It is conventionally assumed that the euro zone crisis arose because Club-Med governments have been too profligate. If only they had been as cautious as northern European countries, the argument runs, they would have retained their export competitiveness. A recent carefully researched paper, popularly known as the RMF Report and compiled by academics at the University of London, SOAS, shows this view to be entirely without foundation, professor George Irvin writes in a recent blog post.
“In effect, we face three possible euro zone scenarios.”
“Inter alia, the Report investigates the relationship between Club-Med current account (external) deficits, government deficits and the countries’ total stock of debt. Club-Med governments have not been wildly profligate: Greece, Spain and Portugal all have government deficits lower than the UK, and with the exception of Greece, their net public debt-GDP ratios are running at 60% or less,” professor Irvin points out.
The key point, however, is that much of Club-Med debt is held by the private sector: nearly 90% of all debt in Spain, 85% in Portugal and over 50% in Greece.
Moreover, less than half of all Spanish debt has been contracted abroad (in contrast to Portugal and Spain where the overseas proportion is much higher).
Secondly, a far higher proportion of private debt is relatively short-term, meaning it will need to be refinanced sooner than much of the public debt.
In Spain, private profligacy has mainly to do with a sharp rise in private investment resulting from the housing boom.
In Portugal and Greece, by contrast, private investment growth was much less important; in essence, private savings have contracted to finance rising consumer demand. Nor is there anything surprising in these patterns—until 2008, the UK experienced both a private housing boom and a private savings collapse to sustain consumer demand.
But as the case of Ireland demonstrates, severe cuts reduce aggregate demand and induce further economic contraction, thus lowering government revenue faster than expenditure.
The main argument used by euro zone deficit hawks—since devaluation is no longer possible—is that public cuts will restore the competitiveness of Club-Med countries.
Once again, the problem is that where everyone practices fiscal retrenchment, aggregate demand throughout the euro zone contracts. Because so much of the euro zone’s trade takes place within it (ie, is ‘intra-trade’), what may benefit one country taken singly cannot benefit all simultaneously.
Competitive wage-cutting has much the same effect as beggar-thy-neighbor devaluation did in the 1930s. And with the poor performance of the US economy increasing competitive pressures in the rest of the world, Club-Med countries cannot easily increase net exports outside the euro zone.
In effect, we face three possible euro zone scenarios.
The first is a decade of very low growth and high unemployment all ’round. The danger is that in a decade’s time, Europeans will be so thoroughly disillusioned with the European project that it will fall apart politically.
The second scenario is default—whether partial or full. A partial default or debt restructuring exercise will, minimally, involve losses for creditor banks in Germany and France and necessitate further bailouts. Maximally, debtor-led full default would lead some Club-Med countries to leave the euro zone, entailing the possible demise of the single currency.
Alternatively, growing German resistance to ‘bailouts’ and a serious falling out with Paris over its export-led growth model might lead Germany to quit the euro and revert to its beloved DM.
The third scenario is fundamental reform of the euro zone: the establishment of a genuine European Treasury with a substantial budget and fiscal powers and reform of the ECB, starting with the emission of federal euro-bonds.
It is becoming increasingly clear that if the euro is to be saved, this is the path Europeans will need to adopt.
By contrast, universal fiscal retrenchment enforced by levying fines on ‘profligate countries’ fails to address the real issues.
But will European political leaders listen?
By George Irvin
Related by the Econotwist’s:
- Who’s Hiding In The Sherwood Forrest?
- Wild-West Capitalism (Don’t Blame The Baby Boomers)
- Socialism For The Rich – Capitalism For The Poor?
- TIMELINE-Euro zone struggles with debt (reuters.com)
- How to run the euro: Fixing Europe’s single currency (economist.com)
- Two Economies With a Common Cold (online.wsj.com)
- E.U. Risks Making a Bad Situation Worse (nytimes.com)
- Are Eurozone bond investors overreacting? (cnn.com)
- Euro-Zone Countries Should Be Ready to Cut Debt, ECB Says (dailyfinance.com)