The Eurozone Crisis: Differences between the U.S. and the Euro Area

In the previous post, we’ve talked about the problems of a diverse group of countries sharing the same exchange rate. However, this leads to a question. If a currency union is such a bad idea, why does it work well in the United States? 

The American Currency Union 

You may not have thought about it, but in fact the United States can be viewed as a currency union as well. After the American Revolution in the late 18th century, the former British colonies, coming together to establish the federal government, chose to use a common currency. 

The reason is the United States is a fiscal union with a centralized tax collection system, as well as a political union where the citizens share the same national identity. When a state government (such as California) lacks money, the federal government will help by transferring money from states with healthier public finances (such as New York). The New Yorkers are okay with helping out the Californians because of a sense of national belonging. Besides, since states are required by constitutions to balance annual operating budgets, fiscal discipline can be ensured. 
 
As Kenneth Rogoff points out, a currency union is unlikely to be successful without political integration and potential fiscal transfers. Since there are many different national identities and many sovereign nations in the eurozone, it’s hard for a common currency arrangement to work.

(Comment: This echoes an article about cultural ties on the Economist in January. In today’s globalized world, differences in nationalities, cultures and languages still play an important role in all aspects of life, including business and finance.)

The Lack of Political Union in Europe

It’s understandable why the Greeks and the Irish are angry. They don’t understand why countries like Germany and France have the right to dictate the terms of Greece’s and Ireland’s domestic policies when they themselves are autonomous sovereign states. On the other hand, since the rescue efforts will cost German taxpayers lots of money, they have little desire to lend to Greece. Plus, Germany is worried about the moral hazard created by bailing out the PIIGS countries, which may lead to even more fiscal indiscipline in the future.

(Comment: Though German politicians want to save the euro to avoid a financial meltdown, they need to be responsible for the German voters. The result is ineffective and indecisive political leadership, which is often criticized by commentators. 

To save the eurozone, imposing fiscal union may be the only option. In the current situation, wealthy countries are only willing to lend to the distressed economies under the condition of fiscal austerity. Understandably, some may view this as a threat to sovereign autonomy. These nation states have already given up control over money supply, interest rate and exchange rate in order to join the currency union, and it’ll be scary if they’re now forced to forgo fiscal power as well. However, maybe this is precisely the level of political integration needed to sustain a currency union.)

Austerity that Crushes the Economy

(Comment: What is more worrying is some European politicians fail to grasp that fiscal discipline is a long-term practice. Austerity at difficult economic times is likely to further contract the economy and reduce tax revenue, which won’t help improve fiscal health either. Even if public debt is controlled, a contraction of economic activity won’t help reduce the government debt to GDP ratio, which is a benchmark indicator for the sustainability of a country’s public finances. While European leaders hope to restore confidence and motivate consumers and businesses to spend more by reducing public debt, it seems this plan is unlikely to work.

What is needed in bad economic times is fiscal stimulus, especially when monetary policy isn’t an available tool. For example, in the early 2000s, Germany exceeded the deficit limits to weather the economic downturn. The fiscal expansion helped the German economy to get back on track back then, and it’s also what the PIIGS need right now.

Sadly, this is easier in theory than in practice. The real question is where these debt-laden states can find money to finance public spending, given that they’re struggling just to meet their debt obligations. To have a feel of the severity of the crisis, consider the debt problems of Greece. Without austerity measures, the Greek government may face bankruptcy immediately.)  

Is the Worst Over yet for Europe? 

The European financial industry is vulnerable to collapse. To understand this, let’s look at Figure 1 (which is from this website) and compare the European financial industry with the American financial industry. As we can see, the assets of American banks are just a small portion of the American economy. Therefore, when necessary, the U.S. government or government agencies can insure or even purchase the troubled assets from American banks.

On the other hand, the assets owned by European banks constitute a much higher proportion of the economic size of the host countries. Worse, these assets include the sovereign bonds of the PIIGS, which may turn out to be worthless. This makes it hard for a European country to rescue its banks when things go wrong.

(Comment: If the eurozone or the European Union can rescue the banks collectively, this may not be such a serious problem. However, the national identity problem kicks in again, and any proposal to prop up the banks of another country will face stiff opposition at the home country.)

This poses a serious systemic threat to the European economy. In the United States, the trigger is the burst of the housing bubbles, and the dynamite is the fall of Lehman Brothers. In Europe, if Greece exits the eurozone, it’ll only be a trigger. The collapse of any major European bank will be the dynamite.

(Comment: In the meantime, many analysts believe that what we’re seeing is only the calm before the storm. More concrete steps needs to be taken to solve the deep-rooted problems. Whether Europe can defuse the bomb remains to be seen, but there is reason not to be too optimistic.)
  
(Entry 6 of 6 in The Global Economic Landscape in 2012 series)

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The Eurozone Crisis: Not a Matter of Fiscal Irresponsibility

A currency union has inherent problems, as mentioned last time. But despite these structural problems, when a crisis like this happens, people naturally want to find someone to blame. So, is any country to blame for the current mess? Are the PIIGS responsible for dragging down Europe with their heavy government debt? 

The PIIGS as Victims, not Free Riders

When it comes to the sovereign debt crisis, we often think of the struggling countries as welfare states. Not only does welfare expenditure put a huge burden on public finances, under the welfare system the citizens don’t have an incentive to work hard, so these countries are to blame for the economic mess they’re in.

These criticisms may all be true, but we’ve missed an important part in the picture. Though Germany doesn’t want to admit it, the Greeks and the Irish aren’t entirely wrong when they blame the Germans. To a certain extent, Germany does gain an unfair advantage from the cheap currency – which boosts its net exports and enables it to earn more foreign money – at the expense of less productive countries in the eurozone.

(Comment: The euro crisis is not really a matter of fiscal irresponsibility. As shown in Figure 1, some of today’s distressed nations only had a small public debt burden at the onset of the crisis. By the way, since Greece’s government debt was very high – at 143% in 2010 and 161% in 2011 – it’s left out of the chart to ensure the other data points are clearly shown. For an explanation of the difference between net debt and gross debt, please refer to this article by two professors at INSEAD.

Figure 2 shows that Spain and Ireland in fact ran budget surpluses from 2005 to 2007. They’re not free riders but are victims suffering from the lack of an adjustment mechanism to deal with recessions. They’re the casualties of the structural problems in a suboptimal currency union.

Whether competitive economies like Germany and the Netherlands benefit from the euro is a debatable question. Some argue that they’ve lagged behind similar countries that chose to stay out of the eurozone, such as Switzerland and Sweden, in economic performances since the launch of the euro. But others refute that such comparisons are inaccurate because they can be easily manipulated by selecting different periods of data. Still, unless the financially distressed nations exit the euro, it looks like a lot of the surplus earned by Germany over the years will be spent on the rescue funds. So it isn’t fair to say Germany is a winner either.) 

The Downward Spiral for Less Competitive Economies 

Of course, this isn’t to say the PIIGS countries don’t benefit from euro membership at all. However, with an overvalued currency and slow productivity growth, these countries can’t compete in the world economy. The lack of competitiveness is reflected by the persistent current account deficits. Though the PIIGS did quite well economically in the first half of the 2000s (see Figure 3), once the economy started to slow, they were sucked into a downward spiral.

(Comment: To understand what triggered the downward spiral, we first have to understand what led to the boom period. As seen in Figure 4, inflation was high in Greece, Ireland and Spain before 2008. Under the “one-size-fits-none” nominal interest rate set by the European Central Bank, real interest rates were low in these countries. This fueled asset bubbles and led to the excessive accumulation of private debt, and was why they enjoyed fast growth before 2007.)
 

After the bubble burst in 2008, growth has slowed dramatically (see Figure 3) and unemployment rates have soared (see Figure 5). As a result, tax revenue falls and government spending on social welfare increases. Given the lack of adjustment mechanisms in a currency union, this can easily spiral into a vicious circle. As we now know, four years later net public debt in the PIIGS, especially in Ireland, has skyrocketed to record levels (see Figure 1).

The culprit of all this mess is the single exchange rate. After all, people in the PIIGS are free to choose a laid-back lifestyle. What they need is a currency that can reflect and match the national competitiveness, not an overvalued currency that raises both private and public debt.

Benefits of a Currency Union

(Comment: Given the risks and downsides of a currency union, you may wonder why the eurozone was formed in the first place. A currency union does have a few benefits. For example, it can deter speculative attacks and promote trade and cross-border investments.

For more detail, you may refer to Robert Mundell’s theory of optimum currency areas. Its central thesis is currency borders don’t necessarily have to follow national borders, because if there is high labor mobility in a region, freely floating exchange rates aren’t necessary to adjust for imbalances. This provided the rationale for the creation of the euro. However, it’s now clear that without a common language and a common social welfare system, the labor mobility in Europe won’t be high enough to correct economic imbalances.) 

(Entry 5 of 6 in The Global Economic Landscape in 2012 series)

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The Eurozone Crisis: Problems of a Currency Union

After a discussion on the United States and China, the world’s two largest economies, it’s time to focus our attention on Europe. The continent, troubled by the sovereign debt crisis, poses the most systemic risk for the world economy. 

To help you understand the structural problems faced with the eurozone, we’ll discuss the lack of adjustment mechanisms in a currency union in this post. 

The Problem with a Common Interest Rate 

(Comment: Let’s review the typical argument first. In a currency union, individual countries lose the autonomy of monetary policy and must share a common nominal interest rate. Since the 17 eurozone members are in very different economic conditions – where some are in a serious recession and others aren’t, and where some face high inflation and others don’t – they need different interest rates to manage the national economy.

In many European countries, monetary policy is especially important because fiscal stimulus isn’t an option given the high level of public debt and the high cost of borrowing. The lack of independent monetary policy means both booms and busts will last longer and be more severe, since the central bank doesn’t have the tools to manage the economy.) 

The Problem with a Common Exchange Rate 

The problem goes deeper than that though. Not only is a common interest rate problematic, but a common exchange rate also causes problems. When market participants trade the euro, they factor in the productivity and the current account balance of all euro members. 

Under these market forces, the value of the euro can be thought of as a weighted average of national exchange rates (assuming hypothetically every country uses a separate currency), where the weights are proportional to the size of the economy.

Since the economic conditions are different in different countries, the national exchange rates are also different. When a country – such as Germany – enjoys high productivity and a current account surplus (see Figure 1), its currency tends to appreciate. An appreciation of the currency will, in the long run, reduce net exports and restore current account balance.
  

Similarly, when a country – such as Greece – has low productivity and a current account deficit (see Figure 1), its currency tends to depreciate so exports will be cheaper. Cheaper exports will help the country regain cost competitiveness and bring the current account to balance over time.

However, with a single currency this adjustment process doesn’t work. Under the euro, Germany’s exchange rate is artificially lowered (an undervalued currency), while Greece’s exchange rate is made artificially high (an overvalued currency). As a result, Germany’s workers and exports are competitive in the world economy, but those from Greece aren’t.

This has led to a huge productivity gap between Germany and the peripheral countries. The result is persistent trade imbalances, which have made the eurozone unsustainable and prone to economic crisis. 

Deflation as the Only Feasible Adjustment Mechanism

(Comment: Persistent current account deficits imply the accumulation of external debt. If the country isn’t in a currency union, it can increase the money supply and lower its interest rate, with the aim to instantly depreciate its currency and stir up inflation in the long term. Depreciation restores cost competitiveness and increases net exports to correct the imbalances, while inflation reduces the country’s real debt burden if the debt is denominated in the domestic currency.

In a currency union, a country with current account deficits is unable to devalue the currency. In theory, it can use deflation to restore current account balance. Deflation, just like currency depreciation, causes domestic goods and services to be cheaper in terms of foreign currency.

However, the adjustment process is painful. Deflation is typically accompanied by serious recession as people delay consumption. Besides, under a constant exchange rate, deflation increases the real debt burden, making it even harder to repay the debt.)

(Entry 4 of 6 in The Global Economic Landscape in 2012 series) 
 

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The Chinese Economy: Slowdown for the Sake of Future Growth

In addition to the artificially lowered exchange rate and interest rate, the Chinese economy faces other structural problems and we’ll explore them in this post. Here we’ll also explain why the Chinese authorities are treating the current slowdown as an opportunity to restructure the economy for future growth.

Problems in the Financial Market 

China’s currency Renminbi isn’t freely convertible and foreigners are often denied access to the currency. The process of internationalization has just started. Besides, the major Chinese banks are still controlled by the state and have to fulfill policy goals instead of putting profitability and shareholder value as the top priority.

For example, in response to the financial crisis, the state banks loosened credit more than private banks run on market principles would optimally do, because they had to help the central authorities to stimulate the economy. This prevents the efficient allocation of capital, and also increases non-performing loans ratio at state banks. These aren’t the features of a mature, sophisticated market economy.

(Comment: Another problem is the lack of competition in China’s financial market, as Premier Wen told the press earlier this month. Besides, the rich and the powerful with connections to bankers and public officials have much easier access to credit. This again makes capital allocation inefficient and undermines the fairness of the financial system. Reforms are needed but they’ll have to face fierce opposition of the vested interests.) 

Fear of a Hard Landing 

Given the above problems, together with the downturn in China’s real estate market and the European debt crisis (which hurt Chinese exports), some observers already worry about a hard landing in China, though its economy isn’t as highly leveraged as the U.S economy.

(Comment: The Guardian published a debate between Andrew Batson and Patrick Chovanec on whether China will face a hard landing this year. A professor at Tsinghua University, Chovanec is an active blogger and an expert on the Chinese economy. His blog features a brilliant analysis of the downturn in China’s real estate market.) 

Restructuring to Pave Way for Future Growth 

You may wonder why the United States can enjoy a high credit rating even when the country owes so much debt, while China can’t. Some Chinese may think this is a conspiracy: the credit rating agencies, which are mainly run by Americans and Europeans, are biased towards America. However, the truth is the American economy can support a bigger size due to its sound economic structure, while the structure of the Chinese economy isn’t as efficient or robust.

The Chinese authorities are well aware of this. That’s why they’d rather slow down the economy than to push for higher growth in the short term. It can be foreseen that, to improve the health and stability of its economic structure, China will try hard to shift the growth engine from investment to consumption in the next few years, with the help of a higher interest rate as well as other policies.

(Comment: Despite the unfavorable conditions, I believe the Chinese economy probably won’t suffer from a hard landing. As a report titled “Growth Worries” from the Economist Intelligence Unit suggests, even if the economic slowdown is more severe than expected, the Chinese authorities can carry out fiscal expansion since they aren’t debt-laden like its Western counterparts.

Indeed, the capacity for fiscal stimulus should be high, given that the heavy local government debt, a chronic problem in China, appears to be under control. Besides, since inflation has fallen to below 4% this year, there is room to inject money into the economy and lower the interest rate, though this is contradictory with the long-term goal to rebalance the economy.)

(Entry 3 of 6 in The Global Economic Landscape in 2012 series)

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The Chinese Economy: Structural Imbalances

After a discussion on the American economy, this time we’ll turn to China, the second largest economy of the world, which is showing signs of a slowdown.

Slowdown to Correct Structural Imbalances 

After years of over 8% annual economic growth, China lowered its GDP growth target to 7.5% in March this year. Some wonder if this is a sign of pessimism about China’s economic prospects. But in fact, the growth slowdown shouldn’t be taken as bad news.

Given the serious structural imbalances in the Chinese economy, the central government aims to use this as an opportunity to restructure the economy for the sake of sustainable growth in the long run. 

A Low Exchange Rate and the Reliance on Exports 

Over the years, China has artificially lowered its exchange rate and interest rate in order to achieve higher growth. An undervalued currency boosts exports and results in China’s huge current account surplus (see Figure 1). But the country’s export-led growth isn’t sustainable. The heavily-indebted, slow-growth Western economies won’t be able to afford to import so much from China forever.

(Comment: In fact, China, which has long been dubbed as the world’s factory, recorded a trade deficit of US$4 billion in the first two months this year. What must be noted is that the figure was distorted by the Chinese New Year, a time of the year when exports drop as factories close down for the holidays. Hence, though some analysts suggest the Renminbi exchange rate may be closer to its equilibrium level than we thought, it remains to be seen if the trade balance will return to huge surpluses.) 

A Low Interest Rate and the Reliance on Fixed Investment 

China’s interest rate is artificially lowered too. Despite a high nominal rate relative to other countries, China’s real interest rates – i.e. the nominal interest rate minus the inflation rate – were low from 2003 to 2008 due to high inflation (see Figure 2). While domestic consumption remains weak (see Figure 3), China experiences over-investment, which is much higher than the world’s average (see Figure 4). Note that the fixed capital formation in Figure 4 covers investment from both the private and the public sectors.

(Comment: To see why firms make decisions based on the real but not the nominal interest rate, consider the case where the nominal interest rate is 5% and the price level rises 10% a year. In this scenario, the real interest rate is -5%. From a firm’s perspective, while it pays 5% interest if it invests this year, it needs to pay 10% more in production costs if it invests next year. Thus, it’s better to borrow money and invest in capital this year rather than next year. The lower the real interest rate, the lower is the cost of capital investment.)

In 2009, for example, capital investment contributed to over 90% of the GDP growth, which is a clear evidence of China’s economic imbalance. This is worrying since investment-driven growth isn’t sustainable. If consumption doesn’t increase along with investment, the economy will only end up with excess production capacity, and afterwards fixed investment will fall drastically. 

(Comment: While its current account balance has fallen sharply, China has failed to rebalance internally. Investment has boomed for the past three years, partly because of the government’s 4-trillion-yuan stimulus package in 2008. The money was spent on various infrastructure, including roads, railways and electricity supply, and was meant to offset the adverse effects of the global financial crisis.)

(Entry 2 of 6 in The Global Economic Landscape in 2012 series)

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The U.S. Economy: Private Deleveraging and the Slow Return to Growth

The first stop in our journey of the world economy is the United States. And to understand the current economic condition in America, we first have to look back to 2007 and before to understand the causes of the 2008 financial crisis.

Too Much Debt Before the Financial Crisis

One of the underlying causes of the Great Recession is the high leverage (i.e. too much debt) before 2008. In the two to three decades before the crisis, America’s consumption/GDP ratio steadily climbed up to 70%, compared to the 2008 world’s average of 61% (see Figure 1). Household debt as a percentage of disposable income, a more accurate measure of the level of financial leverage, rose dramatically, from around 70% in the mid-1980s to a peak of 140% in 2006.

 

The country’s current account balance, of which the trade balance is a major component, recorded rapidly growing deficits before 2007 (see Figure 2). A current account deficit means the U.S. consumes more than it produces, which is made possible because the United States is borrowing from the rest of the world.

A Credit Boom Gone Wrong

(Comment: Prior to the financial crisis, there was too much easy credit in the U.S. For example, Americans could obtain zero down payment mortgages for home purchases, and it wasn’t uncommon for homeowners to take out a 2nd mortgage or a home equity loan. Saving rates were as low as 2% in 2005 and 2006, in contrast with a rate of 10% back in the early 1980s. After years of high leverage, in 2006 and 2007 some debt-laden homeowners, especially those with subprime credit ratings, ultimately failed to repay the loans. As a result, home prices dropped, the housing bubble burst, and banks are hard hit by bad debt.)
 

(Comment: You may ask, what motivated the excessive borrowing of the Americans? Geoff Colvin, a senior editor at Fortune, provided one hypothesis. Under the stagnating living standards since the turn of the century, Americans wanted to create the illusion of prosperity through debt-financed consumption. This applies to the Europeans as well.

Similar to this argument is a new research study cited by The Economist, which attributes widening income inequality and trickle-down consumption as the explanation. It suggests that prior to the crisis the non-wealthy were spending more in order to match the upper class’s consumption level, even though incomes of the non-wealthy were rising much more slowly than upper-class incomes.)

Forced to Reduce Debt

We can use an analogy and compare the economy with a balloon. We want to make the balloon bigger, but a balloon will explode if its size crosses a certain threshold. Similarly, we want to increase the size of the economy through credit creation, but the economy becomes unstable when the leverage is too high. Sooner or later, the economic bubble bursts, and the economy is forced to deleverage (i.e. to cut down the level of debt).

Using another analogy, a consumer who borrows on credit cards can continue to accumulate more debt until she can no longer afford to make the minimum payment, after which she is forced to cut down debt. The financial crisis acted as a similar signal for the United States, which was left with no choice but to cut down debt.

The Road to Recovery

The United States has been deleveraging in the past three to four years. While public debt is still on the rise, with the federal deficit around US$1.3 trillion last year, the private sector has been deleveraging at a satisfying pace comparably faster than many other developed economies.

(Comment: Since households and firms have to deleverage and consume/invest less, the economy takes longer to recover after a financial crisis. Given the rapid deleveraging of the private sector, America has started a slow but stable recovery. Unemployment rate has dropped and the housing market has improved, in the midst of the worrying polarization of American politics that threatens the economic recovery.) 

The central bank responded to the financial crisis with quantitative easing (QE). Some dispute the effectiveness of the policy, but at least it seems useful to boost the U.S. stock market. The S&P 500 went up significantly after both rounds of QE, though the stimulus effect of QE2 was not as huge as QE1.

(Comment: A rising stock market may be the result of a better economic climate and thus expectations of higher future corporate profits, but it’s no conclusive evidence of an improving economy. Even with the same dividends, asset prices may increase due to an increase in liquidity, where higher prices decrease the expected returns of all assets. Still, a buoyant stock market is helpful for recovery since it stimulates consumption through the wealth effect.)

(Entry 1 of 6 in The Global Economic Landscape in 2012 series)
 

The Chinese Economy: Structural Imbalances   Next >

   

The Global Economic Landscape in 2012

On March 23, I attended a talk on the world’s economic and financial landscape. The speaker, Stephen Wong, is a former managing director of an investment bank and now a part-time instructor at the Chinese University of Hong Kong. The talk was succinct and informative, and I enjoyed it a lot.

Sharing many of Stephen’s opinions, I’d like to recap them here. I’ll also add my own points of view, which are in the Comment sections scattered in the posts.

This 6-part series covers the American and Chinese economies as well as the European debt crisis. To better understand the global macroeconomic environment, act now and click on the links below:
 
Part 1  The U.S. Economy: Private Deleveraging and the Slow Return to Growth 
Part 2  The Chinese Economy: Structural Imbalances 
Part 3  The Chinese Economy: Slowdown for the Sake of Future Growth 
Part 4  The Eurozone Crisis: Problems of a Currency Union 
Part 5  The Eurozone Crisis: Not a Matter of Fiscal Irresponsibility 
Part 6  The Eurozone Crisis: Differences between the U.S. and the Euro Area 

In today’s globalized world, what happens in countries thousands of miles away can have a direct impact on your life. The global economy, besides having a growing impact on our life, is an integral part in our understanding of the world. Thus, whatever country you live in and whatever industry you work in, it’s useful to learn more about the world economy.

I hope you’ll enjoy this exciting journey to explore the world economy. You’re most welcome to leave a comment.