Some thoughts on the nature of the European crisis, which I’m writing up for an opinion piece. Comments much appreciated
Just when it seemed that the world was recovering from the global financial crisis, a new crisis has emerged in Europe. This crisis is being analyzed in terms quite different from, and even inconsistent with, the first round of crisis originating in US mortgage markets. Yet, in reality, this is simply a continuation of the same crisis, with the same essential cause. The only important difference is that there are fewer policy options to respond this time around.
Two main stories have been told about the European crisis to suggest that it is fundamentally different from the original crisis centred in the US. Both stories have an element of truth, but neither gets to the main point.
The first story is one of government profligacy and ‘sovereign risk’. The idea that the European crisis is the consequence of excessive public spending gains some credence from the fact that the crisis originated in Greece, where public debt, hidden by a variety of expedients, has been out of control for years.
This interpretation has been encouraged by ratings agencies, eager to resume their role as guardians of fiscal rectitude after the fiasco of AAA-rated CDOs based on subprime mortgages. It has also been welcomed by opponents of Keynesian fiscal policies, eager to restore the ideological dominance of free-market liberalism.
But Greece is not typical. Most of the countries now threatened by the crisis were, or appeared to be, in reasonably good fiscal shape before the global financial crisis. The Maastricht criteria for admission to the euro required member countries to reduce public debt to 60 per cent of GDP, and budget deficits to 3 per cent of GDP. While these criteria were breached in the aftermath of the the 2000-01 recession, they ensured a degree of fiscal discipline in most eurozone countries that seemed adequate to maintain solvency in the face of plausible shocks.
Greece and to some extent Italy were exceptions. But even in the Greek case, the ability to dodge the Maastricht rules was largely due to creative financing options provided by institutions such as Goldman Sachs. The fact that Goldman Sachs was simultaneously creating ways to bet that Greece would be unable to repay the debt should come as no surprise.
The second story about the crisis is favored by critics of the euro, notably including Paul Krugman. In this story, the central problem is a current-account crisis, for which the appropriate remedy is devaluation. But because they share a common currency, Spain and Greece cannot devalue against Germany and France. Hence, it is argued, they must either undergo a painful deflation or leave the eurozone. The underlying problem, in this analysis, is that Europe is not, in the jargon of international monetary economics, an optimal currency area.
But problems with non-optimal currency areas emerge primarily when one country would benefit from an expansionary monetary policy, while circumstances elsewhere require contraction. In the current crisis, the entire eurozone needs a more expansionary monetary policy and an end to the massive overvaluation of the euro relative to purchasing power parity. This has happened to some extent, but the European Central Bank is still more concerned with the shadow of inflation.
In fact, the central cause of the crisis this time is the same as in the earlier round of crisis. Banks and other financial institutions lent too much money without worrying about the capacity of the borrowers to pay it back. Some of this money went to profligate governments, but most, as in the first round of crisis, went to stimulate booming real estate markets in Spain, Ireland, Iceland and elsewhere.
The main problem for the governments in this countries have arisen because they have been forced to bail out their domestic banks. As the losses are too big to be managed by the governments in question, their own solvency is called into question. This in turn creates problems for the French and German banks which have lent heavily both to governments and to banks in the crisis countries. The French and German governments have therefore chosen to bail their banks out indirectly, by assisting the governments faced with immediate crisis. The alternative would be to force those governments to default, then undertake a direct bailout of the banking system.
It remains to be seen whether the eurozone governments can manage this crisis, or whether the whole euro project will collapse. Whatever the outcome, the main policy lesson is that light-handed regulation of a ‘too big to fail’ financial sector is a recipe for disaster.