Fiscal austerity will fail to cure what ails the euro.
It is unfortunate that Greece was the first eurozone member to go bust, for that country’s experience has tinted the crisis as one of “fiscal profligacy.” Although it is true that the Greek government frittered away public funds and lied for years about its liabilities, Portugal, Ireland, Spain, and Italy all kept their fiscal deficits within prudent ranges before 2008. In fact, their primary balances were, on average, positive between 2001 and 2007 (Exhibit 1). A more accurate assessment of the crisis is that it was caused by the combination of current account imbalances, a fixed exchange-rate regime, and the absence of guarantees against sovereign default. But let’s start from the beginning.
Tracing the Origins of the Crisis
The birth of the euro in 1999 meant that Germany locked the exchange rate with its European neighbors. In the following years, Germany’s productivity, contained growth of unit labor costs, and a constant exchange rate created a backdrop that was greatly favorable to German exporters. The country’s trade surplus ballooned—at the expense of the current account balances of today’s troubled economies in Europe’s periphery (Exhibit 2).
Giving up national currencies also meant handing over monetary policy to a foreign entity: the European Central Bank. The new bank’s only mandate was to maintain price stability for the eurozone as a whole. The interest rates set to achieve that goal, it turns out, were too low for the less-competitive members of the Economic and Monetary Union. Those countries, faced with low interest rates and stiff competition in the tradable-goods sector, had two choices: allow a spurt of debt-fueled spending and real estate development (which Ireland and Spain did) or see their private sectors wither (which Italy and Portugal did). Either way, the ratio of external debt/GDP crept up (Exhibit 3).
Fast-forward to 2008. A financial-crisis-cum-deep- recession engulfed the world. Credit dried up, unemployment soared, tax receipts shrunk, and the welfare bill got heavier. Spain and Ireland had to prop their banks as well. Germany and the other competitive countries sprung back to life in 2010. Their peripheral partners were not as successful, and their public finances deteriorated quickly.
To be sure, inefficient regional economies and low interest rates by themselves would not have produced a sovereign debt crisis. Two additional prongs are needed to explain how things got so bad: the mispricing of sovereign risk and bank regulation (or lack thereof).
After the introduction of the euro and up until 2007, investors assumed that Europe’s financial integration meant that all of the union’s government bonds were risk-free (Exhibit 4). They should have known better. European Union treaties explicitly forbade bailouts of sovereigns. Plus, the union’s fiscal rules quickly proved to be meaningless: In the early 2000s, several countries violated the 3% deficit limits and got no punishment for it.
Banks, of all investors, should have been forced to be more prudent. The ECB bears part of the blame, by discouraging financial institutions from distinguishing between sovereign bonds of different countries and initially accepting all EMU debt as collateral of identical quality. The European Banking Authority did not include sovereign haircuts in the stress tests up until 2010. Before the crisis, a stronger regulator would have forced banks to shore up more capital, in a market environment where it was still possible to do so. Once in the crisis, marking-to-market just feeds the bank run.
Current Situation and Solutions
Because fiscal deficit is the (mis)diagnosed disease, austerity is assumed to be the cure. The European Commission, the IMF, and the ECB—better known as “the troika”—have demanded drastic reductions in public deficits from the countries that have received bailouts: Greece, Ireland, and Portugal. Spain and Italy have gone on pre-emptive diets. European economies, already on shaky footing, are now certain to suffer deep recessions in 2012.