17th Jan 2019


How serious is the euro debt crisis?

  • "The Eurozone has been described as ‘a monetary giant but a fiscal dwarf', which means that it has a large and powerful Central Bank in charge of monetary policy, but a negligible federal budget" (Photo: pimousse3000)

Much is being made of the pressure on the euro arising from the sorry state of Greek finances, and of the risk posed by Portugal, Spain, Ireland and even Italy. The interest rate on Greek 10-year Eurobonds is nearly 7%, over twice what the German government is paying to borrow abroad. The recent story in the Financial Times that hedge funds are betting nearly €6bn on further falls in the euro does not bode well for the solidity of the common currency.

Could it be that unless the renewed discipline of the Stability and Growth Pact (SGP) is imposed on eurozone member states, the whole euro edifice might tumble? Politically, the interminable negotiations over Lisbon have left the EU in a sorry state. Currency collapse would destroy Europe's main achievement.

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I'd like to say it's simply not going to happen; so far, there is little sign that contagion will spread. Rationally speaking, just as a budget crisis in Delaware or California cannot bring down the US dollar, one in Greece or Spain cannot bring down the euro. But if financial markets can be ‘irrationally exuberant', to borrow Alan Greenspan's phrase, they can also be irrationally pessimistic.

Paul Krugman, writing on the Asian crisis, points out that the orthodox budget balancing medicine recommended by the IMF in 1997 flew in the face of economic logic - and has resulted today, he might have added, in a large Asian savings glut which has contributed to the crisis. How could so many clever economists get it so wrong?

‘Fear of speculators' was Mr Krugman's answer. In truth, economic policy is increasingly driven not by logic but by sentiment in the financial sector. Europe seems set to apply the same budget balancing medicine used in the 1997 financial crisis. That's what makes the euro debt crisis dangerous.

Three principles

What would a rational economic response be? Broadly, there are four principles at issue. First, is budget balance desirable in a recession? Secondly, is a fall in the euro calamitous? Thirdly, should the Eurozone be prepared to ‘bail out' individual members who get into trouble? And finally, is the economic architecture of the Eurozone adequate to dealing with the problem?

Should budgets be balanced?

Regarding the first principle, it makes no sense to call for budget balance in the midst of a recession. This is not to say that Greece does not need to stop cooking the books and reform its tax system; Mr Papandreou can do many things to improve policy. But it is always the case that in a recession, tax receipts fall and government transfers rise. Belt tightening makes things worse. The greater the squeeze on aggregate demand cause by tight fiscal policy, the longer recovery takes.

This is true not just in Greece but throughout the Eurozone. Moreover, where labour is made to bear the cost of a crisis created largely by the fat cats of finance, the political fallout of squeezing labour too hard could be very serious.

Is nominal euro devaluation a good thing?

Secondly, what about euro devaluation? Recall that the euro was launched at US$1.17, that it fell to US$ 0.82 in late 2000 and has been as high as $1.60 in July 2008. At the time of writing, it stands at US$1.36, which represents a nominal depreciation of roughly 15% relative to its peak against the dollar. The euro has survived plenty of ups and downs.

Given that Eurozone countries run a current account deficit, offset almost entirely by the German surplus, there is a good case for saying that depreciation is desirable insofar as it boosts Eurozone exports. Indeed, since in much of the rest of the world, central banks deliberately manage their currency to stay in line with the dollar, it is arguable that the Eurozone has done a disproportionate share of the heavy lifting in helping the US external adjustment process.

Moral hazard or free reign to the speculators?

Monsieur Trichet at the ECB has taken a very tough line on helping Greece, or any other country that gets into trouble. Supporters of this position will argue that any ‘bailout' of a deficit country simply causes ‘moral hazard', encouraging the country to continue acting irresponsibly. This argument is a poor one.

The danger with this approach is that it gives free reign to the speculators to bet against the weakest countries. The ECB has effectively relegated responsibility for the creditworthiness of Greek bonds to the rating agencies - the very same agencies that gave their blessing to sub-prime mortgage bonds.

During the Asian crisis of 1997, when Hong Kong was attacked by the markets, the government raised interest rates and intervened in the markets. The ECB today is in a far stronger position. It merely has to announce that it will guarantee Greek bonds (or those of any other member state which is attacked) in order for the speculative frenzy to end.

A new Eurozone Economic Architecture

Still, the current crisis might just prove to be a blessing in disguise if it forces the larger countries of the Eurozone to rethink the architecture of Maastricht. The Eurozone has aptly been described as ‘a monetary giant but a fiscal dwarf', which means that it has a large and powerful Central Bank in charge of monetary policy, but a negligible federal budget with counter-cyclical function.

In a recent letter in Le Monde, the Green MEP, Daniel Cohn-Bendit, called for the EU budget to be increased from 1% to 5% of Eurozone combined GDP, echoing the view of many economists who view the absence of an EU Federal Treasury as the main design flaw of the Maastricht compromise reached twenty years ago. Indeed, the McDougall Report commissioned in 1977 but subsequently rejected by the bankers at Maastricht, called for a Federal Budget of 7% of combined GDP.

Much more recently, in 2003, the Belgian economist André Sapir called for a Federal ‘rainy day' fund to be set up in anticipation of precisely the sort of need the Eurozone faces today. By contrast, Monsieur Sarkozy in France at present seems to perceive the solution as that of enshrining ‘budget balance' in legislation following the German model.

The need for European integration

The existence of the euro, far from being an impediment to adjustment, has given the EU the firm bedrock it needs to face a crisis. In its absence, the drachma, the escudo, the peseta and the punt would have all been attacked viciously by speculators in the currency markets. Many millions of people in the Eurozone could have seen their life savings disappear, just as happened in Iceland. Or again, as in the 1930s, the beggar-my-neighbour policy of competitive devaluation could have gained unstoppable momentum.

Nevertheless, the current crisis has tested the euro and will continue to do so. What is needed is a long-term vision of Europe's economic and political architecture, not a short-term response to the vagaries of the international currency market. What is needed, too, is a political class committed to Europe, rather than committed to the narrow pursuit of one set of national interests at the cost of others.

As the Nobel laureate, Joseph Stiglitz, wrote in The Guardian last week: ‘[T]he premise of European solidarity is being tested again. The measure of Europe will not be in the harshness of its actions, but in the spirit of solidarity that it shows in assisting its neighbour.'

The writer is Research Professor at the University of London, SOAS and author of Super Rich: the growth of inequality in Britain and the United States, Cambridge: Polity Press, 2008.

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