The euro crisis is back with a vengeance. This isn't actually surprising, as the way to solve it has been distinctly dubious. At the heart, there was a trade-off. The ECB would, when asked, buy unlimited quantities of bonds (via its OMT program, or "Outright Monetary Transactions") from countries in trouble, if the latter ascribed to the policies du rigeur, that means, strict austerity and economic reforms.
So far, there wasn't a need for the ECB to activate the OMT program, as there was no formal request from any country. More importantly, just announcing the OMT program was enough to douse the flames of panic in the peripheral bond markets, just as we always argued it would.
Adding to the calm was the fact that, most countries more or less adhered to the 'virtual' terms of the OMT program, or the diktat from Brussels (or Berlin), enforcing austerity and economic reforms on the periphery. But there are two problems with that:
- Austerity doesn't work
- Voters see it doesn't work, and are deserting in droves, witness the Italian elections
Austerity doesn't work
It isn't much of a mystery why austerity isn't working under the present eurozone economic conditions :
- There is little to no further offsetting monetary easing possible with interest rates already rock bottom
- Peripheral countries cannot devalue as they don't have their own currency, in fact, the euro has tended to strengthen
- All countries in the eurozone are pursuing austerity to various degrees, reinforcing the negative effects on one another
Austerity isn't even working outside the eurozone, like the UK, which at least has the benefit of being master of its own currency and monetary policy, and can embark on a monetary easing that has bought up the equivalent of 25% of GDP of its own sovereign debt, and substantially lowered the external value of its currency in the process.
It is no surprise, therefore, that even the International Monetary Fund, which had a near iron clad habit of demanding austerity in every financial crisis where it was called to help, had to admit that the multipliers from fiscal policy are about three times larger than previously assumed. Here is the Wall Street Journal summing it up:
In "Growth Forecast Errors and Fiscal Multipliers," Messrs. Blanchard and Leigh calculate IMF and European economists underestimated the euro-for-euro effect of cutting government budgets. While economists expected that cutting a euro from the budget would cost around 50 cents in lost growth, the actual impact was more like 1.50 per euro.
The results of this are rather dramatic. Martin Wolf reminds us in the Financial times of the expectations in 2010:
The G20 communiqué was specific: "Advanced economies have committed to fiscal plans that will at least halve deficits by 2013 and stabilise or reduce government debt-to-GDP ratios by 2016."
Not only are these expectations laughable, many of the advocates of austerity completely misdiagnosed the bond market crisis that led Greece, Ireland and Portugal to ask for a bailout, and then the steeply rising bond yields of Spanish and Italian sovereign bonds that led Mario Draghi, the ECB president, to "do whatever it takes," that is, the OMT program.
Advocates interpreted these crisis as a sign that the countries weren't embarking on enough austerity and were losing the confidence of the markets as a result. It's really difficult to overemphasize the size and consequence of this policy blunder, but it's on a par with the disastrous policy reaction in the aftermath of the 1929 stock market crash that turned a financial crisis into an economic depression.
Something similar is happening in the eurozone periphery right now. Three elements are important here:
- The exploding bond yields weren't the result of insufficient austerity but of insufficient ECB action
- Austerity has made matters far worse, not better
- The disastrous results have undermined the political platform for what's really necessary; economic reforms
Exploding bond yields
If there was any doubt that the self-reinforcing bond yield rise (in economic terms, the 'multiple equilibrium' problem) was the result of a lack of lender of last resort, the dramatic impact of the mere announcement of the OMT program (Draghi's concretization of "I'll do whatever it takes"), should have been enough to convince anybody.
The ECB didn't actually do anything. It merely announced the OMT program, which promised to purchase in whatever quantities necessary bonds (on secondary markets) from countries that had requested assistance and signed up to the conditions. This produced a dramatic fall in Spanish and Italian bond yields, which at that time were on the verge of spiraling out of control.
The fall in Spanish and Italian bond yields weren't produced by any improvement in their budgetary situations (quite the contrary, as it happens), they were the result of a mere announcement of the ECB of potentially unlimited assistance, effectively taking up the role of lender of last resort. We have, for years, predicted exactly this result.
This wasn't exactly rocket science either, if you're familiar with the mechanics. As the great Paul de Grauwe, Belgian economist at the London School of Economics already explained in 2010 when he compared the UK and Spain, which back then had similar budgetary situations (in fact, the UK was considerably worse), the UK could borrow at record low interest rates while Spanish yields were several times higher, see figure below.
It was really extraordinarily simple to explain this difference; the UK borrows in its own currency, while Spain borrows in euros, in essence a foreign currency. The UK can always pay back its debt, as it can always issue currency in exchange for bonds, while Spain can't do any of that, Spain didn't have a lender of last resort.
As de Grauwe has explained, it's the lack of a lender of last resort that set off the bond market crisis in these countries. If you're still not convinced of that, look at Japan. Its public deficits and debts are far worse than any euro member country (only Greece comes close), it as a public debt/GDP ratio well over 200%, yet its bond yields are one of the lowest in the world.
Or just look at the following graph (from Krugman), which sets public debt (horizontal axis) against bond yields (vertical axis) of eurozone countries against non-eurozone developed countries:
(click to enlarge)
The mechanics of a bond market crisis when countries do not issue their own currency isn't that complex either. Sellers of Spanish bonds get euros, which they can invest anywhere in the euro area without incurring any currency risk. In fact, they are likely to do that as they sold the Spanish bonds for a reason.
That is, the euros leave Spain, producing an automatic tightening of the monetary situation in the midst of a crisis, a self-reinforcing mechanism, as higher bond yields and a tighter monetary situation worsen the crisis, reduce confidence further and provoke further capital flight. We're not even mentioning the feedback loop between bond yields and the finances of Spanish banks here. Before you know it, yields have spiraled out of control. It was exactly this that provoked Draghi to promise to do whatever it takes.
Compare this with the UK, a country in control of its own currency. Sellers of UK bonds get pounds. If they don't want other UK assets (like bank accounts, shares, whatever), they'll sell these pounds on the forex markets. The buyers of these pounds will invest in UK assets, that is, these pounds never leave the UK.
Not only is there no monetary tightening, this selling doesn't trigger any self-reinforcing feedback loop like in Spain. What's more, it's quite likely that the pound will fall on the forex markets, producing an offsetting monetary easing and a boost to competitiveness (this is indeed exactly what happened). We told you it ain't rocket science.
Austerity and growth
The crisis seemed to be under control with the ECB finally cloaking itself with the mantel of lender of last resort. However, the mindless insistence on austerity in Berlin and Brussels has precipitated and prolonged what can only be called an economic depression in the eurozone periphery.
In the midst of the worst economic crisis in decades, these countries have to embark on spending cutbacks and tax hikes without any way these can be offset by monetary easing or a lower currency. The result is rather predictable, especially since even the center countries embark on austerity as well.
All countries cutting back spending together will reinforce the effects, as there is no offsetting increase in export demand (the eurozone countries heavily trade with each other). Here is a pretty conclusive graph plotting the relation between the two (austerity here is measured as estimates of real policy changes by the IMF):
But even today, when even the IMF is starting to grasp the disastrous consequences of all this, Berlin and Brussels don't want to know. What's more, austerity, even on its own terms (improving public finances) isn't delivering. The prolonged economic depression that it causes slashes tax receipts (public deficits stay high) and GDP (public debt/GDP is rising rapidly).
Those proverbial green shoots of economic recovery, predicted since 2010 as being just around the corner, keep on being delayed and in the meantime, millions of people in the eurozone periphery have fallen on really hard times without much perspective of any improvement anytime soon. This is an explosive situation.
Austerity undermines platform for reform
Never waste a good crisis, we argued some time ago. The eurozone crisis should have been used to introduce market-friendly reforms in many of the eurozone countries. It was clear to most of the public that something had to be done, and many of the peripheral countries suffer from a competitiveness problem (which is the real problem), and are in urgent need for a doses of market liberalization.
These reforms are often difficult because the benefits of certain regulations are concentrated (often on groups with strong lobby power), while the costs are diffuse and widespread, so in order to improve the economy this way politicians often have to take on well-established interests while the benefits of the measures will not emerge for some time and are difficult to notice at first. Only a deep economic crisis can produce the political courage to embark on these kinds of reform, but that political capital has been wasted on austerity.
Although many countries have indeed embarked on some reform, all that emphasis on austerity and the disastrous results that has produced has toxified the political discourse and turned the population away from necessary measures. We've argued for years that the policy mix was all wrong, with too much emphasis on austerity and too little on economic reform. It should have been the other way around.
Euro crisis, solutions, and electorate
By focusing on the wrong things, an economic crisis of unprecedented proportions has been created, and much political capital has been wasted. Political capital that could have been used to take on vested interests that are holding up liberalizing eurozone countries, restoring economic dynamism and competitiveness.
But perhaps even more important, the eurocrisis can only be solved by increasing European economic integration and greater cooperation (like some form of debt mutualization, strong fiscal rules and common financial policies, making up for the design failures of the present eurozone concept),
However, anything remotely related to deeper European integration and cooperation is met with ever smaller political support. The present path of piecemeal reform is probably the most that can be achieved under the circumstances, but these circumstances are not a constant. They can change dramatically very fast. What would happen to the euro when Beppe Grillo wins the coming Italian elections, or Syriza the next Greek ones.
What happens if the electorate in the periphery turns away from the euro and towards politicians who argue that leaving the euro is better than the present depression prolonging policies?
It will be clear by now (if it wasn't already) that the euro crisis is still far from resolved..