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- 2. Mitchell 1 Introduction While the collapse of Lehman Brothers in September of 2008 was the actual explosion in the coal mine for the United States, the Eurozone failed to view it as they should have: a canary for the longstanding gas leak that is the imperfect Euro currency union. Just over a year later, Ireland and Greece saw their interest rates quickly and suddenly rise past their Euro counterparts for the first time since entering the union1 (Table 1). The cause of the rise was mixed across the board, reflecting the diverse nature of the Eurozone. In Ireland, the housing bubble crash looked eerily similar to the United States, but was magnified by the fact that Irish banks were larger in proportion to Irish GDP, making bailouts more costly for the small nation. For Greece, longstanding high deficits and revelations as to their actual levels of debt led to uncertainty in the markets. Along with the rest of the Eurozone, both were hit by a decrease in US imports from Europe and a devaluation of the dollar relative to the Euro heading into 2010 (Table 2). The Eurozone’s Problem In an ideal currency union, there is high labor and capital mobility, risk smoothing, and symmetric business cycles among regions. For the Eurozone, however, only one of these seems to be true in capital mobility. While the zone rode out the beginning of the US crisis, cracks began to show within a year. Austerity policies put in place to solve high debts have failed to stem the crisis, and a lack of unified monetary policy has crippled struggling countries. The problem now facing the Eurozone is one of existential proportions: can it become a more optimal currency zone? If not, should it, and can it, survive?
- 3. Mitchell 2 Optimality of the Zone The Eurozone’s performance on the first condition of optimality, labor mobility, pales in comparison to the United States. Blanchard and Katz’s prescient 1992 paper described the difficulty that the Eurozone would have in terms of labor mobility; they showed that individual US states tend to recover from asymmetric shocks through moderate to high labor mobility.2 In fact, a 2014 European Commission report estimated that cross-‐country mobility in the EU was .2 percent, less than one-‐tenth of the 2.7 percent state-‐to-‐state mobility in the US.3 This does not bode well for the Eurozone considering that the pressures faced by individual depressed countries are due, in large part, to external demand imbalances. A 2015 working paper by Emmanuel Farhi and Ivan Werning shows that mobility out of depressed regions has a significantly positive effect on those who decide to stay, but only when the source of demand imbalances is external (such as the current Euro Crisis).4 In sum, the unique structure of the Eurozone puts it at a disadvantage for the first pillar of optimality, a condition that may need to change if it is to survive. The strongest area for the Eurozone is capital mobility, with both historical and current trade agreements providing a strong base. The 1957 Treaty of Rome, a precursor to the eventual Treaty of Maastricht, created the European Economic Community, which provided for common goods markets and customs rates. The treaty was a foundation on which the future Eurozone established strong capital mobility. Authority over the customs union was transferred to the European Union after its inception, and was expanded to include all member states. Additionally, the introduction of a single currency has made transfer of capital easier, to the tune of an approximate 10 percent increase.5
- 4. Mitchell 3 Perhaps the Eurozone’s trickiest yet most necessary problem to change, risk smoothing across countries is notably absent in the Eurozone. Ironically, the Eurozone resembles the short-‐lived Articles of Confederation in the United States, with the central authority unable to implement many fiscal or monetary policies without support from member states. Unlike the current United States system, whereby the federal government can shift tax burdens and benefits to states hit by asymmetric shocks, the Eurozone is not set up to complete such actions. The supremacy of individual members over the European Parliament and Central Bank puts a major damper on the ability to shift benefits around the Union. Individual member states would need to use their own tax receipts to support failing countries, something politically difficult for national legislatures. Indeed, the European Fiscal Compact forces members to keep their deficits under 3 percent or face fines, and Germany has so far stood strong in refusing the most recent bailout offers from Greece.6 On the monetary policy front, quantitative easing has long been off the table due to both structural EU requirements and German opposition.7 Simply put, current fiscal and monetary policies do not align with necessary structures required for an optimal currency union. The last problem facing the Eurozone is the asymmetric business cycles facing member states. A 2008 research paper estimated that there were two groups of countries: a core and a periphery. The core consisted of Germany, France, The Netherlands, and Finland (among others), while the periphery was rounded out by Greece, Ireland, Portugal, and Spain.1 In addition to finding that both groups are indeed out of cycle, the researchers also found that the Euro has done little to bring them into alignment.8 As such, it is difficult 1 The last GIIPS country, Italy, was the only one included within the core group
- 5. Mitchell 4 for a central bank to utilize many available monetary policies in a way that can help buoy the struggling periphery countries, while not also harming the stable core countries. How the Crisis Has Played Out Eurozone Policy The Treaty of Lisbon and previous pacts in the EU impose significant restrictions on Euro-‐wide policy and place heavy burdens on member states to keep their financial conditions within certain bounds. Article 123 imposes a prohibition on the “direct” purchase by the ECB of “(Union Institution) debt instruments,” and many have interpreted this to preclude any monetary financing whatsoever. 9 Article 124 prohibits privileged access to financial institutions for any union institution.10 In addition, article 125 imposes severe restrictions on the ability of the EU to “bail out” any government within the EU.11 The European Fiscal Compact, signed in 2012, places tighter controls on the longstanding policy that member countries must have less than 3 percent deficit to GDP and 60 percent debt to GDP ratios.12 Finally, all monetary policy is complicated by the fact that the ECB’s primary job is limited to keeping inflation close to 2 percent.13 These policies, while not inherently meant to impede recovery, clash with what many economists consider the best set of policies in a recession. The most confusing policy stance is the EU’s resistance to quantitative easing in the sovereign bond and securities markets. Most advanced economies rely on countercyclical monetary policy to smooth the business cycle, encouraging growth in troughs and putting on the brakes during peaks.14 Such action in recessions can lower interest rates by driving up the demand in sovereign bond markets, which have seen skyrocketing interest rates for Ireland and Greece. However, Article 123 and the ECB’s own instructions effectively limit their ability to enact
- 6. Mitchell 5 any such policy, even as the crisis has leapt to historic proportions across the globe and EU. Finally, only two months ago, years after the crisis began, the ECB began a €1.1 trillion secondary market bond-‐buying program, now under intense political and legal controversy.15 So why was policy not changed? In short, political considerations trumped economic theory. Germany, the economic bedrock of the Eurozone, has flat out refused to accept such relief to debt stricken countries. Both of their ECB board members have openly opposed such actions, and Chancellor Angela Merkel has expressed her worry that such actions will allow distressed countries to delay or even fail to enact deficit-‐cutting reforms.16 These debt reforms, embedded within the European Fiscal Compact, go against a much more controversial area of economic theory. In order for countries such as Ireland and Greece to hit the 3 percent deficit and 60 percent debt marks, higher taxes and/or extreme austerity measures have to be implemented. Some decision makers used a widely cited research paper by Reinhart and Rogoff as empirical evidence that high debt leads to slower growth, therefore vindicating the Eurozone’s strict policies.17 However, many economists criticized the paper, and the authors were forced to clarify that the two were found to be “associated,” not necessary cause and effect.18 Yet, other research has found that debt can actually have a positive effect on GDP growth, up to certain points.19 Even further, some research has found no threshold at which GDP growth is hampered by additional debt.20 So what is the correct policy choice here? The general consensus in the economic realm is that higher deficits and debt in the short run can certainly have positive effects on growth, much in line with the Keynesian aggregate demand models. The most uncertainty occurs, however, on whether there is a certain level of debt that starts to
- 7. Mitchell 6 impede growth in the long run. Therefore, it seems likely that the EU policy here is likewise counter to what should be pursued in recessed economies, but the evidence is not as firmly grounded as is countercyclical monetary policy. The last controversial Eurozone recessionary policy is the prohibition on most bail-‐ outs. Unlike countercyclical and austerity policies, the evidence on bail-‐outs is decidedly mixed, with economists landing on both ends of the scale. On one hand, when assessing the effects of the US bailout, a University of Chicago forum polled 49 leading economists, who on average agreed that its benefits outweighed the costs, that unemployment was lower as a result, and that businesses were not be incentivized to harm the economy further.21 Additionally, empirical research has shown that not only are bailouts necessary to prevent a banking crisis which would wreak havoc on an economy, but even that Chancellor Merkel’s strong resistance to such policies led to higher bailout costs for distressed countries.22 On the other hand, research of the US bailout has found that banks did end up having riskier portfolios after they were bailed out, evidence of a moral hazard.23 What is seen overall is that economic theory tends to agree that a bailout of some undercapitalized financial institutions is necessary to avoid further economic shock, but some economists show that there is proof that those institutions continue the same risky behavior. Here, Chancellor Merkel’s concerns about moral hazard find stronger ground. Bailouts seem to be beneficial to an economy when they include strong regulations to prevent mistakes from happening again. However, Germany’s insistence for bailouts paired with strict austerity measures muddles recovery. So, how do these policies fit within specific Eurozone countries? Below, the examples of Ireland and Greece are considered. Irish banks, second largest in the world in
- 8. Mitchell 7 terms of GDP, were hit hard by the housing bubble and their economy was the first to tumble. Ireland accepted a contentious bailout with the strict austerity that Germany wanted, and their economy has recovered in part. Greece, bogged down by a drop in exports, bank bailouts, and high interest rates, was forced to implement deep austerity in accordance with bailout partners. Their economy, however, has turned to shambles. Impact on Ireland Ireland was hit hardest by the mortgage and financial crisis. Irish banks, with increased availability of capital from short term lending, increased their balance sheets by enormous amounts. In 2008, Irish banks held assets worth 783 percent of GDP, second to only Luxembourg.24 The vast majority of these assets were held in property, while at the same time, the Irish government increased spending and relied more heavily on property taxes to make up government revenue. As a result, in 2006 property taxes reached of peak of almost 20 percent of total Irish tax revenue.25 This reliance on property by both the Irish financial institutions and government led to a perfect storm as the housing bubble burst. When the US crisis hit, housing prices fell and borrowers defaulted on payments. The short term borrowing that Irish banks had so heavily relied on to increase their balance sheets began to dry up, limiting options for liquidity as the banks began to feel the squeeze. As banks used up their available capital, the Irish government stepped in and guaranteed to cover the liabilities of the struggling institutions. However, in conjunction with sudden structural deficits due to a plunge in property tax revenue, Irish debt soared from 25 percent of GDP in 2008 to over 111 percent by 2012.26 At the same time, Irish yields increased from 4 percent in 2008 to almost 12 percent by the middle of 2011, making additional borrowing too costly.27
- 9. Mitchell 8 The one-‐dimensional scope of the Irish crisis and the nature of their exports made the path to growth difficult, yet simpler than Greece. In response to the banking and emerging government debt crisis, Ireland was essentially forced into a European Union/International Monetary Fund bailout by the ECB.28 The recovery has since been slow and inconsistent. Ireland’s GDP grew 3.2 percent in Q4 2012, then dropped 3.7 percent the next quarter. It had 2 percent+ growth in Q3 2013 and Q1 2014, then leveled off to 0.5 percent in the last two quarters of 2014.29 Unemployment remains at 10 percent, wages are below 2007 levels, and consumer spending growth lags at 0.3 percent, in part due to higher taxes implemented to comply with austerity requirements.30,31,32 So, while the bailout certainly aided the Irish economy, the austerity measures possibly hampered recovery, with continued low consumer spending, low growth in wages, and high unemployment. Impact on Greece Unlike Ireland, which was impacted mostly by the banking crash and housing bubble, Greece was hit hardest by a dramatic drop in exports, high government debt, and a bookkeeping scandal that scarred the government’s credibility. Greece’s exports are mainly low value raw materials, while among Greece’s largest trading partners are Italy, Turkey, and Cyprus, all hit hardest by the global recession.33 Greece’s exports plummeted 21% from 2008 to 2009, only recovering to their 2008 level in 2014 (Table 3).34 Greece also faced a skyrocketing level of government debt: from 2005-‐2010, their debt rose from 100 percent to 148 percent of GDP.35 With a disappearance of risk and interest rates tied to the Euro average, Greece was able to borrow large amounts of money at what turned out to be insanely cheap prices. That changed when, in early January, 2010, the European Commission released a shocking report that accused Greece of falsifying records to cover
- 10. Mitchell 9 up true debt levels.36 Within one year, Greece’s bond yields rose from 6 percent to 9.5 percent, and peaked at 29.2 percent in early 2012 (Table 1). With skyrocketing bond yields, Greece was hit by both a drop in tax receipts combined with the inability to borrow at reasonable prices. Greece was given two bailouts as a result of their rising debt and growth crisis, one in May 2010 and another in July 2011. Both programs, jointly administered by the EU, ECB, and IMF2, required deep austerity cuts. The Greek government did indeed reduce government spending, with seven successive austerity plans from 2010-‐2013, cutting public workers’ pay, overtime, and jobs, while raising and enforcing existing taxes to increase receipts. However, unlike Ireland’s moderate recovery, Greece plunged. GDP fell every quarter from 2010-‐2014, 110,000 businesses declared bankruptcy, and unemployment rose from 10 percent to 27 percent.37,38 The drop in public sector and private sector employment led to lower tax receipts, and massive protests led to even lower productivity and political chaos. With an inability to borrow on the bond market and pressures from the bailout troika, Greece continued to cut, and their economy continued to fall. Only recently, in January 2015, did Greece’s anti-‐austerity party SYRIZA sweep into power, promising to undo the austerity measures implemented over the past five years. The Eurozone’s policies had an even greater effect on Greece than Ireland, and played a large part in their deep recession. First, the prohibition on countercyclical monetary policy prevented Greece from spending money on a stimulus package like the United States. Second, the ECB’s decision not to devalue the Euro meant that the drop in Greek exports had no cushion. Third, the bailouts and their strict austerity provisions 2 The troika partnership was formed for Ireland and Greece in part because of the severe restrictions placed on bailouts by Article 125
- 11. Mitchell 10 forced Greece to cut spending by massive amounts, in the hopes that international investors would lower bond yields. Quite simply, it did not work. The drop in aggregate demand from lower government spending led to a falling GDP and higher unemployment, as the classical Keynesian model predicts. Greece also did not see lower sovereign bond interest rates until mid-‐2013, so borrowing was out of the question. While SYRIZA’s success has caused a rise in interest rates past 10 percent, the ECB’s decision to finally implement a quantitative easing program should help dull the effects. However, many economists worry that the plan is “too little too late”, and that the Greek economy is stuck with slow growth for years to come.39 Conclusion The Eurozone crisis’s origins can be blamed partially on the United States, but the slow recovery of countries like Ireland and Greece is entirely due to the zone’s optimality, poor government management, and ineffective EU policies. The Euro currency union has low labor mobility, poor fiscal policy, and asymmetric business cycles. These three failures have led to the current crisis, wherein the Eurozone has faced its biggest test yet. At the same time, some union members allowed their economic situations to become unstable. Ireland’s banks ballooned past reasonable sizes and Greece’s debt passed 100 percent of GDP. When the crash hit, ECB policies with regards to quantitative easing, deficit reduction, and bailouts slowed their recovery. While Ireland has gained back some of the economic indicators it lost during its crisis, severe structural problems remain. In Greece, the policies have led to an outright depression. Even though the ECB’s monetary policy may finally be catching up, the road to recovery looks long and tenuous.
- 12. Mitchell 11 1 European Central Bank, and European Commission. Long-‐term interest rate statistics for EU Member States. 14 Apr. 2015. Raw data. Https://www.ecb.europa.eu/stats/money/long/html/index.en.html, Frankfurt. 2 Blanchard, Olivier Jean, Lawrence F. Katz, Robert E. Hall, and Barry Eichengreen. "Regional Evolutions." Brookings Papers on Economic Activity 1992.1 (1992): n. pag. Harvard Scholar. Web. 4 May 2015. 3 European Union. European Commission. Directorate-‐General for Economic and Financial Affairs. Labour Mobility and Labour Market Adjustment in the EU. By Alfonso Arpaia, Aron Kiss, Cees Diks, Balazs Palvolgyi, and Alessandro Turrini. Luxembourg: Publications Office, 2015. Europa.eu. European Commission, Dec. 2014. Web. 3 May 2015. 4 Farhi, Emmanuel, and Iván Werning. "Labor Mobility Within Currency Unions." National Bureau of Economic Research (2014): n. pag. NBER. Web. 7 May 2015. <http://www.nber.org/papers/w20105>. 5 Baldwin, Richard. "The Euro's Trade Effects." European Central Bank Working Papers Series 594 (2006): n. pag. Europa.eu. Web. 7 May 2015. 6 Monaghan, Angela. "Germany Rejects Greek Bailout Plan -‐ As It Happened." The Guardian. The Guardian, 19 Feb. 2015. Web. 3 May 2015. 7 European Central Bank. "Fiscal Policies." Europa.eu. European Central Bank, n.d. Web. 4 May 2015. 8 Giannone, Domenico, Michele Lenza, and Lucrezia Reichlin. "Business Cycles in the Euro Area." National Bureau of Economic Research (2008): n. pag. NBER. Web. 4 May 2015. <http://www.nber.org/papers/w14529>. 9 Eurostep, and EEPA. "Article 123." The Lisbon Treaty. Eurostep -‐ EEPA, 2008. Web. 5 May 2015. 10 Eurostep, and EEPA. "Article 124." The Lisbon Treaty. Eurostep -‐ EEPA, 2008. Web. 5 May 2015. 11 Eurostep, and EEPA. "Article 125." The Lisbon Treaty. Eurostep -‐ EEPA, 2008. Web. 5 May 2015. 12 European Central Bank. "A Fiscal Compact For A Stronger Economic and Monetary Union." ECB Articles (2012): 79-‐94. Europa.eu. ECB, May 2012. Web. 5 May 2015. 13 European Central Bank. "Monetary Policy." Europa.eu. ECB, n.d. Web. 6 May 2015. 14 Coulibaly, Brahima. "The Long Road to Countercyclical Monetary Policy in Emerging Market Economies." FederalReserve.gov. Board of Governors of the Federal Reserve System, 3 Dec. 2013. Web. 5 May 2015. 15 Blackstone, Brian, Paul Hannon, and Marcus Walker. "Aggressive ECB Stimulus Ushers In New Era for Europe." WSJ.com. Wall Street Journal, 22 Jan. 2015. Web. 6 May 2015. 16 Ibid. 17 Reinhart, Carmen M., and Kenneth S. Rogoff. "Growth in a Time of Debt." American Economic Review 100.2 (2010): 573-‐78. National Bureau of Economic Research. Web. 6 May 2015. <http://www.nber.org/papers/w15639>. 18 British Broadcasting Corporation. "Reinhart and Rogoff Correct Austerity Research Error -‐ BBC News." BBC.com. BBC, 9 May 2013. Web. 7 May 2015. 19 Baum, Anja, Christina Checherita-‐Westphal, and Philipp Rother. "Debt and Growth: New Evidence for the Euro Area." European Central Bank Working Papers Series 1450 (2012): n. pag. Europa.eu. European Central Bank, July 2012. Web. 7 May 2015.
- 13. Mitchell 12 20 Pescatori, Andrea, Damiano Sandri, and John Simon. "Debt and Growth: Is There a Magic Threshold?" IMF Working Papers 34th ser. 14 (2014): n. pag. IMF.org. International Monetary Fund, Feb. 2014. Web. 5 May 2015. 21 University of Chicago. "Poll Results | IGM Forum." Igmchicago.com. University of Chicago, 13 Nov. 2012. Web. 6 May 2015. 22 Collignon, Stefan, Piero Esposito, and Hannah Lierse. "European Sovereign Bailouts, Political Risk and the Economic Consequences of Mrs. Merkel." Journal of International Commerce, Economics and Policy 4.2 (2013): n. pag. World Scientific. Web. 7 May 2015. 23 Duchin, Ran, and Denis Sosyura. "Safer Ratios, Riskier Portfolios: Banks' Response to Government Aid." Journal of Financial Economics (2014): n. pag. Social Science Research Network. Web. 3 May 2015. 24 Helgi Library. "Bank Assets (As % Of GDP) in Ireland." Helgilibrary.com. Helgi Library, 8 Mar. 2015. Web. 7 May 2015. 25 European Commission. "Ireland's Economic Crisis: How Did It Happen and What Is Being Done about It?" Europa.eu. European Commission, 12 June 2012. Web. 8 May 2015. 26 Trading Economics. "Ireland Government Debt to GDP." Tradingeconomics.com. Trading Economics, n.d. Web. 8 May 2015. 27 Trading Economics. "Ireland Government Bond 10Y." Tradingeconomics.com. Trading Economics, n.d. Web. 8 May 2015. 28 Castle, Stephen. "E.C.B. Threatened to End Funding Unless Ireland Took Bailout, Letters Show." NYTimes.com. The New York Times, 07 Nov. 2014. Web. 8 May 2015. 29 Trading Economics. "Ireland GDP Growth Rate." Tradingeconomics.com. Trading Economics, n.d. Web. 8 May 2015. 30 Trading Economics. "Ireland Unemployment Rate." Tradingeconomics.com. Trading Economics, n.d. Web. 8 May 2015. 31 International Labour Organization. Global Wage Report 2014/15: Wages and Income Inequality. Rep. Geneva: International Labour Officer, 2015. Ilo.org. International Labour Organization, 2015. Web. 7 May 2015. 32 Hannon, Paul. "Ireland's Economy Surges Ahead of Eurozone." WSJ.com. Wall Street Journal, 18 Sept. 2014. Web. 8 May 2015. 33 Trading Economics. "Greece Exports." Tradingeconomics.com. Trading Economics, n.d. Web. 9 May 2015. 34 Eurostat. European Union Goods and Services Exports by Country – Annual Data. 2 Mar. 2015. Raw data. Europa.eu, Luxembourg. 35 Eurostat. European Union Central Government Gross Debt -‐ Annual Data. 2 Mar. 2015. Raw data. Europa.eu, Luxembourg. 36 European Union. European Commission. Economic and Financial Affairs Council Configuration. Report on Greek Government Deficit and Debt Statistics. By European Commission. Luxembourg: Office for Official Publications of the European Communities, 2010. Europa.eu. European Commission, 8 Jan. 2010. Web. 9 May 2015. 37 Trading Economics. "Greece Unemployment Rate." Tradingeconomics.com. Trading Economics, n.d. Web. 9 May 2015. 38 Trading Economics. "Greece GDP Growth Rate." Tradingeconomics.com. Trading Economics, n.d. Web. 9 May 2015. 39 Spence, Peter. "ECB Doing 'Too Little, Too Late' to Rescue Eurozone, Experts Warn." Telegraph.co.uk. The Telegraph, 9 Feb. 2015. Web. 10 May 2015.
- 14. Mitchell 13 Data Source: European Central Bank Chart Source: Author 0 5 10 15 20 25 30 35 2015Mar 2014Dec 2014Sep 2014Jun 2014Mar 2013Dec 2013Sep 2013Jun 2013Mar 2012Dec 2012Sep 2012Jun 2012Mar 2011Dec 2011Sep 2011Jun 2011Mar 2010Dec 2010Sep 2010Jun 2010Mar 2009Dec 2009Sep 2009Jun 2009Mar 2008Dec 2008Sep 2008Jun 2008Mar 2007Dec 2007Sep Interest Rate (%) Month Table 1 – Interest Rates on Eurozone Country Long-‐Term Bonds Austria Belgium Germany Spain Finland France Greece Ireland Italy Netherlands Portugal Lehman Brothers Collapse Greece Debt Scandal
- 15. Mitchell 14 Data source: US Census Chart source: Author 15000 20000 25000 30000 35000 40000 Jan-‐06 Mar-‐06 May-‐06 Jul-‐06 Sep-‐06 Nov-‐06 Jan-‐07 Mar-‐07 May-‐07 Jul-‐07 Sep-‐07 Nov-‐07 Jan-‐08 Mar-‐08 May-‐08 Jul-‐08 Sep-‐08 Nov-‐08 Jan-‐09 Mar-‐09 May-‐09 Jul-‐09 Sep-‐09 Nov-‐09 Jan-‐10 Mar-‐10 May-‐10 Jul-‐10 Sep-‐10 Nov-‐10 Imports ($millions; not seasonally adjusted) Table 2 -‐ Value of US Imports by Month Lehman Brothers Collapse
- 16. Mitchell 15 Data Source: Eurostat Chart Source: Author 0 10000 20000 30000 40000 50000 60000 70000 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 Value of Exports (Millions of Euros) Year Table 3 -‐ Value of Greek Exports by Year Export Shock