Thursday, February 11, 2010

The crisis facing Euroland

The Great Recession has exposed some of the fundamental limitations of a single currency area, as in Euroland, without the complementary institutional framework and closer economic and political integration.

The sub-prime crisis and the recession has ravaged the financial markets and the economies across Europe, with Portugal, Ireland, Italy, Greece and Spain (PIIGS) being the worst affected. The economies have contracted, unemployment has grown, and their public debts have exploded. Adding to the woes, the Euro appreaciated against the dollar, thereby affecting the competitiveness of European exports. Counter-cyclical fiscal expansion, entailing increase in public debt, to stimulate aggregate demand is the need of the hour.

But the Stability Pact that underpins the European Monetary Union (EMU) decrees that for each member, the annual budget deficit should be no higher than 3% of GDP and the national debt lower than 60% of GDP. The rigidity of the Pact constrains member governements from indulging in any meaningful fiscal expansion. And there is no federal super government at Brussels with the power to help members with fiscal assistance during such crisis. Further, in the absence of labor market integration, unemployed workers do not have the flexibility to migrate in search of jobs.

Paul Krugman highlights the fundamental problem with the Euroland, by comparing the plight of Spain to states in the US,

"Spain is an object lesson in the problems of having monetary union without fiscal and labor market integration. First, there was a huge boom in Spain, largely driven by a housing bubble — and financed by capital outflows from Germany. This boom pulled up Spanish wages. Then the bubble burst, leaving Spanish labor overpriced relative to Germany and France, and precipitating a surge in unemployment. It also led to large Spanish budget deficits, mainly because of collapsing revenue but also due to efforts to limit the rise in unemployment.



If Spain had its own currency, this would be a good time to devalue; but it doesn’t. On the other hand, if Spain were like Florida, its problems wouldn’t be as severe. The budget deficit wouldn’t be as large, because social insurance payments would be coming from Brussels, just as Social Security and Medicare come from Washington. And there would be a safety valve for unemployment, as many workers would migrate to regions with better prospects. (Wages wouldn’t have gone up as much in the first place, because of in-migration)."


Krugman's argument is that more than fiscal irresponsibility, the structural limitations of the Eurozone treaty have been responsible for both creating and amplifying the problems faced by these economies. As he illustrates graphically with the case of Spain, the property bubble in countries like Spain attracted massive inflows of capital from outside (especially from Germany) which had the effect of raising demand for goods and services and stoking off inflation. Once the bubble burst, these countries were left with reduced domestic demand and an economy rendered uncompetitive within the euro area due to the rise in its prices and labor costs. He writes,

"If Spain had had its own currency, that currency might have appreciated during the real estate boom, then depreciated when the boom was over. Since it didn’t and doesn’t, however, Spain now seems doomed to suffer years of grinding deflation and high unemployment."


Even the monetary union is incomplete. Unlike other central banks, the European Central Bank (ECB) cannot indulge in open market operations and buy government bonds or offer direct support to troubled banks among member countries. For example, cannot rely on the Central Bank to indulge in printing money.

However, during the recent credit crisis, the ECB did bolster the European banking system by vastly expanding the volume of lending to banks. It has also been aiding debt ravaged members like Greece by accepting Greek bonds as collateral that banks in Greece can use to borrow money.

The Times draws attention to the anomaly of divergence between fiscal and political policies. Even as the monetary policy is centralized, the individual governments have their separate, widely varying social and fiscal policies. Many commentators have for long questioned the sustainability of monetary union without political union, and the present crisis has severely exposed the same.

The massive debt burden built up by the European economies over the past decade has now become another millstone around their neck and another example of the contradictions in the monetary union. The debt spreads of members with the largest public debt have widened dramatically to record levels as the cost of insuring against sovereign defaults by them increased.

The Greek government is facing the problem of persuading investors to buy 53 billion euros of its government debt this year. If it cannot succeed, it has to be bailed out by its EU brethren or IMF or default on its sovereign debt. But the European charter includes a no-bailout clause. Even if this clause were to be overridden, much of the massive financial burden would have to be borne by Germany, something which is sure to rouse strong resentment and opposition there.

Any effort at political union cannot succeed addressing the issue of Europe's generous welfare state. Under the present benefits regime, the richer members will end up transferring huge amount of resources to the poorer ones to maintain the generous welfare benefits flowing. And this may not find popular support in the richer nations.

Update 1
The problems facing some of its economies and the reluctance of members with deeper pockets to bail them out is now increasing the pressure on Euro. The euro, which reigned at around $1.45 and 133 yen at the start of the year has sagged sharply against the dollar and the yen as worries about a potential debt default by Greece began to surface, and is now at only $1.37 and 122.5 yen.

The problems go beyond existing Euro land members and includes those like Latvia who have been pursuing fiscally contractionary policies to attain the Stability Pact requirements and who have been badly affected by the recession. Latvia’s economy contracted an extraordinary 18 percent in 2009, the sharpest contraction in the world. This follows what was widely regarded as an unsustainable burst of growth just before the global crisis.

Update 2
Thomas Palley has an excellent article examining the theoretical flaws in the design of the Currency Union. He argues that all the three fundamental assumptions behings its neo-liberal monetary theory based institutional design - that fiscal policy is ineffective; inflation is caused exclusively by money supply growth; and the real economy quickly and automatically returns to full employment in response to negative shocks - have been proved wrong by the ongoing crisis.

The European monetary union established a central bank that, unlike its US and UK counterparts, is prohibited from providing financial assistance to member country governments. Member economies no longer have their own exchange rate or interest rate to restore full employment and financial balance. His prescription

"European Central Bank should establish annual country loan quotas set according to each country’s economic size and output gap, making them a form of automatic stabiliser. This would create a mechanism for countries to monetise part of their budget deficits. In the current environment it would provide a flow of low cost deficit financing that would facilitate periphery country re-balancing, while also providing an expansionary impulse in Europe’s core economies. Additionally, the ECB should establish emergency stand-by country loan facilities that would be governed by pre-determined policy conditionality. In effect, the ECB would act as an analogue International Monetary Fund for euro member countries... to counter potential inflationary consequences, the ECB could be given discretion regarding distribution of seignorage dividends resulting from issue of currency and bank reserves."


Update 3
More on how countries like Greece manipulated the true exten of their deficits with derivative instruments with the help of banks like Goldman Sachs.



Update 4
Paul Krugman points to the divergence in inflation across the core and periphery nations of EU and feels that this should converge substantially for restoring macroeconomic balance withoin Euro zone. But given the low inflation target of the Stability Pact, the periphery economies will have to experience considerable deflation before they catch up with the core economies. He therefore proposes a higher inflaiton target for Eurozone.



Update 5
Barry Eichengreen writes about the need for emergency financing mechanism for Euroland countries facing financial crisis and requiring bailouts. And for this, as Paul Krugman points out, greater political integration is a necessity.

Update 6 (3/3/2010)
Greece's ballooning sovereign bond and CDS spreads



Update 7 (7/3/2020)
Augusto de la Torre, Eduardo Levy-Yeyati, and Sergio Schmukler compares the Euroland fiscal crisis to the nineties crisis in Argentina and argues that what these countries need is a "good old bailout" – conditional on "getting the house in order".

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