Mess in eurozone

Print edition : January 13, 2012

A PROTEST AGAINST pension cuts and new taxes in Athens. The deficit countries are being asked to generate export surpluses through wage compression and suppression of consumption. The surplus countries, especially Germany, are equally intent on preserving their own model of generating export surpluses by suppressing domestic consumption. - LOUISA GOULIAMAKI/AFP

The European lemmings are now leading the pack of the rest of us into the sea of the next big global economic crisis.

IS it finally the endgame for the euro? Certainly the crisis has unfolded more rapidly in that economic union than most observers anticipated. Many people in positions of responsibility are already voicing what would have been thought unthinkable even a few months ago, talking about the real possibility of a break-up of the eurozone or at the very least the exit of one or more members.

Why and how has it reached this point so quickly? This reflects two major failings: first in the general understanding of the underpinnings of the economic problems in the eurozone; and second, in the insufficient and often misplaced attempts to deal with it by eurozone policymakers and indeed also by the International Monetary Fund.

First, consider the nature of the problem. This is often presented as a problem of excessive public debt and government profligacy. But nothing could be further from the truth. It is true that in the case of Greece, public deficits turned out to be much larger than they were declared to be in the previous decade (as the then government was assisted by the financier Goldman Sachs in concealing the true extent of the gap). In most of the eurozone, as in the developed world generally, it was the financial crisis of 2008 that led to the emergence of very large government deficits.

The crisis meant that automatic stabilisers (which are more advanced in rich countries) and fiscal stimulus packages came into play. Public bailouts accounted for a large part of the deficit, as private bad debts were taken into public hands. The median public debt to gross domestic product (GDP) ratio in developed countries almost doubled (to more than 60 per cent of GDP) between 2007 and 2010. This process was particularly evident in Spain and Ireland, both of which had followed extremely prudent fiscal policies in the run-up to the crisis, and even ran government surpluses. The subsequent shift to large deficits was because the governments took up the burden of dealing with the crisis, which was almost entirely a reflection of private sector imbalances.

Even now, the behaviour of bond markets appears to be inexplicable in relation to the so-called fundamentals of public debts and deficits. For example, as a percentage of GDP Spain's government debt is smaller than that of Germany. Yet Germany is seen as a safe bet, with German bonds trading at very low yields, while Spain has a very high risk premium on its public debt. In general, the eurozone countries that are being punished by the bond markets and whose sovereign debts currently have very high interest rate spreads over Germany's are not really characterised by high fiscal deficit to GDP ratios or high public debt. Rather, they are countries with significant current account deficits.

This provides a clue as to the basic source of the crisis: the current account imbalances between eurozone countries, which have now become unsustainable, as private finance reacts by withholding capital flows. This happens to be expressed in the form of low prices and high yields on sovereign bonds, but the truth is that these peripheral countries are not in trouble because of fiscal imbalances but because capital inflows in the previous decade were associated with a rapid build-up of current account imbalances generated by the private sector. So, this is essentially a banking crisis brought about by private capital inflows that then led to divergences in real exchange rates and trade balances.

Developing countries (or emerging markets as they are now called) are familiar with this kind of crisis we have been there, done that and lost our T shirts many times over. The question is what allowed such imbalances in real exchange rates (which is the same as saying, different price levels in different eurozone countries) to persist despite the claims of the European Single Market, which was supposed to equalise goods and factor prices across the region. This failure of the Single Market to deliver is at least one of the deeper roots of the current crisis.

Since the European Union as a whole has a current account that is broadly in balance, it follows that the deficits and surpluses within the region are broadly equal. So the deficits of countries such as Greece, Italy, Spain and so on are counterbalanced by the surpluses of countries such as Germany, which has clearly been among the most significant beneficiaries of the process of economic integration by being able to run export surpluses that are often supported by capital flows to finance importing countries. Within Europe, Germany and other capital exporting countries have been doing what China has been doing vis-a-vis the United States: providing capital flows that enable continued expansion of its own exports.


This reality is very far from the way matters are generally presented in the European press, with austere Germans supposedly having to work hard to pay for the lazy Greeks lying in the sun drinking ouzo after retiring at 45 years. In fact, Greeks on average have longer working hours and lower pay than Germans, and since the bulk of them are self-employed or work in very small enterprises, many never really retire at all. The higher productivity levels in Germany are a reflection of the continued monopoly of intellectual property rights that prevent productivity-enhancing technologies from being spread to other countries. And the greater competitiveness of Germany results from the fact that the benefits of this productivity growth have not been passed on to workers.

The misreading of the nature of the crisis is then naturally reflected in the misguided and therefore continuously ineffectual attempts at solution. Much is made of the fact that European leaders keep meeting (with lesser or greater degrees of acrimony) and promising speedy resolution, yet things keep getting worse. Even the proposed moves towards fiscal union, necessary though they are, will at best correct the stock aspect of the problem, of dealing with what are now unsustainable debt situations. The flow correction of addressing the external imbalances within the eurozone is still unlikely to evolve within this framework.


A very major reason for this is the assumption that government austerity measures in the deficit countries can correct the situation. In the absence of any possibility of exchange rate devaluation for countries in the eurozone, these countries are being asked to undergo major internal devaluations in the form of falling wages and consumption, thereby severely contracting their economies. Everywhere the emphasis is on reduced spending rather than economic growth as the means out of the crisis. Even the much-vaunted new prudential regulations on finance the Basel III norms will do precious little to reduce the irresponsibility and moral hazards of big banks, but they will cause credit flows to small businesses to dry up even more, thus further reducing growth prospects.

Wrong diagnosis means that the wrong medicine is being prescribed. The countries in deficit are being asked to generate export surpluses through internal wage compression and suppression of domestic consumption. But where are they to export to? The surplus countries in the eurozone, especially Germany, are equally intent on preserving their own model of generating export surpluses by suppressing domestic consumption. This is a recipe for Europe-wide recession if not depression. The problem is compounded by the uncertain growth in the U.S. Other growing economies such as China, Brazil and India are simply not large enough in the aggregate to take up the slack and in any case are also adversely affected by the European slowdown.

All this would be bad news in itself, but everything is rendered more urgent by the behaviour of financial markets, which have accelerated the processes of decline and added to the confusion. The stated goals of fiscal union will take time, a complicated political procedure that cannot be simply pushed through despite the best will of individual leaders.

Meanwhile, a major drop in confidence and movement of capital out of any one country can, indeed will, precipitate a liquidity crisis so severe that some default will be inevitable. The consequences, as developing countries know so well, are contagion to other markets, bank failures, and credit crunch.

No doubt about it, the European lemmings are now leading the pack of the rest of us into the sea of the next big global economic crisis.

This article is closed for comments.
Please Email the Editor