The Great Misconception: Debt and the Euro Crisis


An unprecedented debt phobia struck both sides of the Atlantic during the past year, misguiding both economists and policy makers.   Although indebted countries are finding it harder staying afloat, debt is not the root of the crisis.  The statistical correlation that emerged after the great recession between the quantity of debt on a country’s balance sheet and the increased risk in its financial markets pushed many observers to conclude erroneously that debt is the cause of the Euro crises.To better understand the relationship of debt and the crisis, the first figure below plots the debt to GDP ratio across the GIPS countries, France and Germany.  Two observations stand out.  First, Portugal and Spain had lower debt to gdp ratios than Germany before the Euro crisis began. Second, the debt to gdp ratios of all six countries increased to “unsustainable” levels after 2009, making it hard to conclude that it was debt that caused problems in some countries but not others.

The second figure is the deficit to gdp ratio across the same 6 countries.  Here too, the same observation stands out.  It was not until the end of the great recession that the GIPS countries’ fiscal deficits diverged from Germany’s.  Italy, for example, is the only EU country to run a primary surplus (fiscal balance gross of interest payments on public debt), yet most economists still insist that it is foolish spending that caused the crisis.

If not debt, then how?

Unfortunately, the Eurozone as setup was bound to fail from the beginning, not by debt but by imbalances and sudden stops.  This is what happened  during the Mexican crises of 1994 (among many others).   Moreover, a monetary union without its fiscal counterpart is also bound to fail (Read Sargent and Wallace’s “An Unpleasant Arithmetic of Monetary Policy”).  Have we not learned anything form the Great Depression and the gold standard? Yet any true fiscal union (the Brussels Agreement is not a union, it is an agreement to commit to the Maastricht Treaty) today seems undemocratic and will not be welcomed by all EU countries.

It is useful here to identify the source of the problem and separate it from how the problem became a crises, as both are different failing mechanisms of the Euro system.

The problem:

Consider two neighboring countries with two currencies, one expensive and another cheap.  When a monetary union is formed with a single common currency, prices and wages across both countries have to converge.   While the cheaper country becomes more expensive, its competitiveness will decrease and consumers will shift their purchases to the more expensive country (which happens to become cheaper).  Growth in the poorer country stalls, and its residents will have to rely on debt to maintain a similar quality of life to that before the Union.  Meanwhile on the other side of the border, exports boom, the economy grows and the quality of life prospers.

This can be easily seen in the figure below.  In the turn of the decade, Germany was named “the old lady” of Europe.  Growth was stagnant, and Germany did not have many options to face its economic problems.  Then the Euro came along.  The expensive Deutschmark was replaced with a cheaper Euro and Germany became took over the center stage of exporting countries.  On the other hand, the rest of Europe was not as lucky.  Germany offered higher quality exports, a wider array of exports at a considerably reasonable price.  The account surplus in Germany increased dramatically, while the GIPS countries faced automatic account deficits.

Furthermore, the GIPS countries were now also competing with non-EU countries.  One simple example is Greece and Turkey.  Both countries had very similar structural economies.  Both countries rely heavily on services and tourism.  After Greece joined the EU, the cheap Drachma was replaced with a more expensive Euro.  This made Turkey the prime destination locally for tourism, as tourists could no longer afford a Greek vacations paid with Euros.  This same story applies to German carmakers and their competitors in Sweden and elsewhere in the non-EU Scandinavian countries.

The crisis:

How the problem became a crises can be summarized with the inability of governments to borrow money in there own currency.  After  the great recession in the US, investors and banks fled to safety and liquidity problems (solvency in the case of Greece) arose in the GIPS countries.  Facing financial threats and sudden stops of capital flows, governments did not have any tools to respond.  Unable to borrow or print money to recapitalize banks, the GIPS countries where facing self-fulfilling crises (De Grauwe).  Worried about default, investors rushed to pull out their money from these countries, causing borrowing costs to sky-rocket and make it ever harder to restructure and service their debts even more.

Meanwhile, all efforts to curtail the problem have been short of adequate.  Worse yet, they have made things worse.  The obsession with fiscal order unleashed numerous contractionary policies throughout the Eurozone and the US.  Debt to gdp is a ratio of two numbers but many economists seemingly forget the denominator.  Cut government spending programs and the debt to gdp ratio will increase as a first order effect.  Unfortunately, higher order effects also matter.   Investors will not take the headlines of a  recession during the crisis well, triggering a panic and increasing yields on debt even more.  With increasing unemployment and staggered wages gdp will fall eventually fall (anyone heard of the multiplier effect?), and potentially increase debt to finance basic consumption.  Other efforts have been minimal and did not do much except calm financial markets for a couple of days.

Any solutions?

Other proposals from economists have been declared DOA (dead on announcement).  Any proposal relying solely on productivity (productivity increase in the GIPS area) is unrealistic.  Let’s face it, Greece will never produce cars like Germany.  Proposals seeking expansionary/inflationary policy in Germany have the same fate of asking a vegan to eat deep fried pork, where obviously Merkel and the Bundesbank are the vegans.  Meanwhile, the ECB has been very clear at making sure that any bond buying programs besides the ones that have been already initiated are out of the question.  Anything inflationary policies are too, although we are currently flirting with deflation.  The remaining suggestions include the devaluation of the Euro and deflationary policies in the GIPS region to restore their competitiveness.  A devaluation of the Euro might help, but note that it is the internal spread of exchange rates that is the problem and not the price of the Euro itself.  Making the Euro cheaper will make German exports even cheaper to the rest of the world, while remaining countries that need help do not have much to offer.  As for deflationary policies in the GIPS region, it is unclear how struggling indebted countries are going to find deflation beneficial.  Policy makers should consider reading Irving Fisher’s debt-deflation theory of business cycles before planning any more “genius” plans.
The outlook seems dim and with the current fiscal outlook, no possibility of expansionary fiscal policy, and no intervention by the ECB 2012 is going to be a very interesting year for economists, although I wish I could say the same for the Greek.  I am very pessimistic about the next couple of months but I hope to be proven wrong.  Otherwise, I would need to apply for 27 visas instead of one to travel around the EU…

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