The European Tragedy

The inevitable result of the hubris of political actors

By Stephen Davies

People are closely watching the slow-motion train wreck that is the crisis of the eurozone—that is, the economic travails of Greece, Spain, Ireland, Portugal, and Italy (known collectively as the PIIGS). The problem with much of the discussion in the United States is that both of the main camps are right about some things but wrong about others because neither fully grasps the real nature and cause of the crisis in Europe.

One view holds up the Europeans as a warning to the United States of the consequences of government profligacy. The problem, so the argument goes, is crushing sovereign debt brought about by excessive government spending over many years funded by borrowing rather than taxation. The rising yields on sovereign debt reflect that investors now realize the European governments are bankrupt and cannot be relied on to service their accumulated debt, much less repay it. As yields rise the burden of debt becomes greater until the only ways out are either default or fiscal stringency with a combination of tax increases and cuts in government spending to bring stability. This is also the view, it would appear, of the German finance ministry and much of the German public.

The contrary view is that the European crisis is indeed a warning to the United States—of the dreadful consequences of austerity. For this camp the experience shows the folly of responding to the financial crisis of 2007–08 with cuts in government spending and efforts at balancing the books. These efforts are self-defeating because they will aggravate the economic contraction and reduce government revenues while increasing spending (because of “automatic stabilizers” such as unemployment benefits), worsening the government’s finances. The correct response to the economic slowdown in Europe, therefore, is a Keynesian one of increasing government spending and widening deficits, at least in the short term, until the economy recovers.

Both sides are simultaneously right and wrong. The second side is correct that the underlying problem is not fiscal irresponsibility by governments (Greece is a significant exception to this). Ireland and Spain both had budget surpluses before 2007, while Italy’s finances were responsibly run for the last decade or more. In fact, the figures show that the supposedly responsible and austere Germans had finances and debt comparable to those of the countries now facing a crisis. Above all this side is correct to argue that major cuts in government spending in the PIIGS will not solve their underlying problems and may well make their problems worse in the short run. Greece again is an exception; the levels of spending there are simply unsustainable on any reckoning.

However, this side is wrong to argue that fiscal stringency is the real cause of the problems of the eurozone and that things would be much better if this policy were abandoned or reversed. A common theme is that the relatively better performance of the U.S. economy reflects the lesser degree of austerity and fiscal correction. Europe, in other words, shows what not to do in fiscal policy. The problem with this is, first, that there simply hasn’t been that much austerity in Europe yet—most of the cuts have yet to take place. There have indeed been government cutbacks, most notably in Ireland, but not that much. Looking at the U.S. government sector as a whole, one sees that the extent of cutbacks there and in Europe is pretty much the same. So budget cuts cannot explain the disastrous economic situation in, for example, Spain.

Meanwhile taxes have gone up or are due to go up considerably in the United Kingdom, Ireland, Spain, Italy, and Portugal. If austerity is intended to lighten the burden of government, tax increases are counterproductive.

What Not To Do

Moreover, it does not follow that the correct policy response now is to simply increase spending. In many European countries this would actually make things worse. The reason is that one of the underlying real problems is structural rigidity in the economies of many of those countries brought about by massive overregulation, particularly of labor markets. The package of measures labeled “austerity” includes many supply-side reforms that are vital for the economic future of countries such as Spain and Italy. Simply raising government spending without putting through these measures would raise costs throughout these economies—which is their basic problem, as we shall see.

Even more important, a fiscal stimulus would not deal with the underlying economic problem either in Europe or the United States: the massive distortion of economic activity, asset values, and relative prices brought about by a decade-long boom fueled by an unprecedented growth of credit. In much of Europe this problem is much worse because of an extra element—the way the credit boom of the “noughties” interacted with and exacerbated the structural and design faults of the euro. The problems caused by the euro are aggravated by the policy of central banks over the last decade.

The euro was a bad idea from the start. When it was launched a galaxy of eminent economists warned that it was a bad idea with the potential to be a real disaster. Most also predicted that it would not last, and that the longer it lasted the worse the ultimate debacle would be. This view was not confined to any one economic school or part of the political spectrum: Milton Friedman and Paul Krugman both warned against the adoption of the euro in almost identical terms.

Suboptimal Currency Area

The reason for this unusual near-unanimity is the existence of a generally shared body of economic theory—the optimal single currency area theory. The theory was formulated in the 1960s in a series of classic papers. It says that it makes sense for a population living in a geographical area to have a common single currency only if certain conditions are met. One was for the economy of the area to be homogeneous so that unexpected events and processes (“shocks” in the economic parlance) did not affect different parts of the area in different ways. In reality this almost never applies, so at least one of two other factors has to exist. The first is an integrated labor market with free movement of workers from areas of unemployment to areas of high demand for labor. The second is a central government that can move spending from one part of the currency area to another through tax and spending policy.

Neither of these conditions existed in Europe; language barriers and social obstacles to mobility prevented an integrated labor market from emerging. The euro was a currency without a country or a government in any meaningful sense. The U.K. government made several alternative suggestions at the time, including allowing all European currencies to be legal tender in all member states (so they would effectively compete with one another) and having the euro as a common currency that was legal tender throughout the European Union but alongside existing national currencies (so it would not be a single currency). Both were rejected—because they were not compatible with the political project that was the real reason for creating the euro.

Several economists not only warned against adopting the euro on general grounds, they predicted specific problems. Some argued that one result would be to severely raise labor costs in parts of the eurozone that had rigid economies with controlled markets relative to areas that had more open and flexible labor markets. The consequence would ultimately be higher unemployment in those areas, with a consequent incentive to have inflation in order to remove the faulty relative pricing of labor. Another common prediction was that a common interest rate over such a varied set of economies would lead to inflationary bubbles in some areas. This is almost exactly what has happened.

When the euro was set up, the relative prices of goods and services of all kinds in Europe (including wages) broadly reflected the underlying productivity in the different countries. This was mediated through the exchange rates between the different national currencies. So if you took into account the exchange rate between deutschmarks and pesetas, for example, you had a price level in Spain that was about half that in Germany; this reflected that German workers were almost twice as productive as Spanish ones. The expectation was that the performance of the different countries would converge once they had a single currency, so that Italian and Greek workers would become as productive as German workers. In fact, things went in exactly the opposite direction.

In Germany labor costs actually went down slightly while prices remained broadly stable. By contrast, labor costs and prices in peripheral countries doubled, partly because of the rigidities in their labor markets and because there was no longer an exchange-rate adjustment mechanism. This meant that by 2005–06 the price level in the peripheral countries was much higher than it should have been. Essentially they had been paying themselves like Germans or Finns without having the productivity to support or justify this. The result was that they became utterly uncompetitive while the prices of assets in those countries became severely overvalued.

The lack of competitiveness meant that the peripheral countries ran huge balance-of-payment deficits with Germany. This in itself is not a problem—the payments account shortfall is exactly matched by a capital account surplus, a flow of capital from the “creditor” area to the “debtor” one. This was the point at which the credit boom of the noughties interacted with the euro with disastrous results. Large amounts of money flowed out of banks in core countries such as Germany and the Netherlands, pumped up enormous real estate bubbles in places such as Spain and Ireland, and funded public spending via the sale of government debt at artificially low yields in countries such as Greece and Portugal. The Irish and Spanish governments were helpless in the face of these bubbles because they could no longer raise interest rates.

Then in 2007 the global credit bubble burst. At this point the private credit flows that had been sustaining consumption and investment in the uncompetitive peripheral economies suddenly stopped. In the United States a similar situation faced Arizona and Nevada but this was compensated for by a decline in prices, a movement of people, and flows of federal government spending. Nothing like this was possible in Europe. Instead peripheral countries faced a sudden wrenching readjustment. If they had still had their own currencies much of this could have been borne by a depreciating exchange rate, but this was no longer an option. Another option would have been to allow local banks to go bust and allow asset prices to fall to realistic levels. However, this would also have exposed the insolvency of much of the European banking system, and politicians throughout Europe balked.

So what has happened is this: The “creditor” countries such as Germany are insisting that the adjustment in relative prices between eurozone core and periphery take place entirely in the “debtor” countries, which therefore face the prospect of years of deflation. Politicians throughout Europe refuse to let asset prices fall to real market levels because of fears for the banking system. The result is the crisis we now see, which is not caused by austerity. Such austerity as there is, is a consequence of the crisis not a cause. On the other hand, while there is a real need to reduce government spending in several of the PIIGS in the medium term, doing it now is not going to help with the crisis, which comes from a hopeless lack of competitiveness that is no longer compensated for by private flows of capital, which have now suddenly stopped. The other problem is systematic overvaluation of assets in these countries, which can only be dealt with by revaluing them.

So what could resolve this crisis? One solution would be to create what the eurozone lacks—a federal government. Besides other objections, this is politically impossible, not least because it would mean the German taxpayer perpetually funding other countries via transfers. Another solution would be to have much higher inflation in the eurozone and in particular to have higher inflation in Germany than in the periphery. (This is the solution Paul Krugman advocates.) Again, this is politically impossible, quite apart from being undesirable for other reasons.

A third solution would be to dismantle the euro either by the PIIGS leaving the zone and defaulting or by Germany leaving along with other core countries. (This would be preferable but is less likely.) This move would have dramatic and severe effects but would still be better than keeping the show going since that would condemn most of Europe to prolonged stagnation.

The most radical solution—as well as the least bad—would be to allow banks throughout the eurozone to be wound up while allowing assets everywhere to reach realistic relative levels. This would mean a massive, albeit temporary, shock in much of the eurozone, but after that a recovery could happen.

The alternative to a single government that would enable the euro to survive would be to keep a single currency but scrap the central bank and move to a free-banking system throughout Europe. Nobody with any say in the matter even imagines this solution, though.

The problems facing Europe now are a tragedy in the strict original meaning of the word: the inevitable result of the hubris of political actors who thought they could ignore economic wisdom. The nemesis they have brought on themselves can have no good result and is inescapable.