Practice Exam Questions

Essay Plan: Is the Euro the main cause of the crisis in Greece and Italy?

Level:
A-Level, IB
Board:
AQA, Edexcel, OCR, IB, Eduqas, WJEC

Last updated 21 Mar 2021

Early years of success for the Euro Zone have given way to persistent economic, financial and political stress in countries including Greece, Italy, Spain and Portugal. How much can we attribute their difficulties to structural flaws in the design of the Euro?

Contextual awareness

  • Deep slump in real output, employment and living standards in Greece and Italy.
  • Persistently high unemployment bringing inevitable human costs / negative externalities
  • Continued membership of the Euro in question, fragility of democracy, loss of trust in governing institutions, rise of radical parties

Structural flaws in the Euro

Starting point is the work on optimal currency areas by Robert Mundell. An OCA requires:

  • 1. Real economic convergence i.e. similar trend growth rates, trade patterns, productivity levels, structure of output
  • 2. High levels of geographical mobility of labour / other measures of labour market flexibility
  • 3. Symmetrical responses to external shocks such as changing commodity prices
  • 4. Willingness to use fiscal transfers / active regional policies to helper poorer nations and regions

The Euro is flawed in the most basic sense - it is not an optimal currency area. There are 19 heterogeneous countries - contrast the economies of the Southern Med with nations in north-west Europe. So the risk factor of having a single currency has been amplified - this became readily apparent in the wake of the 2007-09 GFC and subsequent recession.

Not helped by policy inertia / handling of monetary policy by the ECB (late to cut interest rates after 2008 and well behind the curve with unconventional monetary policy such as QE only starting in 2015).

Structural trade surpluses in Germany/Netherlands helping to kept Euro relatively strong - whereas Greece / Spain need a sizeable depreciation of the exchange rate

Nominal interest rates are low in the Euro Area but Greece has suffered deflation so real interest rates remain positive and much higher than is needed to lift the Greek economy out of a state of semi-permanent recession. (The liquidity trap is applicable here).

Imposed fiscal austerity / unwillingness to consider significant debt relief has intensified the slump in output, jobs and real consumption. Greece effectively forced into an internal devaluation in order to correct their current account deficit; deep cuts in government spending and higher taxes (fiscal austerity) to meet the primary budget surplus target applied as part of the most recent ECB/EU bail-out.

Austerity has helped to close the external deficit but at what cost? Suggestions of zero or negative trend growth rates for Greece/Italy. Little realistic prospect of Greece being able to repay her debt, the IMF argues that significant debt relief will be essential.

Strong argument for saying that Club Med countries should not have been allowed into the Euro in 1999-2002. Monetary convergence criteria in the Maastricht Treaty were fudged.

But......

Design flaws of the Euro + policy inertia should not hide supply-side weaknesses in many of the Euro Zone’s debt-ridden and recession-hit countries.

  • Low capital investment
  • Relatively poor productivity / a long tail of under-performing businesses
  • Imbalanced economies (e.g. heavy reliance on tourism, finance and construction)
  • Poor price and non-price competitiveness (see latest rankings from the World Economic Forum)
  • Endemic corruption / low tax base and high rates of tax avoidance/evasion
  • Low export complexity and capacity
  • Failure to implement structural economic reforms before the global financial crisis hit
  • Structural failings in domestic banking systems e.g. high non-performing loans in Italy pre-date the crisis, excessive speculative lending to the Spanish and Greek property market. Spain received a Euro 125n bail out of her banking system in 2012.

Interesting counter-factual - how would Greece, Spain and Italy done if they had been left out of the first group of Euro Area countries? Would they now be better off moving to a two-tier Euro with one group of countries operating with a lower exchange rate in a bid to restore some price competitiveness?

Economic and social risks from leaving the Euro are huge - not least the spike in inflation that would result and the prospect of higher not lower interest rates and another slump in the housing markets of countries affected. Will the Euro Zone change sufficiently quickly to keep the struggling economies inside? In particular will there be a successful growth strategy and a successful debt-relief policy?

Key economists to use in the discussion:

  • Stiglitz – policy failings in ECB
  • Krugman – critique of austerity
  • Mundell – basics of optimal currency area design
  • Hayek – risks from bail-outs and ultra-loose monetary policy Koo – challenges of escaping from a balance sheet recession

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