the debt so much so I thought I'd see if I could get my neighbors to the north to chip in on the payments since they have been living in homes that they have paid off quite awhile ago. Also, I plan to check with the township to see if I can get some of the property tax burden shifted to those homeowners since they don't have to worry about debt service because they have been pretty frugal and are willing to live in those older places and don't mind working on them all of the time.
Posted by: Bruce Hall at March 20, 2012 10:10 AM
Well reasoned for the sovereign part. But you call for bank recapitalization blithely. but its way more than sovereigns. if it was only that your capital transfer would mostly take care of them
In my view the total bank losses are likely say three times any likely sovereign writedown
you and the authorities will have to treat this to come up with a solution that the markets wont blow a razzberry at
Posted by: AWH at March 20, 2012 10:58 AM
"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."
Anything to back up this assertion? I think it more likely that the rates converged, because the monetary union it remove the chance for any member country to have its central bank print away its deficit. That left hard default on sovereign debt as the only way out, which lenders regarded as highly unlikely. Recently, they have been disabused of their optimism, resulting in the reappearance of the interest spreads. I doubt that lenders ever thought that Germans would pay the Greek's debt for them just to avoid "contagion." And a negative effect on the euro would be just what the doctor ordered. Instead, the imbeciles are casting about for Chinese loans, which would put their economies even deeper in recession. Haven't they had enough of the effect of an overvalued currency from the combination of the Ben's QE and China's currency peg, now they want to invite more official purchases?
Posted by: don at March 20, 2012 02:47 PM