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Nature and Causes of the Euro crisis by José Carlos Díez
 

Nature and Causes of the Euro crisis by José Carlos Díez

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    Nature and Causes of the Euro crisis by José Carlos Díez Nature and Causes of the Euro crisis by José Carlos Díez Document Transcript

    • /JOSÉ CARLOS DÍEZ * / Nature and Causes of the Euro crisisSummary; 1. Introduction; 2. Historical background of the Euro; 3. Natureof the Euro crisis; 4. Fixed versus flexible exchange rates: a review; 5. Causesof the Euro Crisis; 6. Conclusions; BibliographySummary This work analyses the Euro crisis. It includes a review of its his-torical background and the exchange rate theory to provide con-ceptual arguments to help understand the nature and causes the-reof. It is an infrequent pathology in economics, particularly indeveloped countries, but with an enormous destructive capacity.* José Carlos Díez is an economist who has combined his academic and corporate rolesthroughout his professional career. His academic activity is linked to the University ofAlcalá, where he was an undergraduate and PhD student and now is Professor ofFundamentals of Economic Analysis.He is currently the Chief Economist at Intermoney, a company founded in 1979 andleader in Spain in money market brokerage. He contributes with his forecasts to thepanel of experts of the ECB on European economy and the panel of FUNCAS on theSpanish economy, and advises companies, financial entities and institutions both natio-nal and international. 63
    • Nature and Causes of the Euro crisisFor this reason, it is important to get the right diagnosis when defi-ning the economic policy that will solve the crisis. The main cau-ses analysed herein are financial integration, the under-assessmentof risks, local imbalances within the Eurozone and the GreatRecession.1. Introduction The world financial crisis, whose first symptom was the collap-se of the subprime asset-backed securities market at the start of2007, has been changing. It is currently focused on Europe, and iscalling into question the future viability of the Euro and theEuropean project itself. This work aims to classify the nature of theEuro Crisis and to identify the main causes thereof. Although theobjective is not to analyse potential economic measures designedto solve the crisis, without an accurate diagnosis of the origin anddynamics of the crisis, finding the right solution would be an exer-cise in chance. To this end, section 2 includes the history of the European pro-ject and the single currency. Section 3 describes the nature of thecrisis, which is a seldom seen pathology in economics but whichcauses devastating damage to unemployment and public debt ofaffected countries. In order to provide the conceptual argumentsrequired to analyse the crisis, section 4 contains a review of the lite-rature on exchange rates. Section 5 analyses the main causes of thecrisis, which are: i) financial integration and under-assessment of64
    • The Future of the Eurorisk; ii) local imbalances; and iii) the Great Recession. Finally, sec-tion 6 includes the main conclusions reached in the article andestablishes the requirements to be met by the roadmap in order toput an end to the Euro Crisis.2. Historical Background of the Euro The Euro is the first monetary experiment of the 21st century. Itis not the first in history and shall not be the last, but it affects aneconomy like that of the Eurozone which accounts for 15% of theGDP and for 40% of world exports. The European Union is a poli-tical project designed to prevent a third world war in Europe. Thefirst assignment of sovereignty was control by a supranationalbody of the coal and steel production in France and Germany, basicraw materials to produce weaponry. Europe was not an optimalmonetary area; therefore, if a country suffered from an asymmetri-cal disturbance which did not affect the rest and it saw the effectsthereof on tis unemployment rate, this could not be offset by wor-kers migrating to other countries with lower unemployment rates.The bubble in Spain is a good example of this. Spain created onethird of the jobs in the Eurozone during the boom years, but wor-kers from Germany, where the unemployment rate was reachinghistorical levels, did not come: instead, it was workers from outsi-de the Eurozone who came. When the bubble burst, our unem-ployment rate shot up, but very few Spanish workers have gone towork in Germany. 65
    • Nature and Causes of the Euro crisis The example of an optimal monetary area is always the US.However, we tend to forget that in order to get there; they firsthad to annihilate the original settlers and then have a civil warwhich led to a default on payment of foreign debt. The Europeanproject belongs to the 21st century and when in Asia, America orAfrica integration processes begin, they look to Europe for inspi-ration. Nevertheless, the Euro was a risky headlong rush. Since theend of the Bretton Woods agreement, Europe has tried to avoidthe unfair competition of competitive devaluations within a cus-toms union. Germany, with the strongest currency in the system,has always led the monetary agreements, as its companies suffe-red the industrial delocalisation created by devaluations, mainlythat of the Italian Lira, a country a few hours away by lorry fromBavaria. After the fall of the Berlin Wall, the acceleration of themonetary union was decided so that it would become the strikerof the political union. However, the political union reached stag-nation after the severe German crisis of 2000, and the singlecurrency project began to crack.3. Nature of the Euro Crisis The nature of the crisis which is hitting the European Union isa classical debt deflation crisis (Fischer, 1933). Since the GreatDepression, this type of crisis had mainly taken place in emergingcountries and was associated with countries with financial vulne-rability, with little tradition of macroeconomic stability and insti-66
    • The Future of the Eurotutional fragility. Japan had suffered a crisis of this kind in thenineties and its economy is today trapped under deflation andliquidity, but it was viewed as an exotic case in the Far East. In2008, the Great Recession led to an abrupt disruption of the pathsof growth in developed economies, and the ghost of the GreatDepression began to haunt the world. By contrast, the decisive andcoordinated action of global economic policies prevented anotherGreat Depression (Eichengreen, 2010). Since then, world trade andindustrial production are 10% higher to levels prior to the GreatRecession, although the MSCI world stock index continues to be20% below the levels of spring 2008. Nonetheless, the crash of Lehman Brothers led to the collapse ofworld trade, and all countries and areas entered abruptly into reces-sion, which favoured policy coordination. But the recovery from2009 was asymmetric, and the coordination of world economicpolicies was conspicuously absent. In the Eurozone, from summerof 2008 to spring of 2009, the euphoria in support of an interven-tion to avoid a depression gave way to exit strategies in autumn ofthat same year and to begin implementing these in spring of 2010.The debt crisis affected a country with huge imbalances in thebalance of payments and high level of indebtedness such asGreece, which accounts for 2% of the GDP and population of theEurozone, and has extended first to Ireland, then to Portugal, andnow to Italy and to Spain. One third of the GDP of the area is alre-ady affected, and it has thus become a systemic and global pro-blem. This is a crisis in the balance of payments, but the existence 67
    • Nature and Causes of the Euro crisisof a currency and the high level of indebtedness mean the lack ofany comparable historical precedents, which in turn makes thediagnosis and the search for policies to solve it much harder. Forthis reason, we must carry out a review of classical literature onexchange rates in order to establish the conceptual bases for theexplanation of the crisis, without which the search for a solutionwould become a random wander.4. Fixed exchange rates versus flexible exchange rates: a review An exchange rate is a relative price between two hypotheticalshopping baskets of two countries. However, exchange rates areclosely related to interest rates (Keynes, 1992), and we are therefo-re speaking of a relative price which is essential when explainingeconomic development. Probably for this reason and as a result ofthe advance of globalisation, both commercial and financial sincethe fifties, in recent decades economists have paid special attentionto exchange rates. Exchange rates can be:i. Free floating: the exchange rate is set freely in the market on the basis of supply and demand, without the intervention of the central bank or the government of a country. The Euro and the Dollar are the closest free floating currencies.ii. Dirty or managed float: the government or central bank suppo- sedly does not intervene but there are verbal interventions or68
    • The Future of the Euro changes in monetary policy which attempt to alter the bases of supply and demand in the currency market. At times of maxi- mum volatility both the US government and the European ones verbally intervene in the market. During the Great Recession, the Federal Reserve, without expressly acknowledging this, has applied a monetary policy which has significantly weakened the dollar. The ECB has always followed in the footsteps of the Fed but in 2011 it managed to exceed its action by weakening the Euro, also without express recognition thereof. Japan is without question the best example of dirty flotation. The country sup- posedly enjoys free exchange rates but when there is tension in the markets and the savers repatriate capital, the central bank intervenes massively in the currency market to counteract the pressures of appreciation on its currency, which would have a very negative repercussion on activity and employment.iii. Fluctuation bands: the European Monetary System or EMS, the predecessor of the Euro, was the clearest example of this system. A central parity and fluctuation bands were established. Whilst the exchange rate in the market fluctuated within the bands, the system behaved like a flexible currency rate, but if it reached the bands then the central bank intervened to prevent these being exceeded, therefore becoming a fixed Exchange rate.iv. Fixed on a currency basket: equal to a fixed rate, but instead of fixing the anchor on one single currency it is fixed on a basket. It has been speculated for some time that China wants to apply 69
    • Nature and Causes of the Euro crisis this system. It makes more sense that just fixing it against the dollar, as the basket should replicate the composition of the current account and financial balance and would allow for bet- ter stabilisation of real exchange rates, which are the ones which determine the impact on activity and employment.v. Fixed adjustable: this is a fixed exchange rate which allows for adjustments. These may be discretionary or else subject to rules such as in the Bretton Woods system, or periodically adjustable. The latter were used in emerging countries which had sustained soaring inflation rates in the eighties and nineties during their stabilisation programmes, especially in Latin America.vi. Non-adjustable or true fixed rate: the country fixes a nominal anchor with a fixed rate relative to another currency with no possibility of change. Middle Eastern countries have fixed exchange rates against the dollar, which is justified by income from oil being collected in dollars. China had a fixed exchange rate against the dollar until 2005, when it moved onto daily fluctuation bands which it has recently broadened to +/- 1% daily.vii. Cash conversion: the monetary supply of a country is determi- ned by the level of currency reserves, and thus monetary sove- reignty is subject to capital flows. This was the exchange system in Argentina until 2001.70
    • The Future of the Euroviii.Exchange Union: the countries waive their national sove- reignty and assume a new currency. This may be a dollarization as has been proposed in some Latin American countries, or else a Euroization where the dollar would be adopted but without representation in the central bank. Or else a monetary and exchange union such as the Eurozone, where countries assume the same currency and are represented in the central bank and in monetary and exchange decision making processes. The debate on fixed or floating exchange rates is as old as macroe-conomics. During the happy twenties and then during the GreatDepression, capital movements were accused of being speculative dueto the extreme volatility of exchange (Nurkse 1942). Subsequently,another school of thought argued that the volatility was caused bydestabilising economic policies and that freedom and speculation hadstabilising effects (Friedman 1953). Rudiger Dornsbush opened up anew avenue of research according to which, even with investors withrational expectations, there was volatility in exchange rates. An incre-ase in the money in circulation by the central bank would increaseinflation expectations and lead to a depreciation in the exchange rate.However, for investors to buy once again there should be expectationsof appreciation; the exchange rate should therefore over-react andexceed its level of equilibrium to enable capital flows to return to thecountry. The truth is that neither the theory nor the empirical evidenceare conclusive in this debate. The problem facing the countries is 71
    • Nature and Causes of the Euro crisisthreefold: exchange rate stability, monetary independence andfinancial aperture. Conceptually speaking, flexible exchange ratesare the optimal solution, but for these to be stable the countrymust have monetary credibility. Flexible exchange rates provideleeway to the central bank in terms of fiscal policy, whereas thefixed exchange rate means this is lost and it becomes dependent onthe decisions made by the central bank to which it has anchoredits currency. The problem is that credibility takes a long time toachieve and takes very little time to lose. Moreover, it cannot beimposed; it is the society of the country in question which mustunderstand stability to be a public asset and to accept sacrifices andlimitations in order to preserve it. Countries lacking monetary credibility have hardly any leeway inmonetary policy, and this reduces the costs of accepting a fixedexchange rate. If the country has suffered from hyperinflation or aspiralling inflation, a nominal anchor on a stable currency allows forstabilisation of the prices of imported goods in the shopping basketand, combined with a stabilisation plan, proves to be highly effecti-ve to get the economy out of hyperinflation. This is what happenedin Argentina in 1990, but then the fixed exchange rate allowed imba-lances to go beyond what was sustainable and ended up by explo-ding in mid-air and amplifying the effects of the severe crisis of 2001. During the nineties the debate in Europe prior to the creation ofthe Euro was very intense (Rodríguez Prada, 1994). Most econo-mists did not call into question the fact that Europe was an opti-72
    • The Future of the Euromal monetary area (Meade 1957 and Mundell 1961). Althoughmuch progress has been made in the freedom of movements ofcapital and people, the labour markets continue to be segmented,mainly due to language and cultural differences, and when a regionsuffers an asymmetric disturbance with an increase in unemploy-ment, this is not offset by transferring workers from another regionas they do, for example, in the US. In this scenario, the countryneeds to transfer capital and work to the sector of non-corporategoods to the corporate goods sector and needs to depreciate the realexchange rate. Without the capacity to devaluate the nominalexchange rate, all the adjustment must be made via inflation orproductivity. When the central country has inflation rates close to2% the strategy must be deflationist, which is where the problemsstart, as many economists warned prior to the creation of the Euroand has been proven since the Great Recession (Obstfeld 1998).Nevertheless, the lack of an optimal monetary union is clearly adownside to the creation of the euro, but in the nineties it was thebenefits that were highlighted (De Grauwe 2009). The main bene-fit is that we Europeans already had a customs union and highlevel of commercial integration. Nowadays, approximately 70% ofthe Spanish exports are concentrated in the European Union and60% of what we import comes from our partners. Therefore, natio-nal exchange policies were very destabilising in this scenario, put-ting the European project at risk. 73
    • Nature and Causes of the Euro crisis The main benefits were concentrated in the financial area.Integration would enable the removal of currency risk and risk pre-miums, leading to a drop in real interest rates and therefore incre-asing the potential growth of the Eurozone and of each of thecountries therein, in turn allowing for convergence in income perinhabitant with the US, which experience a sharp boom in pro-ductivity in the nineties. Chart 1 shows how the introduction ofthe euro did not achieve the desired convergence, except in thecase of Spain. Chart 1 Gross Domestic Product per inhabitant Source: Eurostat structural indicators and own work74
    • The Future of the EuroIn the debate of costs and benefits prior to the creation of the Euro,many economists warned of institutional problems in the design ofthe monetary union. The main ones were the absence of a fiscalunion which would offset the asymmetric disturbances that mighttake place in some states and, that in the absence of exchange ratesand monetary policy, the country would be left without economicpolicy leeway to counteract them (Eichengreen 1998). The othermain limitation was the absence of a true lender of last resort whichthe statutes imposed on the ECB (Obstfeld 1998).5. Causes of the Euro Crisis The Euro crisis is extremely complex like all debt deflation cri-ses in history (Díez 2012), which is why we shall now review themain events to enable us to understand the fundamentals of theover-indebtedness without which we shall not be able to come upwith appropriate economic policies to help digest this.5.1. Financial integration and under-assessment of risk When a country adopts a fixed exchange rate and investors con-sider it sustainable in the future, the risk premium drops. A rationalinvestor must choose between an infinite variety of internationalassets in which to invest his savings, but his yield estimates aremade in local currency as the objective of purchasing financialassets is to protect against the impairment of purchasing power 75
    • Nature and Causes of the Euro crisiscaused by inflation during the investment period. If an investorpurchases an asset in another currency that then appreciatesduring the investment period, his yield will increase in the localcurrency, but if it depreciates it will drop, which explains the directrelationship between interest and exchange (Dornbusch 1976). In the case of the Euro we are dealing with the exchange ratewith the largest commitment and greatest exit costs; therefore itsadded credibility is also greater, just as the drop in risk premiums isalso highly intense. Chart 2 shows the intense process of financialintegration which took place in Europe following the creation ofthe single currency. Investment funds and financial institutions inthe Eurozone went from having 20% of assets from other countriesin the region in their portfolios in 1998, to 45% and 40% respecti-vely in 2007. This means a huge transfer of capitals from countrieswith a savings surplus, mainly Germany, to countries with savingsdeficits and especially those with higher risk premiums. This arrival of capital flows, along with the credibility grantedby the investors to the Euro since its inception, help to explain theintense convergence of interest rates between the public debt of thevarious member countries that can be observed in Chart 3.However, as is the case with all bubbles, at the beginning there arefundamentals which justify investor behaviour, but usually, follo-wing such sharp changes in financial flows, there is usually andover-reaction and asset prices move away from the fundamentals.76
    • The Future of the Euro Chart 2 Financial integration Source: European Central Bank Chart 4 shows how not only did convergence take place inpublic debt interest rates, but that the process was more intense inprivate debt. Covered bonds are the assets with the least likelihoodof default following the public debt of a country and it might evenbe the case, in extreme cases, of default on Treasury bonds but noton covered bonds, as has happened in Greece. The covered bond isa bond with a senior guarantee from the financial institution thatissues it, but which also has a second guarantee. The issuing entityselects its highest credit quality mortgages, those for the main resi-dence, with a debt under 80% of appraisal and a monthly instal-ment below 35% of the household income, and these are attachedas bond guarantees. Therefore, in the event of bankruptcy of the 77
    • Nature and Causes of the Euro crisis Chart 3 10 years Public debt spread v. Germany Source: Bloomberg and own dataentity, the buyers of the covered bond would prevail over the restof creditors to collect on such mortgages until recovery of theirinvestment, irrespective of whoever purchases the bankrupt entity.This is what distinguishes them from asset-backed securities wherethe investor assumes the direct default of the mortgages. In thecase of the covered bond, the risk belongs to the entity and, secondto the default of the mortgages, and thus they have a dual guaran-tee and lesser likelihood of default. Moreover, the rating agenciesrequire the over-collateralisation of the issue, so that if an institu-78
    • The Future of the Eurotion issues a covered bond worth 1000 million euros, they wouldbe required to provide between 1300 and 1500 in mortgage portfo-lio as a guarantee. Hence, the entity would first have to be declaredbankrupt and then it should have to have a default in the mortga-ge portfolio of over 50% for the investor not to recover 100% of hisinvestment. This helps one to understand that since 2007 no cove-red bond issued by a European entity has experienced default.These types of assets do not exist in the US, as the Fannie Mae andFreddy Mac played the same role, but evidence has shown that theEuropean system, by maintaining the risk in each institution, wasmore efficient and, in fact, there are legislative proposals under wayto develop a covered bond market in the US. Until 1997, the companies of peripheral countries such as Spainfound it difficult to issue bonds on the international markets. ThePeseta was a currency which had experienced several devaluationsover the last few decades, its financial markets were very narrowand were practically taken over in full by public debt. The entry ofthe Euro enabled Spanish financial entities to access an organisedmarket of covered bonds with a longstanding tradition and depthin Germany, which rapidly spread to all other countries in the area.As we shall explain shortly, this coincided with a deep and complexdebt crisis in Germany, as a result of the excesses of its Unification,which increased the savings rate in a structural way, and thus thesupply of top quality credit assets for its financial institutions, insu-rance companies and pension funds, which in turn boosted therapid growth of this market as well as its (Díez 2012b). 79
    • Nature and Causes of the Euro crisis Chart 4 Spanish covered bonds spreads Source: Bloomberg and own data In Chart 5 we can see how such structural changes in the fun-damentals led to a credit boom in the Spanish economy. The ori-gin of the boom was justified by the fundamentals, but in the endthe only fundamentals were the self-realisable expectations, lea-ding to the bubble. In 1995, when the likelihood assigned by inves-tors that Spain would form part of the founder members of theEuro was very low, practically all of the Spanish bonds in the handsof non-residents were public. Since then, the percentage of publicdebt over GDP had become constant, but when our incorporation80
    • The Future of the Eurointo the single currency was approved in 1998, the internationalissues market opened up for the private sector and grew exponen-tially until it doubled that of public debt in terms of GDP. The hea-ding “other resident sectors” includes the asset-backed securitiesfunds, rendering most of debt as pertaining to banks. Chart 5 Spanish bonds in the hands of non-residents Source: Bank of Spain, INE and own data Covered bonds are purely a bank product, despite carrying asecond mortgage guarantee, and are accounted for as bank debt. Themost developed covered bond market in the world was the German 81
    • Nature and Causes of the Euro crisisone of Pfandbrife but in Chart 6 one can see how in 2006 theSpanish banks issued 70,000 million euros in covered bonds, 30%less than the German banks which had a balance three times aslarge as that of Spanish banks. In summer 2007, before the start ofthe financial crisis, the outstanding balance of covered bonds issuedby Spanish banks exceeded 300,000 million euros, 30% of the GDPand an amount equal to the outstanding balance of Spanish publicdebt. In 2006, the issues of covered bonds and asset-backed securi-ties by Spanish banks comfortably exceeded the current accountdeficit which was approaching 100,000 million and were the mainfinancing instrument of our economic, without which it is not pos-sible to explain the credit and real estate bubble. The dynamics were straightforward. The Spanish banks used theloans granted in retail banking as a guarantee for new issues whichallowed the granting of new credits. The issues of covered bondswere carried out at variable interest rates of Euribor plus 10 basispoints and the mortgages were granted at Euribor plus 50 basispoints. A strong growth in credit, low rate of default and spreadsbetween stable asset and liability rates constituted the basis of thedemand for funds of Spanish banks. What were the fundamentalsof the supply of funds? The key lay in the Shadow Banking System(FSB 2011, European Commission 2012). This consisted mainly ofvehicles created by international banks, based in tax havens andnot consolidated in their balance sheets and thus outside the peri-meter of oversight by the central banks. The vehicles purchasedassets, mainly of high credit quality and were funded by the com-82
    • The Future of the Euro Chart 6 Issues of Covered Bonds Source: International Monetary Fundmercial paper market using those assets as guarantees. Let us assu-me that the vehicle bought a covered bond at Euribor plus 10 basispoints and was funded by Euribor commercial paper. This resultedin a profit of 10 basis points per transaction. If the vehicle only had5% of capital and 95% of debt, this meant a 20-fold leverage, suchthat the yield over equity was Euribor plus 200 basis points. The growth of the shadow banking system was exponential andin 2007 in the US reached 20 billion dollars, whereas the non-sha-dow banking system supervised by the Federal Reserve amounted 83
    • Nature and Causes of the Euro crisisto 16 billion dollars. The asset-based leverage which used mortgageguarantees already granted enabled the banking system to generateliquidity in an endogenous manner without having to resort to thecentral bank, leading to the loss of monopoly by the monetary aut-horities of the issue of money in circulation. When in February2005 Alan Greenspan, then President of the Federal Reserve,announced that there was an enigma in the behaviour of the bondmarket, he was responsible for this for allowing the development ofthe shadow banking system. Until 2009, no statistics were publis-hed on the shadow banking system but, once they became public,it was much easier to understand the causes of the largest global cre- Chart 7 Current account balance Source: International Monetary Fund84
    • The Future of the Eurodit bubble burst since the Great Depression and which was parti-cularly severe in some Eurozone countries, including Spain.5.2. Local imbalances: Over the last few decades, the economic paradigm has analysedthe real economy and the financial economy separately. The GreatRecession has proven the failure of the paradigm and, as we wereshown by Luca Paciolo in the 13th century, when an economy isanalysed, the assets and liabilities cannot be separated. Therefore,although it is evident that the hurricane began in the financialrealm, there are imbalances in the real economy which also helpto explain the crisis. Chart 7 shows the divergence betweencurrent account balances among developed and emerging coun-tries in the last decade. Several causes help explain this phenome-non which the literature has called “global imbalances” (Caballero2009). The main cause was the aftermath of the Asian crisis of 1997.The affected countries had large current account deficits and lowlevels of currency reserves before the crisis, and subsequently theygeared their economic policy towards exports. This led to currentaccount surpluses and high currency reserves, and the ensuingstructural increase of the world savings rate (Bernanke 2005). Theaccumulation of reserves was concentrated on sovereign funds andcentral banks with a conservative approach, which significantlyincreased the demand for fixed income funds of top credit quality, 85
    • Nature and Causes of the Euro crisisknown as AAA. Without understanding the Asian crisis and its con-sequences it is not possible to understand the intense developmentof the shadow banking system and the strong increase in leveragein the world banking system which has been analysed in the pre-vious section (Caballero 2008). Chart 8 shows how the Eurozone was hardly affected by thephenomenon of Global Imbalances, with a current account balan-ce close to equilibrium since the Asian crisis. However, Chart 8shows that there have indeed been huge differences between thecountries within the Euro and, for this reason, the phenomenonhas now been called Local Imbalances. In 2001 Germany suffered adebt crisis similar to the one suffered at present in Spain, althoughit hardly translated into a current account or foreign debt deficit.Germany, as was the case in Japan in the eighties, suffered from aproblem of over-indebtedness of households and businesses, withreal estate bubble, burst and depression all thrown in to the packa-ge. Following the burst of the bubble in 2000, German householdswere reluctant to take on debt and structurally increased theirsavings rate to reduce such a debt. Private consumption plumme-ted and businesses sought the supply that was absent in the domes-tic market in the export market. The fiscal revenue dropped dra-matically and Germany failed to meet the Stability Pact and wat-ched its public debt increase significantly until 2005. The birth of the euro and the credit boom in peripheral coun-tries enabled Germany to overcome the severe recession thanks to86
    • The Future of the Eurothe strength of its exports. Moreover, German savings found aneasy path without assuming exchange rate risk with its partners inthe Eurozone. The causes of the Euro crisis are focused on theanalysis of the imbalances of debtor countries, but it is not possi-ble to understand and explain the crisis without analysing thesaver countries, particularly Germany. Debtor countries are facinga prolonged period of debt reduction, which will ensure a weakinternal demand, and shall be obliged to show a current accountsurplus as was the case in Asia in 1998 and in Germany in 2001.But this will not be possible if the creditor countries reduce theircurrent account surpluses and boost internal demand. Chart 8 Current account balance Source: International Monetary Fund and own data 87
    • Nature and Causes of the Euro crisis5.3. The Great Recession: The European Monetary Union was born with institutional pro-blems but these did not become evident and to put its viability atrisk until 2009. Chart 9 shows how the Great Recession which rava-ged the world and Europe in 2008 has been the worst for seventyyears, although it did not reach the depth and length of the GreatDepression, which it is being called the Great Recession. Withoutan earthquake of this force, it is possible that the institutional flawsof the European project could have endured for longer, but the cri-sis has highlighted them and the Euro is now at a crossroads. In 2007 it was financial disturbances which anticipated therecession. Chart 6 shows how the covered bond market practicallydried up for Spanish banks as well as for all other indebted coun-tries. This brought the credit boom to a halt and acted as the trig-ger for the recession. In 2008 the disorderly collapse of Lehman ledto the worst global run since the Great Depression. The investorsquickly resorted to short term public debt of the internal reservecurrencies, the money markets dried up as did the currency mar-kets, and world trade collapsed in a matter of weeks. The coordi-nated reaction of the G20 with the most expansive monetary, fis-cal and financial policy in history prevented the world from ente-ring into a depression and enabled a V-shaped recovery of worldeconomy and trade in 2009.88
    • The Future of the Euro Chart 9 GDP EU 15 Source: Angus Maddison. University of Groningen Economics is an empirical science but it is difficult to findhomogeneous experiments to compare policies, but this crisis hasprovided one. The Great Recession was synchronized and mostcountries entered into recession at the same time. However, therecovery since 2009 has been disparate and the economic policieshave been very different between the US and the Eurozone, whichenables a comparison of its effects to be drawn. Europe began fis-cal consolidation at the beginning of 2010, despite the boostgiven in 2008 to get out of the recession, whereas the US has con-tinued to renew its fiscal incentive plans. The ECB has been reluc-tant to intervene and has only done so when the markets havebeen on the edge of collapse and it even took the liberty of incre- 89
    • Nature and Causes of the Euro crisisasing the interest rated in July 2011, making the same mistake asin July 2008, anticipating the recession. The Federal Reserve haskept its rates at 0% and has renewed its quantitative policies. After two years of experimenting, what has the result been? Thegrowth in the US has been twice that of Europe, its inflation hasalso doubled and its unemployment rate has reduced to 8.5%,whereas in Europe it has exceeded 10%. In the US, several states,among them California and Florida, burst their real estate bubblesand California defaulted on payments and created its owncurrency, what was known in Argentina as Patacones. Therefore,the Euro crisis is not the cause of the problems in Europe butsimply the result of mistakes made in economic policy in Europesince 2009. Neither is the argument of the greater rigidity ofEuropean labour markets and the mobility problems betweencountries valid. In the US, the unemployment rate increased withequal intensity in states which did not have a real estate bubble,thus confirming that the cause of the growth in unemploymentwas a sharp drop in demand caused by an intense banking crisisand credit restriction. But the most spectacular result of the expe-riment is probably what happened with public finances. The US,without resorting to raising taxes, without great cuts and simply byfreezing public expenditure has managed to increase fiscal revenueby 12% and has reduced the deficit by four percentage points ofGDP. Europe, by raising taxes and cutting costs has managed arevenue increase of 6% and a reduction of the deficit of two pointsof GDP.90
    • The Future of the Euro The emergence of almost ten points of public deficit in a newGovernment in Greece was the spark which ignited the Euro crisiswhich we currently face. The Greek Tragedy spread first to Portugal,then to Ireland, and currently threatens Spain and Italy, thushaving affected one third of the GDP of the Eurozone, (Díez, 2012).Chart 2 shows how the Great Recession began a process of finan-cial disintegration in the Eurozone which was intensified by theGreek Tragedy and the contagion of all other economies. In amonetary union, the outflow of capital is equal to a contractivemonetary policy and, on the contrary, the inflow of capital isexpansive. This helps us to understand why the countries subjectedto financial tension entered once again into deep recession in 2011whereas Germany, the main receiver of capital flows, has continuedto grow.6. Conclusion The European project is a political one and it is born out of theneed to end wars and conflicts which had ravaged Europe in the20th century. The Euro was an attempt to accelerate the politicalunion but has ended up being a headlong flight.· The Euro is the most extreme version of a fixed exchange rate. Indeed, it is reinforced and with high cost of departure, which renders it more credible, but while it lacks a political union there will always be doubts as to whether it will be a single currency. 91
    • Nature and Causes of the Euro crisis· In the nineties the benefits – and there were some which have been clearly demonstrated – of the creation of the euro were overvalued. But at the same time there was an under-assessment of the costs which reality has proven were also there. The two main institutional problems which must be solved are: i) the absence of a fiscal union to complement the monetary union and ii) the absence of a lender of last resort due to the limita- tions imposed on the ECB in its bylaws.· Financial integration and the undervaluation of risk, both glo- bal phenomena, are essential to explain the credit boom and the problem of over-indebtedness which are the origin of the Euro Crisis. The case of the covered bonds is a good example that not only were credit risks undervalued, but liquidity risk was likewi- se under-assessed.· The Local Imbalances, the high current account surplus in Germany and the deficits in Spain and other countries forced the transfer of financial flows and boosted the credit boom and over-indebtedness. Countries subjected to financial tension are implementing sharp reductions in their current accounts, but Germany has hardly reduced its foreign surplus since 2007.· The institutional problems of the Eurozone became apparent at the Great Recession, as a result of the sharp drop in activity and the collapse of the financial markets and credit channels which have rendered many debts unsustainable and unpayable.92
    • The Future of the Euro Without such a deep recession, the problems would have taken longer to appear.· The aim of this article was not to discuss solutions, but from the analysis of the nature and causes of the Euro crisis, we can con- clude that the solution must: i) dispel doubts as to the future via- bility of the euro, ii) to do so we must work towards the fiscal union and the creation of Eurobonds would be the precedent for a future single European treasury, iii) we must change the bylaws of the ECB so that it may act as a lender of last resort as the Federal Reserve does in the US, iv) we must halt the process of financial disintegration and ensure the return of part of the capi- tal flows which have exited from peripheral countries, and v) we must urgently reactivate growth in Europe. In order to do so, the monetary policy must opt for quantitative strategies of debt pur- chase, the fiscal policy must be less restrictive and the financial institutions and countries with greater solvency problems must be recapitalized in order to restore the credit channels as soon as possible. 93
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