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 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.