Eurozone Crisis: Sources, Symptoms and Solutions

Martin Wolf gave a lecture at the EUI last week titled ‘Eurozone Crisis: Sources, Symptoms and Solutions’. His analysis is quite straight forward. The monetary union was a political project that has failed. But there can be no way back for Europe. They must put in place a banking-fiscal union if the shared currency is to survive. But this requires a level of political solidarity that does not exist. There will either be a default by a weaker member-state or Germany will leave the common currency. I will return to the latter point toward the end. The remainder of this post is a reflection on the discussion.

Here are some facts on the Eurozone that are generally under appreciated in the crisis. The Eurozone is effectively a closed trade area (not the mass open economy that underpins a lot of neo-institutionalist, new Keynesian oriented economic theories). The overall GDP of the Eurozone (17 countries) is €8.4 trillion. Only ten percent of this leaves the Eurozone, and mainly goes to other European countries. There is significant variation among countries (i.e. Ireland exports significantly more to non-Euro countries than the EMU average) but when combined the trading bloc is the second largest in the world (after the USA).

The Eurozone accounts for approximately 14.6 percent of global trade. It has a population of 317 million (the USA is 300 million). Collectively it has one of the best trade surpluses in the world. As a percent of GDP it exports 21.7 percent and imports 20.9 percent. Internally within the Eurozone, Germany accounts for 26.7 percent of GDP, France 21.1 percent, Italy 16 percent, Spain 11 percent and Ireland 1.8 percent. Like any large country it has rich and poor regions, industrial and agriculture production and divergent employment rates. But given that it is a closed trade area, made up of competing nation-states, trade for each region has become a zero-sum game. A gain for one country is a loss for another. The crisis of the Eurozone is one of an internal balance of payments.

The single biggest predictor of which countries got into trouble when the financial crisis exploded in 2008 was the extent of capital imports. Countries who imported large amounts of capital (in the Eurozone – Ireland, Spain, Portugal and Greece, alongside many Eastern and Central European countries) got burned when cross-border financial flows came to a sudden halt in 2008. This sudden stop was revitalised when the ECB started pumping billions into the European banking market. Simultaneously, some countries, such as Ireland, gave a blanket debt guarantee to all its major banks. These turned out to be insolvent and the Irish sovereign state went bankrupt (yet, much like in the USA and UK, most of the blame has been channelled toward the public sector).

The financial crisis (as history would show) quickly turned into a fiscal crisis, then a sovereign debt crisis. Many countries, such as Germany, manged to hide their bank problem. Long before Ireland guaranteed its bad bank debt, Germany had been bailing out many small regional-state run ‘Landesbanken’. Two thirds of toxic US assets (credit default swaps and the infamous subprime mortgages) were traded through Europe (mainly via the Cayman islands, UK and Ireland). German banks were up to their neck in the casino of global finance. This global financial relationship between the Euro and the USA was something that Martin Wolf never mentioned in his lecture. The Eurozone got caught up in the mess because its banks and financial institutions were just as reckless as their US counterparts. Most of these were UK, French and German institutions.

But Martin Wolf regularly reminds us of one crucial fact. The fiscal deficits and growing public debt in European member states are a consequence not a cause of the Eurozone crisis. Political leaders across Europe did not see the danger of a massive increase in financial-capital flows that underpinned the current account imbalances within the Eurozone. This imbalance is not a problem in a single country with weak regions (such as the Landen within Germany). These regions can expect financial support, fiscal transfers and labour mobility. These policies (and their social effect) are accepted by citizens as an act of solidarity. They are not accepted in the Eurozone because there is no European citizen (no matter how much scholars like Jurgen Habermas would wish there was). In the absence of these fiscal transfers, weaker regions such as Ireland, Spain and Italy must pursue the painful strategy of internal devaluation.

Martin Wolf then went on to make an interesting observation: whilst the bond yields in Spain are growing rapidly, the UK is experiencing its lowest bond yields on government debt for over 300 years. Why is it that a country with a lower fiscal deficit and debt-GDP ratio (Spain) is being priced out of the bond market whilst the UK is getting cheap money? Similar to the argument of Prof Paul de Grauwe, Wolf traces this to the Bank of England. The central bank in the UK will always ensure the UK pays its debts (i.e. it will print money if necessary). Spain cannot rely on the ECB to do this. In effect, it is a state issuing debt in a foreign currency. Hence, all countries of the Eurozone are easy targets for the speculators in finance markets because they have no influence over core macro-economic policies. This makes the Eurozone architecture the causal source of the problem for countries in crisis. Needless to say, this point was hotly disputed in the discussion.

But I agree with the general point that Eurozone countries were not politically or economically prepared to deal with the adjustment to a financial cum currency crisis. I would go further and trace this less to the absence of technical capacity to solve ‘market’ problems but to politics. When the crisis emerged, political leaders across Europe adopted national based strategies. Policymakers denied that Europe had been caught up in casino finance. This was considered a US problem. The leaders of France and Germany, consolidated their local power base by adopting a discourse of ‘it is somebody elses fault’. They successfully hid from their electorates the reality of what their reckless banks had been doing since the late 1990’s. German banks invested over €300bn in US toxic securities. This complete lack of trust and information (which can be traced to a total absence of European wide regulation) meant that it was impossible to adopt a coordinated political response to the banking crisis (even today, four years later).

Wolf then proposed two solutions to the crisis. Partial or complete breakup of the Eurozone or an extended period of painful adjustment. The latter is only possible if there is adjustment in the core of the Eurozone. Nobody mentioned what the latter entails. But as regular argued by the Left Party (Die Lienke) in Germany this requires four things: a greater share of national income going back to citizens in the form of higher wages, improving the low wage temp-economy, higher inflation, and a shift in macro-economic policy away from export driven growth to the domestic internal economy. All of this would have a positive knock-on effect in the rest of the Eurozone.

Of course, none of this resolves the political problem of who is going to pay for the debt in Europe. This is a question of distribution: who foots the bill? For David Levine, losses need to be allocated in a clear and credible way. Nobody wants to admit how much money they have lost. This is true. One only has to look at the losses incurred by Hypo-Real estate in Germany. This has cost over €150bn. A large amount of this can be traced to Depfa, a financial institution that moved to Dublin in 2007, to take advantage of Ireland’s lows tax, no regulation regime. I have no doubt that the case of Hypo-Real estate informs Angela Merkels position that Ireland should clean up its own ‘merda’. Banks are global in life but national in death.

Whilst Massimilano Marcellino brought up the social cost of the crisis (i.e. the level of unemployment) there was very little discussion on what alternatives are available to ‘structural reforms’. Most common sense economic analysis of the Eurozone crisis would accept that the employment problem will not be resolved by short-term policies aimed at flexibilising the labour market. Even Martin Wolf accepted that Margaret Thatcher’s reforms in the 1980’s only had a marginal effect fifteen years after they were introduced. Labour market reforms (on the supply side) only work when the economy is booming. This is a recognised social fact amongst political economists but it has yet to influence the policymakers of Europe. The ECB-German solution remains focused on removing market imperfections through structural reforms.

Exiting the Eurozone crisis clearly requires more than just austerity and structural reform. As pointed out by Pepper Culpepper, any serious reform (or adjustment in the core) requires overthrowing the policy compromise underpinning the dominant social coalitions in both the core and periphery over the past fifteen years. Whilst he never unpacked what this mean, it certainly includes the following. German employers and unions need to give up their industrial policy of wage restraint and export led growth. In Ireland, it probably requires government moving away from a low tax economy. In effect, we need a new politics of social solidarity. Pepper Culpepper proposed that this might come from European wide political parties selling a new social contract to constitute a new European identity. Martin Wolf was less sanguine, he concluded that “the monetary union is a political project that cannot work”.

So, back to my initial comments on the Eurozone as a regional bloc. Almost everyone accepts that a monetary union must be underpinned by some sort of political union. Most do not realise how big a collective action problem this is. Others think it will be resolved by stricter fiscal rules. The reality is that a political union requires a shared identity. This cannot come about through market integration or market liberalism. There has to be a social contract whereby European citizens are provided with a social incentive to transfer sovereignty from the nation-state to a federal parliament. Citizens in Ireland, Italy, Portugal, Greece and Spain would probably accept a European wide equivalent to the German ‘sozialmarktwirtschaft‘ . German citizens would not. This is probably why Martin Wolf thinks it is more likely for Germany than Greece to exit the Eurozone.


2 responses to “Eurozone Crisis: Sources, Symptoms and Solutions

  1. I think you’ll find that DePfa, subsidiary of Hypo Real Estate has made nothing like the claimned losses of €150 bn. I think this is used as a convenient smoke screen for Germany allowing them to place blame for losses on Ireland. Fact: DePfa was/is a ‘Public Sector’ bank, that is, it only dealt in government bonds. As no government, bar Greece has defaulted/restructured, DePfa cannot have made any losses or in worse case, losses are limited to any holding of Greek bonds. Any losses of €150 bn incurred by Hypo Real Estate are directly related to commercial property activities, and there subsequent writedowns, of Hypo Real Estate based in Germany.
    Good article, enjoyed it, good points on balance of payments and political unity.

    • I don’t think I claim DePfa lost €150bn. I state Germany has spent this amount, overall, bailing out its banks, particularly Hypo Real Estate.

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