Headlines label the Euro crisis as one caused by sovereign debt. Unfortunately, the problems in the most affected countries—Greece, Ireland, Italy, Portugal, and Spain (GIIPS) and other smaller economies pegged to the euro, such as Latvia—are much more severe than just fiscal profligacy.
At its heart, the crisis was created by a misallocation of resources among and within countries and a loss of competitiveness that resulted from—and was in many cases concealed by—the economic boom associated with the adoption of the euro a decade ago. Today’s fiscal problems are in large part the consequence, rather than the cause, of these changes, a fact that policy makers must recognize in order to successfully resolve the crisis.
The Euro Boom
In February 1992, European leaders signed the Treaty on European Union (also known as the Maastricht Treaty), laying the foundation for monetary union and adoption of the euro. The agreement eventually bound the currencies and monetary policy of the signatories—which included all the GIIPS except Greece—to that of Germany, Europe’s largest and most stable economy, and to those of other successful economies in northern Europe.
Expecting that the stability and wealth of Europe’s northern members (EUN)—Austria, Belgium, France, Germany, and the Netherlands—would diffuse throughout its periphery and that the EUN’s stronger institutional and economic frameworks would prevail over those of the GIIPS, confidence in the GIIPS surged. After averaging inflation levels and public borrowing costs from 1980 to 1990 that are comparable to those of Ghana today, the GIIPS (excluding Greece) saw their inflation and interest rates converge with those of the EUN during the 1990s. Long-term government bond yield spreads of the GIIPS vis-à-vis the EUN, which indicate the perceived risk of lending to the GIIPS instead of the EUN, fell from 550 basis points in 1980–1990 to just 10 in 1999.
Widening External Imbalances
Low interest rates and improved confidence fueled a domestic demand surge partly financed by foreign lending. The GIIPS, especially Greece, Ireland, and Spain, saw an increase in domestic spending accompanied by deteriorating current account balances and rising private debt.
The demand surge drove up both prices and wages, particularly in service and non-tradable sectors, leading the price of non-tradables to rise relative to tradables and attracting even more investment in the former. From 1997 to 2007, the price of services in the GIIPS rose by an average annual rate of 1.5 percentage points more than that of goods, compared to a difference of 0.5 percentage points in the EUN. The GIIPS’ economies realigned away from manufacturing and industrial sectors and toward services and housing construction: 4 percentage points of GDP shifted from industry to financial services, real estate, and business from 1997 to 2007, compared to a shift of 2 percentage points in the EUN.
Over the same period, per capita employee compensation rose by an average annual rate of 5.9 percent in the GIIPS, considerably faster than the EUN’s average of 3.2 percent. These increases were not matched by improvements in productivity, particularly in the GIIPS, where labor productivity per employee grew by 1.3 percent per year, compared to 1.2 percent annual growth in the EUN. As a result, unit labor costs rose by 32 percent in the GIIPS from 1997 to 2007, compared to a 12 percent increase in the EUN. Underpinning these trends was a remarkable transformation of the German economy following the country’s unification, making it the world’s largest exporter.
The result was a dramatic decline in competitiveness in the GIIPS against other advanced countries. The loss was particularly severe relative to countries outside of the Euro area, which saw labor costs increase only moderately and whose labor costs in euros benefited from the euro’s nearly 50 percent appreciation against the dollar from 2000 to 2007.
Nevertheless, the effects of this common loss of competitiveness and sector realignment varied across the GIIPS. Greece, which saw the most dramatic decline in interest and inflation rates, enjoyed sustained growth over many years on the back of strong capital inflows—net foreign assets fell from approximately -5 percent of GDP in 1995 to -100 percent in 2007. In Ireland and Spain, housing and construction bubbles further fueled strong GDP growth. From 1997 to 2007, housing prices rose at an average annual rate of 12.5 percent in Ireland and 8 percent in Spain, compared to 4.6 percent in the United States during its bubble. Over the same period, construction as a share of gross output rose from 9.8 percent to 13.8 percent in Spain and from 7.9 to 10.4 percent in Ireland. In the United States, the same figure only increased from 4.6 percent to 4.9 percent. Furthermore, in Greece, Ireland, and Spain, output growth encouraged private debt to build up; from 1997 to 2007, domestic credit increased by an average of 155 percent, compared to an average increase of only 27 percent in the EUN.
In Portugal and Italy, where export sectors were already suffering from declining productivity and labor market inflexibility, growth improved only briefly before reverting back to being the lowest in Europe. Nevertheless, these countries also saw private sector balance sheets weaken, with household savings rates dropping 4.7 percentage points in Portugal and 5.7 percentage points in Italy from 1997 to 2007.
The troubles in the GIIPS were exacerbated by the difficulties associated with having a single monetary policy in the Euro area. Without control over interest rates, Greece, Spain, and Ireland were limited in their ability to deal with the bubbles, while Italy and Portugal, both fighting slowing economic growth, would have benefited from looser monetary policy. A recent OECD study estimates, for example, that policy interest rates over 2001–2006 were approximately 50 basis points too high for Germany but between 300 and 400 basis points too low for Spain, Greece, and Ireland. These divergences added to the widening competitiveness gaps by stimulating economic growth and wages in the latter countries.
Importantly, the GIIPS are not the only countries to which this narrative applies. Other EU members that have pegged their exchange rates to the euro—Estonia, Latvia, and Lithuania chief among them—experienced similar, if not more severe, crises.
In all of the GIIPS, lower borrowing costs and the expansion of domestic demand boosted tax revenues and tempted governments to expand spending as well. Rather than recognize that the revenue increases from the boom were windfall gains that should be saved, the GIIPS accelerated government spending. From 1997 to 2007, public spending per person rose by an average of 76 percent and government’s contribution to GDP rose by 3.5 percentage points. In the EUN, average per capita spending increased by 34 percent and the government’s contribution to GDP stayed constant.
In Ireland and Spain, the temporary revenue surge more than compensated for these spending increases—both countries averaged government surpluses from 2000 to 2007, despite increases that were greater than those in nearly all other Euro area countries. Nevertheless, signs of budget weakness emerged. For example, Ireland’s structural deficit, a figure that ignores the cyclical changes in revenues and expenditures, worsened from 1 percent of GDP in 2000 to over 8 percent in 2007.
Other GIIPS showed more evidence of fiscal deterioration. As growth in Portugal and Italy slowed at the end of the 1990s, their deficits gradually increased, rising by approximately 1.3 percentage points of GDP by 2007. In Greece, blatant mismanagement added to the troubles—despite strong growth, Greek deficits averaged 5 percent of GDP from 2000 to 2007.
The global financial crisis fully exposed the flaws of the GIIPS’ post-euro growth model. Tax revenues collapsed as output growth slowed, revealing that the expanded state sector was unaffordable. The housing bubbles in Ireland and Spain burst, putting additional strain on government budgets. Ireland was forced to rescue its hugely expanded financial sector at an estimated cost of 13.9 percent of GDP, greatly increasing its difficulties. As their domestic recessions deepened, the GIIPS’ loss of competitiveness made resorting to export markets extremely challenging. Rising borrowing costs and ballooning public debt—up by an average of 20 percent of GDP from 2007 to 2009—further restricted public spending when it was needed most.
Though the GIIPS are currently suffering from overextended governments, the roots of their problem run much deeper and reflect a structural misallocation of resources that will require more complex and protracted reforms than just deficit reduction.