Sunday, September 18, 2011

The European Debt Crisis

An excellent post by Jeffry Frieden, Professor of International Peace at Harvard University, in Econbrowser, yesterday: “Europe’s Lehman Moment”.

Frieden explains that “Europe is in the midst of its variant of the great debt crisis that hit the United States in 2008. Fears abound that if things go wrong, the continent will face its own “Lehman moment” – a recurrence of the sheer panic that hit American and world markets after the collapse of Lehman Brothers in October 2008.”


“most of the public discussions have been highly misleading. In Northern Europe, and especially in Germany, the tone has been one of outraged indignation. The high moral tone is misplaced. Certainly many Southern European banks and households, and the Greek government, borrowed irresponsibly; but German and other Northern European banks and investors lent just as irresponsibly. It’s not clear that there’s any real ethical distance between irresponsible borrowers and irresponsible lenders.

And most Northern Europeans also seem to believe that the bailouts have gone to lazy Southern Europeans. In fact, their purpose has been to shore up the fragile Northern European financial systems. German banks are among the weakest in Europe; some of them (especially the state-owned landesbanks) are effectively bankrupt. If they were forced to mark down their Southern European debt, they might well collapse in a heap, and the European financial system could grind to a halt.”

“In Europe as in America (in 2008, JJR), the real question is how the costs of this devastating debt crisis will be distributed. Who will pay – creditors or debtors? Taxpayers or government employees? German or Greeks? More realistically, what combination of sacrifices will be politically tenable, both across countries and within countries. The aftermath of every debt crisis sinks into conflict over who will bear the burden of adjustment to the new reality.”

Europe’s experience, however, differs from that of America’s because of the existence of the euro. While the United States went on a consumption spree financed by borrowing trillions of dollars from abroad, much of it going to the housing’s market, in Europe the ECB’s interest rates at “Northern” relatively low levels have been made available – due to the euro – to rapidly growing countries in Southern Europe that had previously had high interest rates, reflecting both their higher inflation rates and their past exchange rate risks.

It followed that for a decade, a group of countries on the edge of the Euro zone borrowed massively from Northern European banks and investors. In Spain, Portugal, and Ireland, most of the borrowed money flooded into the overheated housing market, while in Greece, it helped finance a continual budget deficit and a consumption boom.

This, I would add, even though Frieden does not mention the point, is a classical case of an artificially distorted price (here the “Northern euro interest rates” offered, due to the euro and the single monetary policy, to the more inflationary and more risky Southern borrowers that should have paid inflation and risk premiums) generating a massive misallocation of resources, and specifically a boom in borrowing that reached unsustainable levels. As in the U.S. case, the responsibility of the lenders is a major one: they made huge profits in providing excess finance to the South, just as the mortgage lenders in the U.S. were offered an excess supply incentive by the governmental regulations subsidizing housing finance.

Frieden rightly concludes that the very solvency of major European financial systems is at stake and that “this – not some abstract desire to extend a hand to the Greek and Portuguese people, or to save the euro – has been the principal reason for Europe’s ongoing debt bailout.”

But until now, these bailouts have not been enough:

“It seems clear that the Greek and Portuguese austerity measures will not be sufficient to allow the countries to service their debts; Spain seems on the verge of a similar slide into default; and even Italy is now at risk of going the way of the other debtors. Some or all of these debts will have to be restructured, the interest rates reduced and maturities extended. If not, there will be a wave of defaults whose reverberations will rival those of Lehman failure.”

What Frieden does not contemplate, however, is that the situation is made much worse by the existence of the euro, and the absence of a central government in Europe. The euro has destroyed, over a decade of existence, the competitiveness of the Southern economies that benefited mostly to German exports. It follows that the austerity policies intended to reduce the indebtedness of the South are applied to enfeebled economies, thus pushing them further towards contraction and default. Today, the U.S. economy is still paying the price of the credit bubble’s burst. But in Europe the price will be much higher if the Southern economies are not allowed to regain competitiveness through an exchange rate depreciation that would purge it from the large costs differentials relative to the rest of the world in general (due to euro overvaluation) an to the Northern ones within the euro zone, accumulated over a decade of euro membership. And that means both a euro depreciation, and, on top of it, specific national currency depreciations that imply a return to national currencies.

The euro zone is thus facing a worse challenge than the one to which the U.S. were confronted in the 2008 debt crisis, because not only the sharing of losses is at stake, but simultaneously a radical reform of the monetary constitution is required. While the U.S. economy if following a slow, uncertain path back to recovery four years after the crisis, the recession could be much worse and extend for a longer period in Europe because of the difficulty involved in accepting to acknowledge the reality of the euro’s failure, and of the responsibility of the single currency in the current crisis. What is required is nothing less than a reversal of the monetary empire-building of the last few decades. And I understand that this is a rather hard truth to swallow for the euro zone elites.

The whole post is well worth reading here .

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