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The (never-ending) Eurozone Crisis

J. Lawrence BrozAssociate Professor of Political Science

UCSD

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Europe’s Bleak Outlook (est. 2015)

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Scariest Graph in the World

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When young people lose faith in the economy, political chaos usually follows

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Consider The Great Depression• The Great Depression of the 1930s bred

support for extremist ideologies that advocated the overthrow of the political system– e.g. National Socialists in Germany, Iron Cross in

Hungary, the Iron Guard in Romania, communist parties in many countries

• Recent research shows that the share of votes for extremist parties in elections in 1930s correlates strongly with economic hard times

Source: Alan de Bromhead, et al. “Political Extremism in the 1920s and 1930s: Do the German Lessons Generalize?” Journal of Economic History (July 2013).

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Lecture Outline• Origins of the Euro Project–Political motivations for European economic

integration–Path toward monetary union

• Weaknesses that lead to the crisis– EU not an “optimal currency area”– Eurozone banks viewed the creation of the

euro as an implicit bailout guarantee • The Greek Debt Crisis–Bargaining and Bailouts

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Origins of the Euro Project• Creation of the euro—or “Economic and

Monetary Union” (EMU)—is the latest step in a long process of politically motivated economic integration

• After World War II, the U.S. and the political leaders of France and Germany sought to bind the former antagonists economically, so as to ease Franco-German tensions and build a bulwark against Soviet expansion

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European Coal and Steel Community• Coal and steel had been the source of conflict

between Germany and France for a century– they had battled over the coal of the Ruhr, iron the

Lorraine, and steel mills of the Saar since 1870• With the backing of the U.S. and in the shadow of

the Cold War, the French came up with the “Shuman Plan” for inducing Franco-German cooperation in this area

• French foreign minister Robert Schuman said the aim was to "make war not only unthinkable but materially impossible.“

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European Coal and Steel Community• ECSC (1951) marked the birth of Europe--its first

supranational institution• It’s members—France, Germany, Belgium, the

Netherlands, and Luxembourg—were bound under a joint authority, with a common market and common regulations

• ECSC was a remarkable accomplishment given that France and Germany were at war a few years earlier

• It also provided the model for further integration and was followed in 1956 by the European Economic Community (EEC) which extended the common market and built a customs union within Europe

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History of the Euro• To promote greater cooperation and further

integrate their economies and, Europeans sought to minimize the variability of their exchange rates

• In 1979, the European Monetary System (EMS) linked EU member currencies to the Deutschemark in a fixed-rate regime

• In 1992 Maastricht Treaty, EU members agreed to create a common currency (the euro) managed by a single authority, the European Central Bank (ECB)

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Transition to the Euro took 8 years• Maastricht Treaty (1992) committed countries to

fiscal discipline prior to the rollout– Reduce national budget deficits to within 3% of GDP,

and government debt could not exceed 60% of GDP• Most countries failed to heed these rules– Even Germany and France breeched rules 3 years in a

row• Nevertheless, the Eurozone was created in 1999

and the physical currency was rolled out in 2001

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Economic Benefits of Currency Union • Having many currencies is costly because it

impedes the flow of goods and capital across borders

• Thus, a key benefit of currency union is that it encourages trade and financial integration– Europe was to be like the United States, with its

single currency and its single central bank• In the context of Europe’s continuing quest for

greater economic integration, a currency union seemed the next logical step

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Economic Costs of Currency Union• The main cost is that a nation gives up one of the

most powerful tools of macroeconomic management: a flexible exchange rate

• A flexible exchange rate is a kind of macroeconomic “shock absorber” that allows governments to adjust policy to changes in economic conditions – e.g., if demand for U.S. goods decreases, a weakening of

the U.S. dollar (which makes U.S. goods cheaper for foreigners) can help offset the negative impact on the economy

• Adopting the euro meant that EU nations gave up this shock absorber

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When do the benefits of currency union outweigh the costs ?

• “Optimal Currency Area” (OCA) criteria:– When members have sufficiently similar economies

such that a “one size fits all” policy is appropriate– When labor mobility among members is high • e.g., in the U.S. people move from where unemployment

is high to where it is low– When members are part of a fiscal union • e.g., in the U.S. , unemployment insurance flows to areas

that face region-specific shocks

• Europe did NOT meet any of these criteria…

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So why did the project proceed?• Currency union was desirable because it

furthered political integration within Europe, which was the point all along– Members also thought they could approximate

OCA criteria with a steady flow of EU edicts aimed at increasing cross-country labor mobility

• Powerful business and banking interests with major cross-border economic ties supported the project

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Underlying Weaknesses

1. EU was NOT an Optimal Currency Area. It is composed of two different types of economies:– “Core” (Germany, France, the Benelux countries,

Austria, Finland)– Periphery” (Greece, Ireland, Portugal, Spain, Italy,

Cyprus)2. An implicit “bail out” guarantee that loosened

borrowing constraints for the periphery– Core banks made risky loans to the periphery

because they believed a bailout would be forthcoming if a member state got into trouble

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Calm before the storm• From 1999 to 2007, the Eurozone faced a

benign economic environment– The nation-specific economic problems that

occurred were not so serious as to call into question the integrity of the Eurozone

• But underlying problems grew…– Lending from Core to Periphery fueled

housing bubbles in Spain and Ireland, and a massive public debt buildup in Greece

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Implicit bailout guarantee and the “disappearance of risk”

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Variety of crises, but a Common Cause• Foreign borrowing was the common cause but

there were a variety of failures• Greece’s problem was fiscal policy and a large

government debt– Foreign borrowing financed generous public sector

pay, welfare, and retirement benefits• Ireland and Spain were fiscally responsible but

their banks lent the foreign money to property developers, generating massive housing bubbles– When the housing bubbles burst, governments

assumed the debts via bank bailouts (sound familiar?)

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Onset of the Crisis• Benign environment gave way to the Great

Recession in 2008 which shook confidence in lending to the periphery

• As their debts mounted, foreign banks became doubtful that peripheral countries could repay, which forced interest rates higher—a vicious circle

• With news in 2010 that Greece had hidden the truth about its problems, lending to the periphery stopped altogether—a “sudden stop” that marked the onset of the crisis

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Risks beyond Greece• If peripheral countries like Greece can’t borrow

to rollover their debts, they will be forced to default• If Greece defaults, it could trigger other defaults• If a defaults occur, it could bring down the entire

European banking system since banks in the Core are heavily exposed– If a nation defaults on its foreign debt, the banking

systems of creditor nations face large, perhaps fatal, loses

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The Core’s Banks are on the Hook

France

Netherlands

Portugal

Germany UK

Switz

erland

Italy US

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Foreign banks combined consolidated claims on Greece, Ireland, Italy, Portugal, Spain (% GDP)

% G

DP

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Greek Debt Crisis• In 2010, the EU faced the choice between

Greek default or a bailout• The EU (and IMF) chose a bailout - €146 billion

to Greece over 3 years in installments• In 2012, the “Troika” (EU, IMF, ECB) provided a

second bailout worth €130 billion. The terms:– Greece has to impose austerity: hike taxes,

cut public sector salaries, pensions, etc–But there was debt restructuring too: banks

in the core agreed to debt reduction of 53%

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Debt Crisis Bargaining• Countries in the core square off with debtor

countries in the periphery to see who will bear the burden of adjustment

• A “morality play” over who is responsible:– Creditors blame debtors for and “living beyond

their means.” Derisively “PIIGS.” Creditors demand debtor austerity to maintain debt service

– Debtors blame core banks for making huge profits on risky loans and they demand debt restructuring to make their debt burdens more manageable

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Outcomes Depend on Relative Bargaining Power

• Core’s leverage: Since private loans are not available, official creditors (EC, IMF, ECB) have leverage over debtors– Without their loans, a debtor government can’t

pay its bills, leading to economic and financial collapse and an existential socio-political crisis

• Periphery’s leverage: since core banks hold so much of the periphery’s debt, defaults pose an existential threat to the core’s banking systems– This give the periphery substantial leverage

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Muddling Through• The EU has muddled through each new

crisis—Cyprus being the most recent—with outcomes reflecting a mixture of austerity and debt restructuring (creditor “haircuts”)

• Despite their differences, the core and periphery are mutually dependent, which explains why they have found compromises and avoided disaster

• No one wants to see the Eurozone collapse

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Reasons for Optimism• They EU has fixed some of the underlying

problems by way of new treaties– “European Stability Mechanism” (2012) can

provide instant financial assistance . It has €500 billion in resources

– “European Fiscal Compact” (2013) creates stronger fiscal discipline

• Public opinion throughout the EU remains strongly committed to the Euro

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Public opinion is surprising resilient

Pew Research Survey conducted in March 2013

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Towards Political Union• “Political union” is often presented as the

culminating and final stage of European Union• The irony is that the crisis has fostered a lot of

political union— the decisions made recently to reinforce fiscal, economic, and financial governance are significantly fostering political union

• Recall Shuman: “Europe will not be made all at once, nor according to a single plan.”

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End

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What happens when a country defaults