My position on the Eurocrisis

For what it is worth, I wish to shortly clarify my position on the Eurocrisis. One reason is that I have shared a lot of links that have influenced and/or changed my position.

First, the sources of the eurocrisis. Following Paul de Grauwe, I am convinced that the current eurocrisis has structural sources, because the free movement of capital is not coupled tight enough with fiscal and monetary policy. The real estate bubble in Spain is a good example of this. In de Grauwe’s words (p. 8):

The previous analysis leads to the conclusion that the appearance of unsustainable private
debt levels is the result of a combination of animal spirits and bank credit. This phenomenon
has been very pronounced in Ireland and Spain. This also leads to the conclusion that not only
national governments bear responsibility for these developments (because they fail to
counteract them by anti-cyclical budgetary policies) but also the monetary authorities
(because they fail to exert a stronger control on bank credit). Since bank credit is a more
proximate cause of the bubbles and booms, and since the monetary authorities can control
bank credit, it can be argued that the responsibility of the European monetary authorities in
the development of unsustainable private debt levels is stronger than that of the national
governments. Thus the failure of the European monetary authorities, and in particular of the
ECB, in checking the unsustainable private debt developments and the ensuing public debts is
at least as high as the failure of national governments.

The Eurocrisis is not a result of ‘profligate government spending’ – except in the case of Greece. Government debt rates were mostly declining prior to the crisis (except in Germany and Portugal), but private debt was rapidly increasing. This means that households became more indebted, and as a result banks became more liable. But this was not seen as a problem, since there were housing booms in many countries. De Grauwe (p.9):

From the preceding analysis follows that the Eurosystem bears its part of responsibilities in
allowing bubbles in national housing markets and the associated increases in private debt to
develop. Reforms of the governance in the eurozone should therefore not only focus on the
responsibilities of national governments (and these are serious) but also on those of the
European monetary authorities, and in particular those of the ECB. Some more hard thinking
about how this can be done will be necessary.

The problem of household indebtedness is serious in its own way, if we remember the subprime mortgage crisis in the US. Suddenly the housing bubble popped and banks got into trouble and households came ‘under water’. But although this was a large shock to the financial system, it was not an existential problem because the US has its own currency (i.e. it is a full monetary union). This meant the Fed could flush the markets with extra liquidity and buy up some of the ‘toxic assets’. The US Treasury bond interest rate has not really suffered regardless of this (which relates to the liquidity trap/Zero Lower Bound discussion, see e.g. Krugman)


Which brings us to another important piece of the puzzle: in the Eurozone, essentially all governments borrow and spend in a foreign currency – because they can’t issue the euros themselves (the ECB does that). Paul de Grauwe has a very important paper on how this influences rates on government bonds. This is also a crucial piece in the puzzle as far as the link banking crisis-sovereign debt crisis is concerned. The banking crisis which started in the US spread to Europe, where suddenly all kinds of banks got into trouble with their assets. Because of fears of ‘another Lehmann brothers’ or worse, governments took up the task to save banks which were deemed important for the system (or simply because too many people would lose money). This greatly increased the goverment debt ratio, and after Greece, many Southern European countries got into grave trouble regarding their refinancing of debt. Paul de Grauwe and Yemei Ji write about what happened next. Ireland and Portugal formally submitted themselves to the governance of the so-called Troika, which meant these countries were to implement harsh austerity measures. The authors conclude (among other things):

The intense austerity programs that have been dictated by financial markets create new risks for the Eurozone. While the ECB 2012 decision to be a lender of last resort in the government bond markets eliminated the existential fears about the future of the Eurozone, the new risks for the future of the Eurozone now have shifted into the social and political sphere. As it becomes obvious that the austerity programs produce unnecessary sufferings especially for the millions of people who have been thrown into unemployment and poverty, resistance against these programs is likely to increase. A resistance that may lead millions of people to wish to be liberated from what they perceive to be shackles imposed by the euro.

They explicitly mention that countries like Italy or Spain do need reform and some kind of austerity to got back to sustainable finances, but not at this current pace. The reason is given by the technical paper by the IMF: the fiscal multipliers of austerity are far greater than assumed and (thus) do much greater damage than assumed – both economically and socially.

So I can support the conclusion de Grauwe and Ji reach:

The desirable budgetary stance for the Eurozone as whole consists in the south pursuing austerity, albeit spread over a longer period of time, while the north engages in some fiscal stimulus so as to counter the deflationary forces originating from the south. The northern countries have the capacity to do so. Most of them have now stabilised their debt-to-GDP ratios. As a result, they can allow a budget deficit and still keep their ratio constant. Germany in particular could have a budget deficit of close to 3%, which would keep its debt-to-GDP ratio constant. Given the size of Germany, this would allow for a significant stimulus for the Eurozone as a whole.

But what happens? Finland, Germany and the Netherlands all engage in belt-tightening of their own, thus through various mechanisms making deflation in the South even worse. Unless there is a big policy change soon, before the ¤%& hits the fan again, there will be extended recession again (or still). The Netherlands is regarding housing and private debt an accident waiting to happen. If things go worse still, then it may be unavoidable that the Eurozone breaks up. This is not my own original idea, but Finland, Italy or Germany could be the first to leave. Finland because it is small and rich enough, Italy because it is big enough and in a fiscal sense in an almost proper shape (primary budget surplus) and Germany because it is the largest and richest economy of the eurozone.

So for this not to happen, I hope policy makers will soon shelve the austerity policy in Northern Europe.



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