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Debts and imbalances – the making of the euro crisis

Frans Bieckmann is former executive director and editor in chief at The Broker
Evert-jan Quak is now Research Officer for the K4D Programme at the Institute of Development Studies.

The structural causes of the euro crisis – high unemployment, low growth rates and debt-ridden states in the eurozone – are not the fault of lazy Greeks, Portuguese and Spaniards. The euro itself cannot be blamed either. The problem is that the European single currency is part and parcel of an economic and financial model which contains all the ingredients for the current crisis. For example, deregulation of the financial markets went hand in hand with indebtedness of the eurozone countries. Economies within a single currency zone need to harmonize, but the national economies in the eurozone developed in very different directions, increasing the imbalances between the member states. The key to finding the right answer to the crisis is understanding the debts and imbalances in the eurozone. Just blaming debtor states like Spain, Portugal, Italy and Greece and focusing reforms on them, as is the case at present, is to ignore the whole picture. Other solutions for recovery were possible, but a deliberate policy choice was made to offload all the rebalancing efforts onto the weakest economies.

About our living analysis on the euro crisis

This article is part of our living analysis on ‘The rebirth of the Eurozone‘, which gives an insight into the current crisis in the Eurozone.

The first article, ‘
Ideals versus reality – a false start for the Eurozone‘, looks at what has become of the ideals of the Eurozone through some reality checks.
This second article focuses on the economic analysis of sovereign debt and imbalances within the Eurozone.

Reckless debtors and reckless creditors

The German finance minister Wolfgang Schauble, backed by his counterparts in other creditor countries, is keen to say that the Southern member states of the eurozone did not invest in labour market reforms and did not build competitive sectors for the future. According to him, the blame for the financial problems in Greece lies entirely with the Greeks: ‘The reasons for Greece’s problems can be attributable only to Greece and not to actors outside the country, and certainly not in Germany.’ Although this is often the only discourse heard in the mainstream Northern European media, most economists actually take the opposite view and argue that the creditor countries, such as Germany, the Netherlands and Finland, are equally to blame. Professor Paul de Grauwe of the London School of Economics explains this most clearly. ‘For every reckless debtor there must be a reckless creditor,’ he says. In other words, you cannot blame just the countries with heavy debts for being in that situation, as their plight is the result of an interplay between debtor and creditor.

Background article

The argument that pits the lazy Greek or Spaniard against the hard-working Dutchman or Fin is clearly too simplistic. Instead of a clash of nations, we should rather speak of a clash of economic classes.

Read the full background article here

De Grauwe is certainly not alone. Cambridge economist John Ryan took a similar stance in the journal Policy Review: ‘The most striking single macro-economic feature of the Euro introduction,’ he explains, ‘was the near total convergence of risk-free government bond rates among the Eurozone members.’ In other words, credits from countries with a current account surplus, mainly Northern European countries, began to flow into the financial system of countries in the South as interest rates across the eurozone were plummeting. The creation of the single currency convinced the financial sector that government borrowing was now a very safe investment across the eurozone, because countries were no longer able to nominally devalue. As a result, for many governments, including those of Greece, Spain and Italy, the costs of borrowing fell to historically low levels.

Some sources about the imbalances in the eurozone

Lending to eurozone governments and banks became very attractive and was further stimulated by reforms in the Basel II banking regulatory framework. The deregulation of financial markets coupled with the introduction of the single currency made if very profitable for the financial sector to loan money to Southern European countries. The capital flowing out of Germany, the Netherlands and other countries with a current account surplus and on the lookout for safe investments began to be loaned across the eurozone in large quantities to governments, companies and individuals. The result was cheap capital flowing into Spain, Portugal, Italy and Greece.

Basil II regulatory framework

These massive credit flows led to escalating private and business debt in Southern Europe. Consumption levels rose and the booming demand for labour drove up wages, especially in Spain, Ireland and Greece. These receiving countries all enjoyed much higher growth rates than Germany and the Netherlands in the years leading up to the crash of 2007 and their economic growth and escalating house prices made it more attractive to invest in these countries. Rising wages increased the demand for imported products and inflated local prices. This made cheaper Northern European imports even more attractive, increasing the trade surplus even further in Germany and the Netherlands. And so the imbalances grew ever bigger, fuelling further lending and debt-financed spending. In Ireland and Spain in particular, speculative property bubbles began to inflate, and in Greece and Italy government debt ballooned. All this was fuelled by cheap capital flowing out of surplus countries such as Germany, the Netherlands and Finland.

Wage and debt increase in Southern Europe

Why was this capital not invested wisely, for example to improve productivity and competitiveness in the global market? Why did governments not interfere? To answer that question, we can turn to the work of economist Michael Pettis. His work demonstrates that there is no example in history of governments being able to handle such large capital inflows in a proper and coordinated way. They are simply overwhelmed by the massive capital influx from creditor countries. Sensible investments fall by the wayside in favour of short-term prestige projects based on optimistic speculation.

From Michael Pettis’s blog

In addition to this paralysis of government common sense, the increasing role and influence of the financial sector in the economy, called ‘financialization’, favours short-term profit over longer term performance, making it even harder to invest money in creditor countries for the purpose of securing economic stability. It simply became easier to make short-term profits from investments in Southern Europe and many creditor countries found themselves investing less at home and more abroad. These low investment rates at home resulted in lower productivity levels, which had to be compensated by lowering wages, in turn raising the short-term competitiveness of Northern European countries. The competitiveness of the Southern eurozone countries suffered in the longer run.

The myth of export-led growth

So, can we hold the euro responsible for the crisis, especially as the differences in international competitiveness already existed before it was introduced? Well, we can hold it partly responsible. Countries like Germany, Finland and the Netherlands benefited from the introduction of the single currency and increased their export base because the value of the euro was far too low for their economies; the value of their own currencies would have been much higher. At the same time, the value of the euro was too high for the economies of Spain, Portugal, Greece and Italy; the value of their own currencies would have been lower than the current value of the euro.

Imbalances – winners and losers of the single currency

In other words, Northern countries in the eurozone were able to significantly improve their competitiveness because of the undervaluation of the euro in relation to their economic performance, in combination with a policy of wage moderation. This came at the cost of the Southern countries. Without the euro, exchange rate differences between the eurozone countries would make Spain, Italy, Greece and Portugal more competitive on the international market, while German, Finnish and Dutch exports would be more expensive, resulting in higher unemployment and lower economic growth in these countries.

Germany's economic success

The global financial crisis of 2008 halted the flow of capital into Southern European member states. The property bubbles in Spain and Ireland burst and many banks with huge stakes in the property business instantly became insolvent as the value of their assets plummeted. As the property market crashes in Ireland and Spain threatened the banking systems in those countries with collapse, the Irish and Spanish governments bailed out their banks, leaving them with a mountain of public debt.

The end of cheap capital flows and greater uncertainty in the financial markets began to force up the costs of refinancing government debt in Southern European countries. The previously harmonizing interest rates split apart and for some governments the cost of borrowing became more expensive. Some countries, such as Greece and Italy, found themselves paying huge rates of interest to roll over their loans and as a result their debt mountains began to grow uncontrollably. The European Central Bank, other EU governments and the IMF loaned money to Southern European countries, but 90% of that money was given to banks to pay off their bad loans to prevent widespread banking collapses across the eurozone, turning yet more private debt into public debt.

One response to this could have been to rebalance the eurozone. Although surplus countries cannot revalue their currencies to rebalance their trade relationships with the rest of the eurozone, they could achieve the same effect by allowing domestic costs to inflate, for example by increasing wages. In October 2013, the US Treasury Department’s currency report noted: ‘Within the euro area, countries with large and persistent surpluses need to take action to boost domestic demand growth and shrink their surpluses.…Stronger domestic demand growth in surplus European economies, particularly in Germany, would help to facilitate a durable rebalancing of imbalances in the euro area.’ And in 2012 Bundesbank chief economist Jens Ulbrich also openly supported a significant rise in wages as part of a recovery strategy. Wages did rise a little and Germany introduced a minimum wage, but these measures were limited.

Minimum wage Germany

Instead, the EU position on solving the euro crisis was to concentrate purely on the debtor countries. It asserted that recovery was only possible by cutting public spending (austerity), reducing wages and social costs (internal devaluation), and running a trade surplus (export-led growth). As Simon Wren-Lewis, professor of economics at Oxford University, said, ‘wages and prices are “sticky”, this adjustment will not happen quickly’. The price of such measures is high, including long-term high unemployment and low wages.

The idea behind this recovery package is that rising competitiveness will boost exports and growth, generating income to pay off the debts. In 2010 the European Commission opted for liberalizing collective bargaining and introducing structural supply-side reforms of the labour market. In 2011 a new report assumed, again, that a loss of competitiveness was the main problem and an export-led growth model should be implemented, along with measures for national governments to cut public spending and impose supply-side reforms in the labour market. In other words, the strategy of the eurozone is to strive for every country to be like Germany or the Netherlands or Finland.

Excessive Imbalance Procedure

The reality is that slashing domestic demand in economies that are not export-driven will hardly increase growth rates in the short term, which is needed to create jobs and pay back the creditors, and that transforming these countries into export-led economies is a long-term strategy. To become an export-led economy needs time and above all intensive investments. ‘If European policymakers are serious about enhancing the competitiveness of these countries it will require huge levels of social investment in education, training and research, not to mention institutional capacity building. All of this expenditure implies that member states should ignore the political and legal treaties of the European Union,’ writes Aidan Regan of the Max Planck Institute for the Study of Societies.

Two varieties of capitalism

Besides, it is economically impossible for all eurozone countries to become like the Netherlands and Germany. All trade surpluses have to be matched by trade deficits elsewhere, so the idea that everyone can have a simultaneous trade surplus is impossible. This echoes the argument by Financial Times columnist Wolfgang Munchau that ‘the failure [of the eurozone] to adjust to the necessities of a large closed economy is the single largest force behind the crisis’. A significant trade surplus for the whole eurozone, even if it were possible, would imbalance the world economy even further and ultimately have a negative impact on Europe as well. And which deficit countries would they export to?

Simon Taylor explains

The rise of the debt state

We know now that imbalances in the eurozone between surplus and deficit countries have triggered a capital flow of cheap debts to the Southern European countries in particular. But this does not explain why it has run out of control. That can only be explained by the deregulations in the financial sector. What happened at the national level is the same as what happened to countless households. Before the financial crisis low-income families received a lot of cheap credit and they are now struggling to pay off their debts.

Related expert opinions from The Broker

Money found its way to these countries and households in such large quantities because of a shift in the economy from labour towards capital. Less money was invested in productive sectors to increase productivity and improve labour and more was put into short-term speculative ventures. As economist Rolph van der Hoeven wrote in an article for The Broker, ‘Financial globalization has especially weakened workers’ bargaining positions as capital is much more mobile and can move more easily to other regions.’ Moreover, in the drive to maximize shareholder value, labour is seen primarily as a cost, which explains the policy of cutting wages rather than investing in higher productivity. (See more on the shift from labour to capital in the background article.) Because this took place in the mid-1990s when many governments were busy reducing their budget deficits by cutting back on the welfare state, the demand side of the economy slumped. The gap was filled by cheap credits, which drove many low-income families into very lucrative debt contracts for bankers.

Background article

Profits are reinvested less in productive sectors, where labour can benefit, and more in capital markets.

Read the full background article here 

One logical but simplistic conclusion could be that the euro crisis was caused by bad or greedy investors, bankers and corporate managers. But this ignores the fact that they changed their practices and business models after policy changes allowed them to do so. These policy changes deregulated the financial market, put the shareholder economy above a stakeholder economy and de-standardized labour contracts. The financial market was indeed very willing to adapt quickly to this new situation of self-regulation, but it is complex and its actors are not aware – and not encouraged to be aware – of their actions in the broader societal context, creating huge risks of financial booms and busts. According to Cambridge economist Ha-Joon Chang, neoliberal market economies are more often prone to financial bubbles than in the era before the 1980s, when markets were more regulated. He demonstrates this by pointing to the Asia crisis in 1998, the dot-com bubble of 2000, the financial crisis in Argentina in 2001, and the global financial crisis in 2008.

The biggest show on earth

Emeritus Director at the Max Planck Institute Wolfgang Streeck shows how financial bubbles can be linked to financialization and ultimately with the indebtedness of states. Financialization made it easier for governments to manage their debt level. The financial sector ‘soon began luring governments into substituting credit for taxes as the latter became more difficult to collect,’ he writes. The result: governments and the financial sector became very much intertwined.

The rise of the European consolidation state

And this not only had consequences for the state. As we have seen, the banks kept demand going while public spending was being cut by providing cheap debts for households, for example to buy houses or holidays. In economics this is called ‘privatized Keynesianism’. It helped European states to stabilize their debt levels during the mid and late 1990s in comparison with the two previous decades. But, in economic terms, debts never go away; they shift from the private to the public sector. So when governments reduced their debt levels in the 1990s, it was the private sector that became overwhelmingly indebted, especially the lowest income groups, and this triggered the financial crisis.

Governments thought financialization was the solution for managing their debts levels. What happened when the bubble burst in 2008 was that banks held an array of ‘bad debts’ and it was a political choice to bail them out at the taxpayers’ cost, which ultimately led to a surge in state debt. This affected all members of the eurozone, but particularly the Southern member states because of the cheap credits they had obtained over the years due to the imbalances in the eurozone.

Systemic change

To conclude, it is not the single currency itself that can be blamed for the economic woes of our time. The picture is more complicated. The euro is part and parcel of an economic and financial model which contains all the ingredients for the current crisis. The structural causes of the economic crisis in Europe are linked to the policy choices made in the single market in the wake of the single currency, mainly related to financialization. Finding a solution is therefore not a question of simply restoring business as usual.

Financial globalization and the rise of short-term speculation did not start with the euro. The euro is a product of a long-term economic strategy that started with the single market and promotes an export model that undervalues the demand side of the economy. The answer cannot simply be to cancel the single currency and keep the single market, as this will not solve some of the root causes of the euro crisis. Abandoning the euro will not change much and arguably will be a step too far for countries like Germany, Finland and the Netherlands, as they benefit from having a global reserve currency that is undervalued in relation to their economies. They would do everything to avoid such a move because their economies are increasingly dependent on exports. Even a eurozone without Greece, Spain, Portugal and Italy would not be their preferred option, because without these countries the value of the euro would rise significantly, damaging their export potential.

Engineering a recovery while keeping the single currency needs a radically different perspective on the economy and policies taken at the supranational and national level. For example, the view that the euro can only exist in combination with a one-size-fits-all export-led economic model based on wage moderation must be disputed. New policies can only be made in a more democratic environment in which all European citizens believe they have a say in the future of the European Union. There are several alternatives to counter the political choice of returning to business as usual, bailing out the banks, shoring up faith in financial markets and encouraging more stringent wage moderation and public spending cuts. These alternatives seek to put new values into the economy and they will be discussed in Part 3 of this living analysis.

The economic model of the creditor countries has created a low-wage economy, which is not the solution for a sustainable development path either. Ángel Ubide from the Peterson Institute for International Economics wrote in the Spanish newspaper El Pais: ‘The German attitude to minimize the potential cost of monetary union is similar to the current debate about inequality – the obsession with fiscal austerity and inflation risks is explained by the focus of the better off to protect their interests as savers and investors, even if that leads to an increase in the gap between the rich and the poor.’

Any alternative approach must therefore focus on democracy, wage-led economic growth models, and countering the trend of financialization. This is only possible if citizens and politicians accept that within the eurozone there must be more solidarity – in the same way that the western part of the Netherlands subsidizes the north-eastern part of the country. The reunification of Germany was only successful because the solidarity shown by rich West Germany to poor East Germany. In the end everyone benefits, because you can only improve your welfare if your neighbours are doing well too.

Authors: Frans Bieckmann, Evert-jan Quak

About the authors

Frans Bieckmann is former executive director and editor in chief at The Broker

Evert-jan Quak is now Research Officer for the K4D Programme at the Institute of Development Studies.

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