Sunday, May 6, 2012

What ails Eurozone?

This from Ezra Klein is instructive, 
After it joined the euro area in 2001, Greece went from paying about 7 percent interest on a 10-year bond to a bit more than 3 percent because investors assumed that its debt was backed by Germany and the European Central Bank. This encouraged profligacy in Athens.
When the European economic and monetary union (EMU) became operational from 1 January 1999, all the peripheral eurozone economies experienced windfall gains from the sharp reduction in bond yields and resultant cost of borrowing. Over a four year-period, beginning 1995, the bond yields more than halved and converged around 4% across most of the eurozone economies (see graphics on France, Spain, Portugal, Greece, Italy, Ireland, Belgium).

Governments and, especially, corporates piled up debt, especially by way of borrowings from banks in the core area economies, as they splurged on this sudden access to cheaper capital, triggering off resource mis-allocation and asset bubbles. The boom also led to rise in wages and input prices, with the resultant decline in relative economic competitiveness. Therefore, deleveraging and restoration of external competitiveness is critical to a sustainable resolution of Eurozone's problems.

Update 1 (7/5/2012)

Paul  Krugman has this excellent analysis of how Germany managed its successful reforms last decade. As he writes, Germany benefited hugely from an export boom, driven by a combination of inflation in its periphery and rise in trade competitiveness vis-a-vis its Eruozone partners.

Update 2 (10/5/2012)

Spain is a classic example of a country brought to its knees by reckless private external borrowing. Even today, the government debt as a percentage of the total economic output for Spain is a relatively low ratio of 70 percent, compared with 165 percent for Greece and 120 percent for Italy. But, according to a recent report by McKinsey on global debt, Spain’s nonfinancial private sector debt is 134 percent of gross domestic product, higher than any major economy in the world with the exception of Ireland, where the figures are skewed by the outsize presence of foreign multinationals. Factoring in bank, household and government obligations, the total figure rises to 363 percent of GDP, trailing only Japan at 512 percent and Britain at 507 percent.

Corporates borrowed heavily to invest and to diversify by buying large equity stakes in companies in Spain and elsewhere. Massive public investments in infrastructure helped boost the demand for private supply. The Times writes about a "relentless private sector downsizing in Spain — by individuals weighed down by mortgages and corporations tethered to their boom-time loans — that threatens to make the Spanish economic collapse semipermanent as opposed to cyclical".

Update 3 (23/6/2012)

Jay Shambaugh argues that Euro area is bedevilled by three crises - of banking, sovereign debt, and growth. He writes,
The euro area faces three interlocking crises that together challenge the viability of the currency union. There is a banking crisis – where banks are undercapitalized and have faced liquidity problems. There is a sovereign debt crisis – where a number of countries have faced rising bond yields and challenges funding themselves. Lastly, there is a growth crisis – with both a low overall level of growth in the euro area and an unequal distribution across countries. Crucially, these crises connect to one another. Bailouts of banks have contributed to the sovereign debt problems, but banks are also at risk due to their holdings of sovereign bonds that may face default. Weak growth contributes to the potential insolvency of the sovereigns, but also, the austerity inspired by the debt crisis is constraining growth. Finally, a weakened banking sector holds back growth while a weak economy undermines the banks.

Update 4 (9/7/2012)

Nice article in the Times chronicles how in Spain the regional governments, the regional cajas, and property developers formed a system of trading favors during the boom years. Now that the party is over, the central government is forced to pick up the cost of the revlery.

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