The Lessons of the European Debt Crisis

With the only commentary about the European Union in recent years seemingly related to the “intellectual black hole” that is Brexit, a very important milestone in the history of the Union has gone by largely, and shamefully, unnoticed. Indeed, the continuing European debt crisis, or “Eurocrisis”, became a decade old at the end of last year, an event marked by little public attention. This anniversary deserved far more coverage than it received because it demonstrates not only the failures of the single currency, but also of the EU more broadly.

Brought into existence primarily to strengthen Europe’s economic and political integration, the euro and the Eurozone are in many ways the defining features of the European Union. However, after scarcely ten years of growth, a debt crisis initially triggered by the global financial crash plunged the Eurozone nations into a deep and protracted downturn, from which the ramifications have been immense. Not only did this Eurocrisis require Ireland, Spain, Greece, Portugal and Cyprus to receive an EU or IMF bailout, it also led to the electoral success of many anti-establishment left-wing “populist” parties in Greece and elsewhere amid a climate of heightened political upheaval.

By and large, it is also true that the Eurocrisis was the inevitable result of the institutional workings of the central financial system in the EU; namely, the Eurozone itself. Structural imbalances built into the Eurozone from its inception interacted with monetary policy considerations, and the fact that individual nations could not devalue their currency, to create substantial intra-Eurozone capital flows; a situation that resulted in a massive asset bubble that caused the Eurocrisis once it inevitably burst. In Greece, the Eurozone’s institutional workings also created an environment that necessitated the excessive government spending that ultimately brought about the Eurocrisis in that nation.

The seed of the Eurocrisis was planted with the very inception of the Eurozone; when the creation of a monetary union welded together two broad groups of nations operating under dramatically different varieties of capitalism. Indeed, the root cause of the Eurocrisis is anchored in the divergent capitalist growth models pursued by nations inside the Eurozone. One of these growth models is that of northern European co-ordinated market economies (CMEs) such as Germany and the Netherlands, which rely on the expansion of their export sectors to ensure development. According to Canadian political scientist Peter A. Hall, these nations’ export-led growth models [are] built on high levels of wage co-ordination, sophisticated systems of vocational training, the inter-firm relations necessary to operate collaborative research and development, and intra-firm relationships that promote continuous innovation and quality control.

In contrast to the CMEs stand the peripheral Eurozone nations, such as Ireland, Spain, Portugal and Greece. Here, in Hall’s words, “wage bargaining is difficult to co-ordinate … [and] employer associations are … less deeply institutionalized … and poorly equipped to operate collaborative vocational training schemes”. Therefore, without the structures and institutions that enable sophisticated wage co-ordination and quality skill formation, which are necessary for an export-led growth model, the nations of the Eurozone periphery instead pursue a growth model centred on domestic demand and consumption.

In itself, the operation of these two different growth models in Europe would not make a financial disaster inevitable. However, when they were incorporated into a monetary union, the result was the institutional asymmetry that caused the Eurocrisis. The uniting of nations with export-led growth models in the same monetary union as nations with demand-led growth models was a critical institutional failure that was built into the Eurozone from its inception. To explore why this was the case, a discussion of the capital flows necessitated by the Eurozone’s creation is required.

After their entry into the Eurozone, the northern European nations, given their export-led growth models, accumulated substantial current account surpluses; while the demand-driven periphery accumulated similarly substantial current account deficits. Between 2003 and 2007, Germany averaged an annual current account surplus of over 5 per cent of GDP, while Portugal and Spain averaged an annual current account deficit of over 9 per cent of GDP. Such current account surpluses in northern European countries meant that these nations also experienced substantial savings gluts, which were ultimately redirected towards the “savings-strapped” periphery in the form of bank-to-bank lending; a phenomenon that the actions of the European Central Bank (ECB) did a great deal to foster. Indeed, the ECB, in spite of the different growth models that the Eurozone nations operated under, could only implement a “one-size-fits-all” monetary policy that had to compromise between what would have been best for the high-inflation Eurozone periphery on one hand, and the low-inflation northern states on the other. Therefore, the single monetary policy of the ECB inevitably resulted in very low or even negative real interest rates in the periphery occurring alongside comparatively high real interest rates in northern Europe. This scenario gave economic agents in peripheral countries, such as banks and businesses, major incentives to borrow, and investors in the north major incentives to lend. After the introduction of the euro, northern European investors could earn substantial real returns by lending the excess savings generated by their nation’s export industries to banks in the periphery, to be invested in their expanding consumption-driven economies.

In short, the underlying structural imbalances that came about because of the different growth models practised by Eurozone countries interacted with the monetary policy of the ECB to encourage significant capital flows from northern Europe to the periphery. This phenomenon, caused by the institutional workings of the Eurozone, would ultimately lay the groundwork for the Eurocrisis. However, to demonstrate how it did so, the specific nature of the “north-to-periphery” capital flows also needs to be explored.

The vast amount of capital that the banks in the Eurozone periphery borrowed from their northern counterparts was, in the words of Dutch economists Servaas Storm and C.W.M. Naastepad, “not used to finance productivity-enhancing investment in tradable (manufacturing) activities, but instead … mostly fuelled investment in non-traded, lower-tech sectors [such as housing]”; primarily because growth in the peripheral economies was driven by domestic demand. By and large, this investment therefore accelerated both non-productive asset prices and consumer price inflation in the periphery. Such rapidly increasing asset prices and inflation also further encouraged the existing capital flows, by increasing the potential real return on investment for northern European banks and lenders. This substantial investment in housing in the Eurozone periphery created one of the biggest asset bubbles in recent history. Between 2002 and 2007, Irish house prices increased by 70.24 per cent, while in Spain the figure was 102.96 per cent. By contrast, German house prices actually fell by 2.48 per cent over this period, as capital fled the domestic market chasing higher returns in the periphery. Put simply, the 2000s saw a monumental asset price inflation in the Eurozone’s periphery that was primarily financed by substantial capital flows from savings generated by northern Europe’s export-oriented economies; a phenomenon that the institutional dynamics of the Eurozone had made inevitable. 

As with all asset bubbles, the decade of Eurozone prosperity following the inception of the single currency was not to last. Indeed, when the global financial crisis (GFC) hit Europe it, according to academics Jeffry Frieden and Stefanie Walter:

brought the merry-go-round to an end. Peripheral European nations faced a “sudden stop.” The lending spigot was shut, and the borrowing nations were left with massive debts, a collapse in housing and other asset prices, and a terrible recession. It was soon clear that the continent’s financial system was saddled with trillions of euros in debts that were very unlikely to be serviced as originally contracted … Without direct intervention, European finance was likely to collapse.

With their countries’ banking and financial systems on the verge of total meltdown, many governments in the Eurozone periphery were all but forced to assume their banks’ bad debts. For some governments, the borrowing that they had to engage in to do this would ultimately require them to be bailed out; even if, like Ireland, they had a low debt-to-GDP ratio before the crisis began. This is how the institutional workings of the Eurozone created a chain of events that inevitably caused the “private-then-sovereign” debt crisis known as the Eurocrisis. 

Another concept that is important in understanding how the institutional structure of the Eurozone made the Eurocrisis inevitable is currency devaluation. In the 2000s, as the inflation rates in the demand-driven periphery exceeded those of northern Europe, the periphery nations needed to be able to unilaterally devalue their currency to, as a 2012 Foreign Affairs article made clear, “reduce the price of exports and increase the price of imports [and therefore] … keep up with their economically competitive neighbours”. In this way the peripheral nations would have been able to dampen the excessive current account deficits they had accumulated. However, inside the Eurozone, and without national currencies that could be devalued by national central banks, this vital monetary tool was unavailable. Therefore, when also considering how important current account imbalances were in creating the intra-Eurozone capital flows that led to the Eurocrisis, the occurrence of the Eurocrisis can largely be attributed to the inability of the Eurozone periphery to devalue its currency. And because this inability was tied to the institutional workings of the Eurozone, this was one way in which the Eurozone’s institutional structures made the Eurocrisis inevitable.

As revealing as the above account is, it risks giving the impression of national homogeneity regarding the causes of the Eurocrisis. For example, while in Ireland and Spain the Eurocrisis did develop as already described, the crisis in Greece cannot be properly explained in this way, although the institutional workings of the Eurozone are still partially to blame. In Greece, the Eurocrisis actually began as a problem of government over-indebtedness when, during the 2000s, successive governments enacted over-generous spending and lax taxation policies that resulted in consistently large budget deficits. From Greece’s entry into the Eurozone in 2001 until 2007, in what was ostensibly a booming economy that should have generated increased tax receipts, the nation’s average annual deficit was 6.71 per cent of GDP. And while there are many uniquely national factors, such as poor tax collection practices and undeniably bad policy-making, that contributed to Greece’s financial meltdown, these factors cannot fully explain what occurred.

Indeed, there was substantial institutional pressure that encouraged the agents within the Greek government to borrow heavily during this period: namely, the fact that the government bond yields of Eurozone nations had converged in the lead-up to the Eurozone’s inception, to the point where Greek and German bonds were considered to be low-yielding, near-substitutes. The reason for this phenomenon was that, in a single monetary union where inflation rates are not expected to vary significantly between nations, the yield on a bond is primarily determined by a measure of lending uncertainty that takes into account the risk of the borrower defaulting. And, in the lead-up to the Eurocrisis, despite the Eurozone’s formal “no-bailout” commitment, investors believed that debtor states would be bailed out if they faced default. This meant that, in the eyes of investors, all Eurozone bonds were of equal risk, and therefore, as American academic Jeffrey Frankel succinctly put it, “even the least creditworthy member states were able to borrow at rates roughly equivalent to those charged to Germany”. If it was not for the Eurozone and the EU’s blatantly hollow no-bailout commitment, the Greek government would not have been incentivised to, or even been able to, accrue the ruinous level of debt it did during the 2000s, because the bond market would have been too fearful of default to lend the Greek government money at a low risk-premium. Importantly, without such a high rate of borrowing, Greece would not have experienced the sovereign-debt-induced financial humiliation that it did after the GFC.

Another of the Eurozone’s institutional failures that led to Greece’s disastrously high government borrowing was the weakness of the Sustainability and Growth Pact (SGP). Aimed at combatting the potential for fiscal profligacy, the SGP theoretically limited the annual deficits of Eurozone members to 3 per cent of GDP, and total government debt to 60 per cent of GDP. While positive in principle, as one German paper identified:

the experience of the SGP clearly [showed] that its major shortcoming [was] its weak enforcement mechanism … There [were] no strong incentives for member states to prevent other member states from deviating from the non-binding political commitment.

Indeed, the credibility of the SGP was ruined in the early 2000s, when both France and Germany flouted it, and almost all the signatories broke its unenforceable rules at some point in the lead-up to the Eurocrisis. Therefore, the institutional workings of the Eurozone not only created the potential for Greece’s ruinous fiscal imprudence by indirectly lowering the cost of government borrowing, but the EU also simultaneously failed to co-ordinate fiscal policy and fight the incentives that such institutional workings had brought about. In this way, the tragedy of Greece, and its crisis-causing sovereign debt, lies, at least in part, at the feet of the Eurozone and EU.

 It was the institutional structures and mechanisms of the Eurozone that caused the factors that resulted in the Eurocrisis—irrespective of the heterogeneous national experiences of the event. The damage the Eurocrisis has wrought throughout Europe is far worse than even the most imaginative ramblings of Project Fear spokesmen when they talk about the supposedly negative future impacts of Brexit.

Oliver Friendship lives in Queensland. He wrote the article “The Convergent Thinking of Burke and Hayek” in the December issue.


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