In essence, the eurozone crisis is a balance of payments crisis, engendered by the introduction of the euro itself. This created misalignments (the loss of competitiveness in the periphery) and removed ways to deal with them.
However, there is some automatic correction to these misalignments going on. It will take a long time to run its course, and there is a lot that can go wrong in the meantime, but at least there is a ray of hope.
First, some explanations. Not everyone appreciates how the euro itself created much of the problems that the euro area economies are now faced with. The introduction of the euro:
- Created shocks that impacted countries differently ("asymmetric" shocks)
- Incapacitated tools to deal with those asymmetric shocks
The creation of the euro removed the exchange rate risk on countries that traditionally had a higher inflation rate compared to the likes of Germany and the Netherlands. This propelled a large capital inflow, which produced little economic booms and higher inflation in the periphery.
The three policy tools to deal with these kinds of asymmetric shocks are exchange rate policy, monetary policy and fiscal policy. But all three are rendered ineffective or worse by the common currency arrangement.
Entering a common currency removes the ability to devalue (or revalue) one's currency versus other member states, needless to say. So any inflation differentials, especially those that accumulate over time, become quite dangerous and difficult to deal with. Unfortunately, even other policy tools were rendered ineffective by the euro.
For instance, countries gave up their monetary policy independence as well, so they were unable to set interest rates. The ECB sets rates for the whole of the eurozone, but this invariably is a "one size fits nobody" rate that exacerbates problems. That ECB rate was way too low for the countries experiencing capital inflows, which exacerbated their inflationary problems.
The capital inflows and low interest rates were to a large part responsible for producing credit-infused housing bubbles in Ireland and Spain, for instance. Funny enough, while the ECB interest rates were clearly too low for the likes of Spain and Ireland, they could be considered too high for the likes of Germany, reinforcing the inflation moderation and magnifying the inflation differentials with the eurozone periphery.
That leaves fiscal policy as an adjustment mechanism. But according to the stability pact, countries for which the ECB interest rates are too high have limited scope (if at all) to boost their economy via the fiscal route. Richard Koo of Nomura had this to say about that:
In 2005, I told a senior ECB official that it was unfair to force other countries to rescue Germany by boosting their economies with loose monetary policy without requiring Germany to administer fiscal stimulus, when it was Germany that had become so deeply overextended in the bubble. The official responded that that is what a unified currency means: because Germany could not be granted an exception on fiscal stimulus, the only option was to lift the entire region with monetary policy.
The bubble Koo is talking about here is the Dot.com bubble, which hit Germany pretty hard. Its Neuer Market, a stock market for technology companies, crashed 96%, for instance. It closed down in 2002 and a mini-balance sheet recession struck Germany.
This produced an interesting result:
- ECB interest rates were too high for Germany, but too low for many other eurozone countries.
- But in a bid to help the eurozone's largest economy, rates were lowered from 4.75% in 2001 to 2% (then a postwar low) in 2003, exacerbating the problems in the periphery.
- Germany couldn't reflate via fiscal policy due to the constraints of the Stability Pact (which limits budget deficits to 3% of GDP).
- Other countries had to "rescue" Germany by expansionary policies.
Well, we all know what the result of that was. These other countries were partly forced upon an inflationary path (due to capital inflows and inappropriate interest rates as a result of ECB policy) and partly by design (too loose fiscal policies). As a result, inflation differentials were accumulating and these countries rapidly lost competitiveness, enabling Germany to reflate itself via exports.
All this was unnecessary, according to Koo:
In other words, there would have been no need for such dramatic easing by the ECB, and hence no reason for the competitiveness gap with the rest of the eurozone to widen to current levels, if Germany had used fiscal stimulus to address its balance sheet recession.
For those not familiar with Koo's concept of a balance sheet recession, it's where monetary policy becomes impotent (the private sector is paying down debt, no matter how low interest rates are), while fiscal policy becomes more potent (as there is no danger of crowding out the private sector and the public sector can borrow at low rates).
Fast forward to 2012
If the above situation appears vaguely familiar, it is because it is almost exactly the reverse of the situation today. Now it's the periphery suffering from a (much larger) balance sheet recession, without the ability to devalue, lower interest rates, or embark on fiscal stimulus.
Quite the contrary, they're forced to embark on austerity, which is a stupid idea, according to Koo:
At a time of collapsing private sector demand in several member states, the eurozone's obsession with slashing public spending will only aggravate its problems, he suggests. Its fiscal compact is more likely to kill the patient than cure it. [FT]
On top of this, the banking system is contracting credit as well, meaning all levers of policy are in reverse, accelerating the downturn from all directions. It is therefore no surprise that in Italy, the budget deficit is actually increasing again, despite austerity measures.
Capital flows and adjustment
Countries in a balance sheet recession should turn on the fiscal stimulator, as private sector deleveraging automatically generates the savings to finance the public deficit at low cost. Indeed, all the more so as monetary policy is powerless. Even zero interest rates combined with massive QE, as in the U.S. and the U.K. (or Japan between 2002 and 2008) hasn't achieved much, if anything.
The problem is much more complex in a currency union like the eurozone. Savings can move abroad without incurring currency risk, which is exactly what happens. Investors and depositors move their money from the periphery to the center, causing a monetary contraction in the periphery that is deepening the slump.
The domestically generated savings in countries like Ireland and Spain, the result of a deleveraging private sector, are not available for their public sector to borrow, but instead flee to Germany (where it's not needed) to produce the lowest bond yields on record. There is something of a (very faint) silver lining though.
But with an already booming economy and enormous capital inflows, one could argue that ECB rates are now too low for Germany, while the capital outflows from the periphery cause monetary conditions to be way too contractionary there. So once again, one size fits nobody monetary policy exacerbates the problems. Or perhaps not quite.
You have to keep in mind that:
As Thomas Mayer of Deutsche Bank notes, "below the surface of the euro area's public debt and banking crisis lies a balance-of-payments crisis caused by a misalignment of internal real exchange rates". The crisis will be over if and only if weaker countries regain competitiveness.
And indeed, some adjustment along the right ways is now happening. In Germany, unemployment is at a decades low and wages are starting to rise strongly. Even house prices have started to rise considerably, while in the periphery. exactly the opposite is happening, albeit at absolutely terrifying cost in lost production and damaged lives in the periphery.
But before this adjustment has repaired the accumulated competitiveness imbalances that lie at the heart of the crisis, the patient can have passed away already. There is simply too much that can go wrong in the meantime.
Still, it's good to know that if policy makers can actually manage to kick the can for years to come (not very likely, but one never knows), the imbalances might actually have corrected themselves.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.