Eurozone Crisis - Lessons Learnt

Last week I attended a very interesting lecture at the LSE on the Eurozone crisis, given by Leszek Balcerowicz, a Polish economist who is former chairman of the National Bank of Poland and Deputy Prime Minister.

The following blog outlines his thoughts, but also includes useful links to articles to read. Using the crisis as a case study will hugely benefit A2 students as it encompasses many of the topics covered in the syllabus.

What has caused the Eurozone crisis?

• Excessive spending in the private and public sector due to the cheap availability of credit.
• Governments held an unequal fiscal stance due to a combination of taxes not being high enough and the expansion of the welfare state (increased welfare payments).

Consequences

This has ultimately led to a financial crisis and a breakdown of long run growth.

Two types of crises

1. A banking crisis which led to a fiscal crisis (Ireland, Spain, UK)
Expansionary monetary policy led to commercial banks’ lending a large amount of credit at low interest rates fuelling a private sector boom, particularly in the housing market. As the housing bubble burst, households and firms defaulted on their loans, causing banks to default themselves. This was because they failed to hold sufficient capital as a ratio to the loans they loaned. Government had no choice but to ‘bail them out’, through provided large loans or in some cases being a majority shareholder (nationalisation – e.g. Northern Rock, RBS). A global recession followed, causing mass unemployment. Households have been doubly squeezed; not only from a loss of income, but due to the rising costs of raw materials throughout the world, there has been above target inflation.

2. A fiscal crisis which led to a financial (banking) crisis. (Greece)
Systematic overspending by the government as they expanded the welfare state and politicians became more popularist promising more spending (the Santa Claus effect). In Greece this coincided with the adoption of the Euro. It’s well known that the Greek government accounts did not reflect the true size of the budget deficit. Otherwise they would not have met the Maastricht criteria of a low fiscal debt and as percentage of GDP. The fiscal crisis of the Greek government led to a banking crisis as the banks had bought the government’s debt, but as time has moved on, the Greek government haven’t been able to pay back their debts.

Escaping the Crisis (Policy Options)

There are six potential options that can be used in attempting to recover from the crisis:

1. Bailouts
2. Austerity measures (reducing the fiscal deficit)
3. Quantitative Easing (Monetary Policy)
4. Debt reduction/cancellation
5. Leave the single currency
6. Reform (Supply-side policies)
http://www.economist.com/blogs/freeexchange/2012/05/euro-crisis-0?fsrc=gn_ep

Bailouts

Balcerowicz believes there has been too much focus on bailouts as a policy option. For a start the IMF and its contributors cannot provide enough funds to completely bail the struggling governments out. It is only a short term solution and more importantly creates a moral hazard, weakening the incentive to reform, not to mention the additional cash can fuel inflation. In addition, there is a political limit to bailouts, as the Angela Merkel is finding in Germany with German taxpayers becoming increasingly frustrated with the amount of money being used to bail out the Greek government.

Austerity Measures

It’s been empirically proven that it is more effective to lower government spending than raise taxes. By lowering government spending governments can at least guarantee a reduction by a given amount, where as it is hard to gauge how effective a tax rise may be (Laffer curve analysis). However, even if a government cuts the deficit, the overall level of debt as a percentage of GDP is dependent on growth. Without growth the ability to repay the debt becomes increasingly difficult. More from the economist here

Quantitative Easing

As bank credit has all but dried up and base rates are zero-bound, Central Banks have adopted expansionary monetary policy by using quantitative easing. This involves Central Banks buying government bonds from private firms and commercial banks, with the aim of injecting much needed funds into the financial system, increasing lending and investment and thus boosting the economy. Unfortunately, there are limitations to this policy. The additional supply of money in the economy can also contribute to inflation. There is also as a case of asymmetric information, with the CB not knowing how much QE will be effective. Too much of an increase in the money supply will fuel further inflation within the economy. In reality banks have preferred to build up their balance sheets and have not lent as much as the CB may have wished. Having said that, evidence suggests that the UK economy has grown as result of QE being used.

Debt reduction/cancellation

Back in February, investors foregave 53.5 percent of their principal and exchange their remaining holdings for new Greek government bonds and notes from the European Financial Stability Facility. More here

Leave the Eurozone

Some economists and media commentators believe that Greece would not be in as much of a mess if they were not part of the European Monetary Union (EMU). By being part of the EMU, monetary policy is controlled by the European Central Bank (ECB) who set one base rate for all 17 member countries. One interest will not also be applicable to all the countries. They will be at different stages in the business cycle and will suffer from asymmetric shocks. This is illustrated when comparing the economies of Ireland and Spain to Germany, prior to the start of the financial crisis. Ireland and Spain were at a different stage of economic development to Germany and required a higher natural rate of interest in order to control their growing economy. Germany, as more established economy, required lower interest rates to encourage further investment and keep the value of the Euro low and thus keep exports competitive. However, the difference in business cycle isn’t as great as it might have been given the criteria that accession countries are required to meet, which aims to synchronise the economies prior to entry.

The inability of Greece to be able to devalue their currency is a major factor in there struggle for growth, as highlighted by Michael Portillo in a recent BBC documentary (available on iplayer). Leaving the Eurozone would be have major ramifications, not only for Greece, but for the other Eurozone countries and the global financial markets. The policy response to the euro crisis has four elements.

A summary of Ian Stewarts remarks on his ‘Monday Briefing’ blog, outlining the consequences of a country exiting the Eurozone:

• The precise effects of a country leaving the euro would depend on the circumstances, in particular the degree of preparedness of the euro area and the seceding country and the ability of policymakers to resist contagion.

• An exiting country would hope that, by devaluing its currency, defaulting on its external debt and, perhaps, stoking inflation, it could eventually boost growth. The key word is “eventually”.

• UBS last year estimated that the economic cost of secession for Greece could be in the range of 40-50% of GDP. The potentially huge costs involved provides perhaps the best reason for thinking a breakup will be resisted and, were one country to secede, European and global policymakers would make great efforts to limit the collateral damage.

• To limit bank runs and a mass exit of capital the authorities would probably close the banking system and impose capital and exchange controls.

• A currency law would be needed to specify the new currency as legal tender and to convert existing euro contracts and financial instruments into the new currency. Contracts written in the law of seceding countries would be more likely to be switched from euros to the new currency than contracts written in international law. Legal battles around contracts written in euros would keep lawyers busy for years.

• The newly introduced currency would probably devalue sharply. Citibank recently estimated that a Greek New Drachma would devalue by 50-70% against the euro.

• Big shifts in currencies would mean large and arbitrary shifts in wealth. Foreigners would see sharp declines in the value of their holdings in the seceding country. And holders of euro denominated liabilities in the seceding country would see a sharp rise in the burden of their debts. The likely result would be a wave of bank, corporate and household bankruptcies.

• Inflation would also surge on the back of a falling currency. This was seen in Argentina in the 1980s when a sovereign debt crisis and the introduction of a new currency – the austral – drove inflation above 200%.

• Such prospects make it difficult to ensure an orderly breakup of the single currency. Foreign holders of assets in a country which was thought likely to devalue would sell to avoid future losses. Domestic holders of euros would take cash out of the bank and either hide it or convert it into hard currencies to avoid forced conversion to the new, devalued currency.

• Corporates and individuals in a seceding county might well turn to US dollars or euros as an everyday parallel currency, much as happened during Zimbabwe’s hyper inflation five years ago.

• There appear to be few strong historical parallels for a euro break-up. Some supposed precedents, such as the fracturing of the Gold Standard or Argentina’s breaking of its dollar peg, involve the devaluation of an existing currency. This is a simpler and less traumatic process than exiting a currency union and introducing a new currency with all the legal, logistical and political challenges this involves.

If the move succeeds then the pressure on the other weaker economies inside the single currency area (Spain, Portugal) to do the same will be huge. 2 Excellent videos and a well written piece from the FT.

However, as Balcerowicz highlighted, countries are able to improve their international competitiveness without leaving the Eurozone/devaluing their currency. The ‘BELL’ countries of Bulgaria, Estonia, Latvia and Lithuania suffered deeper recessions following the collapse of Lehman Brothers, but have adjusted quickly in lowering unit labour costs and significantly lowering their current account deficit. Balcerowicz concluded that it isn’t fatal that Greece is unable to control its currency, it is a complication. Other policy options are available, such as supply-side reform. However politics can often get in the way of these reforms being implemented in full.

Supply-side reform (improve international competitiveness)

With the limitations and short term nature of the policies solutions outlined previously, Balcerowicz believes that there is only one viable option left (why should China/ IMF lend more money!?) and that is supply-side reform because growth can’t be created out of nothing. Policy suggestions include:

• Improve the flexibility of labour markets (e.g. increase retirement age, make it easier to higher and fire workers. This would lower the amount of youth unemployment that is currently common place in many European countries. More from the Economist here.
• Deregulation to increase competition and efficiency of firms, but also the right type of regulation to prevent similar crisis’ happening in the future.
• Improve productivity (lower unit labour costs)

Supply side reforms would not only see long term benefits, but Balcerowicz believes they would cause benefits in the short run too as bond yields would fall and confidence would return to the markets when such policies were announced.

However, policies can be subject to political bias, so I believe political parties need to become less populist. This poses the question of whether the EMU needs a tighter political union?David Cameron thinks so.

The Eurozone can be used as a very useful A2 case study for revision as it covers a number of key topics in the syllabus. These include:

• Globalisation
• Fiscal Policy
• Monetary Policy
• International Competitiveness
• Supply-side Policy
• Exchange Rates
• Balance of Payments
• Debt Cancellation (traditionally covered in the development economics part of the course)