Understanding the Euro Crisis

My favourite contemporary economist is UCL’s Professor Wendy Carlin.  She was my tutor at UCL, and led my second year macroeconomics course, and a third year course on European institutions.  Her patient, dispassionate analysis is worth so much more than all that shoot-from-the-hip banging on by celebrity economists, Nobel Laureates and all.  It was her analysis, well before the current crisis broke, that demonstrated to me that the last government’s economic “miracle” was unsustainable (the combination of an appreciating real exchange rate and a trade deficit being the giveaways).  She also helped me understand the Eurozone, and pointed out the trouble ahead, again well before it happened, arising from diverging real exchange rates within the currency bloc – in other words Germany was becoming more competitive while Italy, Spain and others were becoming less so.

So I was delighted to read her summary of the Eurozone crisis – 10 questions about the Eurozone crisis and whether it can be solved.  The is a wonderfully clear summary of the whole situation, written in early September.  Her central point is that the zone’s banking system is at the heart of the crisis, and tackling the banks will the heart of any solution.  European politicians have been trying to avoid this, no doubt because it shows that Northern European countries have played an important role in creating the crisis.  However, not least thanks to the new IMF chief Christine Lagarde, this is changing.

Of course Professor Carlin cannot point to an easy escape.  She points to two alternatives paths, other than the breakup of the zone:

Scenario #1 – a more decisive approach based on current policy (bailouts)
Policy-makers need

  • the existing bailout schemes to be successful and to be seen to be working in the next year
  • to keep Italy out of the bailout regime
  • to develop a replacement for the high moral hazard regime for banks and for governments but to do this in a way that does not undermine the bailout regime in the meantime.

Scenario #2 – large-scale restructuring of bank and government debts (defaults)
Policy-makers need

  • to move decisively now to end the high moral hazard regime by accepting that default on bank and government bonds on a much larger scale than envisaged in Scenario #1 is necessary
  • to engage in restructuring sovereign debt and bank debt by, for example, forcing bond-holders to swap existing short-term bonds for long-term
European politicians are attempting the first path, but the problem is contained in Professor Carlin’s third bullet: devising a financial scheme that avoids moral hazard by banks and sovereign states – this reckless behaviour in the belief that it will be underwritten by everybody else.  The favoured answer of many is a “Eurobond” – i.e. government borrowing underwritten collectively, combined with a toothier version of the failed Stability & Growth pact.  But this decisive step towards a more federal Europe runs well beyond any democratic mandate.  The German Chancellor, Angela Merkel, is rightly suspicious.
Which leaves the second scenario, which is favoured by American commentators, based on their experiences of Latin American debt crises.  This is surely much more convincing, and I hope that the IMF will use its influence to push down this path.  Bank regulation clearly needs to change, but beyond that it doesn’t need a more federal Europe.  We can use bond spreads to act as a break on government profligacy – which is how the Eurozone should have been run from the start.
A final point worth making from Professor Carlin’s analysis is that dropping out of the Eurozone wouldn’t really help Greece or any other country that much.  They would still have to run a government surplus, and so still have to go through a very painful reform programme sucking demand out of their economies.  Of course the hope is that a rapid devaluation would kick start exports – but it does not stop the need for painful supply-side reforms if these countries are to recover anything like their former standards of living.
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6 thoughts on “Understanding the Euro Crisis”

  1. Thanks for this, insightful as ever.

    I am not an economist, and for me there is a big element missing from the economit’s narratives. I am concerned about the future of the british and european economies. I am an individual within this zone – what am I supposed to do? If I ring up the DTI and offer 2 hours of my time every week to help ‘solve the crisis’, what do you think they would ask me to do?

    The solutions put forward by economists do implicate me, but in a way too general for me to act on. They would like an ‘increase in tradeables’, which presumably means I should try to get a job in an export industry, or set up an export business. They would like an ‘increase in domestic demand’, which presumable means I should spend my savings on going out to eat in restaurants.

    Economic miracles have often happened during or just after wars. This is because the people have been directly engaged. During WWII, there was rationing. Painful it may have been, but it was surely a direct and understandable solution to a real problem, which everyone could share in.

    I have commented elsewhere that I believe that with the increasing technological efficiency, there is simply not enough for everyone to do any more. Be this as it may, surely we can’t only talk in terms of ‘growth’ and ‘productivity’, but in terms of real people (you and I) solving real problems (what are the real material needs? What can we usefully export? etc)

    1. First a digression: economics and wars. In wars it becomes necessary to divert productive resources towards the war effort. This carries a cost to the population at large, even if in modern times (Vietnam, Iraq, etc) this has been somewhat hidden – and it may possible to dupe foreign creditors into pay for some of it (China, as it happens, in the case of Iraq). The focus of war can inspire heroic efforts and achievements. What happens after wars is more interesting. Effort is directed back from the war effort to everyday life – and that often leads to rapid improvement. Most miraculous of all can be nations, like West Germany and Japan, that have suffered a lot of physical destruction. That seems to be because the physical assets side of an economy isn’t important as human networks, and it is easier rebuild (and in so doing improve) infrastructure than build it from scratch. And real energy can be unlocked from wiping the slate clean. The miracle is in fact the taking up of slack.

      Now, what’s happening in 2011? First is a tangle of past contractual relationships: debts, investments and so on; these are now blocking progress as creditors demand to be repaid, and so forth. Next is the question what kind of a society we want: essentially do we try and recreate things as they were, are do we move to something different? The first job is to pick through the tangle of relationships by agreeing a series of compromises that everybody can be happy with. There’s not a huge amount an ordinary citizen can do about this: we’ve delegated all that responsibility to governments, pension funds, banks and so forth. On the second point you should try to move towards whatever you think the solution is. To recreate the old world, you should get back to normal levels of consumption as soon as possible. Otherwise you should help build, in any way you can, the new tomorrow.

      In my view the main problem in developed economies is not lack of consumer demand, it is lack of investment. The future seems so uncertain, that many are reluctant to take risks. What we have to do is to establish a faith in a new future.

      I think you are right that “growth” and “productivity” are becoming less and less helpful as concepts. We should instead be thinking about “waste” (or efficiency), and “wellbeing” with a special focus on reducing the numbers with poor wellbeing, the real poor. In one sense the old and the new values converge at the moment: we all hate unemployment – it is wasteful and means poor wellbeing. But the key to progress is envisioning the future – and that’s were there is a divergence. Technological advance is both threat and opportunity.

      Oh dear. I’ve tried to conflate into a few paragraghs what should be a whole book, or more!!

  2. Thanks for this. When one leaves the cosy norms of conventional economics one immediately finds oneself on the vast and wind-swept plains of free thinking! Most tempting to retreat and shut the door again, but I admire the pioneers who are willing to make forays and hopefully claim new territory for us.

    Efficiency and wellbeing. I would like both, but what really want is inspiration. I remember working 12 hour days for months (mostly unpaid) because I had the bit between my teeth, and when the project turned out a success – such satisfaction!

    But I can’t see how we can all get inspired. I know the green party want us to do so to crack global warming, but it doesn’t seem that anyone’s that bothered.

    I look forward to you next post…

  3. Please help me understand one thing given I’m mostly a novice to economics. How can countries like Greece stay in the Euro zone when they have relatively uncompetitive economies? This is part of what I understood led them to incurring of so much debt since they had no control over the currency? Do you just envision that they would need to improve their productivity along with the third bullet keeping them from getting back into the same place they are now? Any extra insight would be greatly appreciated. Thanks.

    1. A very good point Russ. Greece in particular, together with other Southern European economies got itself into trouble by letting the competitiveness of their economies erode, while Germany was becoming more competitive. In economics jargon, their “real” exchange rates appreciated relative to Germany’s. In getting out of the mess they will have to address this by raising productivity and, in the worst cases like Greece, reducing nominal pay rates. Something like this has already happened in Ireland and the Baltic states. It is also not dissimilar to the UK in the 1990s under Mrs Thatcher, when recession hit, but the pound when up rather than down – forcing the country to raise productivity, though there was not much in the way of nominal wage-cutting.

      If they weren’t in the Euro they would not have been able to get into the current mess, as they would been unable to finance their trade deficits for as long. Financial integration was running to far ahead of other economic integration. In the case of Greece this was about profligate governments racking up debt. IN Spain (and Ireland) the governments were amongst the most prudent in the EU – the problems were in the private sector, which then dragged their governments in after the crisis blew up. Portugal and Italy are an intermediate cases

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