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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