The acute phase of the global financial crisis was short, lasting from the collapse of Lehman Brothers on September 15, 2008, to the day the Dow hit a trough on March 9, 2009. But, like a violent heart attack, the interruption of credit—the economy’s life blood—lasted long enough to permanently damage the industrial countries at the center of the crisis. The damage took three main forms, each of which poses a major risk to the stability of the global economy today: high and rising public debts, fragile banks, and a huge liquidity overhang that will need to be eventually withdrawn.
The Euro crisis, which strikes at the heart of the world’s largest trading block, contains only two of the three fateful elements—problematic sovereign debt in Greece and other vulnerable countries, and fragile European banks, which hold a large part of that debt. Monetary policy in the Euro area and in industrialized countries more generally, remains expansionary and, if anything, the crisis pushes back the time when tightening can occur safely. As a result of the problems in Europe, the world economy has become even more exposed to the three mega-vulnerabilities.
The Deeper Causes of the Euro Crisis
While ballooning public debt may be the clearest manifestation of the Euro crisis, its roots go much deeper—to the secular loss of competitiveness that has been associated with euro adoption in countries including Greece, Ireland, Italy, Portugal, and Spain (GIIPS).
The sequence of events that led to the secular loss of competitiveness is depressingly similar among the GIIPS countries:
- The adoption of the euro was accompanied by a large fall in interest rates and a surge in confidence as institutions and incomes expected to converge to those of Europe’s northern core economies.
- Domestic demand surged, bidding up the price of non-tradables relative to tradables and of wages relative to productivity.
- Growth accelerated, driven by domestic services, construction, and an expanding government, while exports stagnated as a share of GDP, and imports and the current account deficit soared amid abundant foreign capital.
- The result was that indebtedness—public, private, or both—surged.
Meanwhile, following reunification, Germany was undergoing a historic transformation to become the world’s largest exporter, and all of Europe’s northern economies reaped the benefits of the expanded market and decreased competition offered by the GIIPS. But the growth model in the GIIPS was inherently flawed: eventually, the domestic demand bubble burst. Now, governments must shrink, and high costs preempt any efforts to resort to export markets for growth. Countries are stuck in a low growth equilibrium—and potential domestic battles over the limited resources will only accelerate the onset of crisis.
This basic story fits the Euro area periphery, but the details vary within each country. For example, Italy and Portugal saw growth peak very early on, while Greece, Ireland, and Spain enjoyed decade-long booms followed by busts during the global crisis. The single monetary policy of the euro was too loose for the countries who enjoyed the biggest boom and accentuated their inflation and competitiveness loss, while it was too tight for larger economies like Germany, depressing domestic demand there and widening its unit labor cost advantage vis-à-vis the GIIPS.
Effects on Other Countries
A similar and even more virulent strain of the euro disease has already hit countries that are not part of the Euro area but that pegged their currencies to the euro many years ago, beginning with Latvia, Estonia, and Lithuania. Other recent EU joiners, such as Hungary and Romania, retain flexible exchange rates, but are constrained by large foreign currency debts in their ability to devalue. As a consequence, they too suffer from the euro disease.
The rest of the world will feel the effects of the Euro crisis via six important channels: first, the crisis will lower growth in Europe, a market toward which about a quarter of world exports are destined. Second, it will lead to further euro depreciation, sharply reducing profits from exports to Europe while also increasing competition from the continent. Third, by keeping policy rates low in Europe and potentially other industrialized countries as well, the crisis may encourage capital surges into emerging markets. Fourth, the crisis will add greatly to the volatility of financial markets and will lead to bouts of risk-aversion. Fifth, and potentially most important, the crisis could deal a mortal blow to many fragile financial institutions. Sixth, a failure to contain the crisis will raise the alarm on sovereign debt in other industrial countries and, inevitably, in any exposed emerging market.
Policy in the Euro Area
The disastrous recession in Argentina, which broke its convertibility law, devalued, and defaulted in 2001-2002, and Latvia, which chose instead to adjust through fiscal consolidation and wage cuts, show that there are no easy options for dealing with a large loss of competitiveness combined with high indebtedness denominated in a foreign currency. To be sure, the euro is no longer a foreign currency to Greece, but it would become so if Greece chooses to leave the Euro area to regain its competitiveness, which may one day prove to be Greece’s best viable option for dealing with the crisis.
Unless the nine most affected countries (the GIIPS, Estonia, Latvia, Lithuania, and Bulgaria) are prepared to break from the euro, they must resort to a well-known cocktail of fiscal consolidation designed to stabilize their debt-to-GDP ratio, and structural reforms designed to boost productivity, competitiveness, and potential growth. Fiscal consolidation can by itself help reduce domestic demand and moderate wages, but relying on it alone—without structural reforms—to restore competitiveness could require as many years of painful austerity as have elapsed since the start of the euro boom.
Even in the best of circumstances—where the adjustment is politically feasible and financing is stable—reestablishing competitiveness, fiscal sustainability, and a more balanced growth model will take several years. As a rough guide, countries have to engineer a fiscal adjustment of 5 to 12 percent of GDP, and claw back a unit labor cost disadvantage of between 15 and 30 percent, though the precise figures vary by country. Bearing in mind that the imbalances have built up over a decade or longer, at least three or four years will be required to affect the necessary reforms and, during that period, domestic demand will decline or, at best, stagnate.
Even with the recent support packages for Greece and other vulnerable countries, these adjustments will be deflationary. Nominal GDP in the adjusting countries could decline, compounding the challenge of stabilizing the debt-to-GDP ratio, unless the deflationary effect is offset by a combination of the following: a continued recovery of world trade; expansionary monetary policy; a lower euro; and expanding domestic demand in Europe’s surplus countries, including Germany and the Netherlands, which are likely to benefit most from a lower euro. Since European countries trade predominantly with each other and the least competitive countries tend to be most oriented toward other European markets, most of the competitiveness and aggregate demand realignment needs to occur within Europe.
Response in the Rest of the World
Most importantly, this crisis shows countries outside the Euro area that they need to rely more on domestic demand and on the demand of emerging markets and be even more cautious when formulating macroeconomic policy. In addition, prospective euro joiners should take heed and delay entry until they have dealt with their lack of competitiveness. Based on the experience of the GIIPS, if and when they enter, they must discourage a flood of investment from going into non-tradable sectors and they must maintain large fiscal surpluses.
The Euro crisis experience has also reinforced the message that strictly pegged exchange rates, combined with open capital accounts and the ability to borrow abroad (as in the GIIPS and the Baltics), can be dangerous. Countries with flexible exchange rates or pegged exchange rates but tight capital controls have dealt with the dislocation caused by the Great Recession better.
Last but not least, the Euro crisis has exposed the limitations of regional mechanisms—even among countries with deep pockets—in dealing with financial crisis and underscored the vital role that a global lender of last resort, in the form of the IMF, can play. Not only can the institution bring more resources and broader expertise than would plausibly be available to a regional institution, but its distance from potentially divisive regional politics can represent a big asset.