ECONOMY OCTOBER 11, 2011
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It’s all Greece’s fault. That’s what a lot of Europeans secretly—or not so secretly—think as they grumble at the prospect of coming up with yet more money to bail the eurozone out of its debt crisis. But what if that easy view of how Europe landed in its current predicament is not just simplistic, but wrong?
Nonsense, argue the grumblers. Clearly the crisis started because debt in the eurozone’s periphery—Greece, Ireland, Portugal, and Spain—became so large that investors grew frightened that entire countries were at risk of default. If those countries hadn’t racked up all that debt by shamelessly living beyond their means, then none of this would have happened. But this narrative misses a crucial element of the true origin of the eurozone debt crisis. In particular, it misses the fact that the very design of Europe’s common currency area not only caused, but was meant to cause the eurozone’s periphery to incur large amounts of international debt. Further, there was little that the governments of those countries could do to stop it. Far from causing the crisis, the peripheral eurozone countries were up against powerful forces outside their control, forces that probably made this crisis inevitable no matter how responsibly they behaved.
ONE OF THE PRINCIPAL goals of Europe’s common currency has always been to promote greater financial market integration between member countries. It was hoped that the common currency would make it easier for investors in one euro country to find good investment opportunities in other euro countries because they would no longer have to worry about fickle exchange rates. In other words, one of the perceived benefits of the euro was to make it easier for capital to flow from countries with abundant capital, and thus relatively low returns to investments, to countries that were relatively capital-poor, and that therefore offered high returns on investments. This is considered a crucial ingredient in the process of economic convergence, in which less developed countries catch up with the more developed.
In the case of Europe, the capital-rich countries were at the core of the eurozone: Germany, France, the Benelux countries, Austria, and Finland. The adoption of the euro by the periphery countries in 1999 allowed lenders in the eurozone’s core to take advantage of relatively high rates of return in the periphery. And the periphery countries, in turn, were able to benefit from the influx of capital that reduced borrowing costs. In a nutshell, the adoption of the euro as a common currency was designed to cause large capital flows from the eurozone core to the periphery—and it is those very capital flows that set the stage for the crisis.
By the early 2000s the effects of this exuberant capital flow from the core to the periphery were quite evident. The flow of capital into a country is measured by its current account deficit; a negative current account deficit means that the country is the recipient of international lending, while a surplus indicates that capital is being invested abroad. And the current account deficits of the periphery countries grew enormously in the years following euro adoption in 1999, while the core countries became substantial sources of capital outflows.
This had the desired effect, of course, and interest rates in the eurozone’s core and periphery rapidly converged. Investors in the core were happy about the relatively high returns they were getting in the periphery, the periphery countries enjoyed an economic boom financed in part by this easier access to the abundant capital of the core, and exports from the core to the periphery surged. By 2004 there was virtually no difference in interest rates of the periphery countries and that of Germany.
THIS IS NOT the first time we’ve seen a dramatic influx of capital when countries break down economic and financial barriers. The same thing happened in Mexico following the creation of NAFTA in the early 1990s, and East Asia in the mid-to-late 1990s. When less developed countries become more integrated with the rest of the world, investors typically try to take advantage by sending lots of capital their way.
The problem is that such surges in capital flows depend on the whims of international investors, and therefore have a notorious tendency to come to a sudden stop if investor sentiment changes. And when that happens, severe financial crisis often follows. Research by Carmen and Vincent Reinhart shows that capital flow “bonanzas” (to borrow their term) significantly raise the risk of financial crises; in fact, they find that such episodes systematically precede sovereign debt crises, because once the capital flow stops, the country on the receiving end is suddenly unable to roll over the debt it has accumulated. As noted by Rudi Dornbusch in the context of the Mexico crisis of 1994, it’s not speed that kills; it’s the sudden stop.
Crucially, sudden stops may happen even when a country is following all the right macroeconomic policies. The Mexican and East Asian financial crises of the 1990s are good examples of that. In the case of the eurozone, the sudden stop to capital flows in 2009 indiscriminately hit all of the periphery countries, regardless of how well they had managed their finances. Spain and Ireland, for example, were more fiscally responsible during the boom years than France or Germany, yet that wasn’t enough to inoculate them from the sudden end to the capital flow bonanza. So even if Greece and Portugal (which did run large budget deficits) had been paragons of fiscal prudence, it’s quite likely that they would still have been hit by the sudden stop to the capital flow bonanza. That’s why the best predictor of which countries were hit by this crisis was not budget deficits, but rather the size of the capital flows they were receiving.
So what triggered the sudden stop, if it wasn’t irresponsible behavior by the periphery countries? The financial turmoil of 2008 and ensuing deep recession in 2009 are probably sufficient explanation. That’s not to say the periphery countries did everything perfectly; Greece and Portugal should have cut their budget deficits more when they had the chance during the good years (though we could say the same about the U.S.), and it certainly didn’t help that the Greek government was caught fudging its official statistics.
But we know that one of the main features of the worldwide financial crisis that struck in 2008 was that investors suddenly had no interest in any but the very safest assets. So when it came to investments in the eurozone’s periphery, they decided it was time to cash in their chips. Add to that the ensuing recession, which caused budget deficits to explode in the periphery—along with everywhere else—and those countries probably didn’t stand a chance, no matter how responsibly they had managed their finances.
THE IMPLICATION IS that the very creation of the common currency area sowed the seeds for this crisis, not the behavior of the periphery countries. While these countries didn’t necessarily do everything right, they were playing against a stacked deck. But if the easy explanation for this crisis—namely, that it was due to the irresponsible behavior of the periphery countries—is not the right answer, then we need to reevaluate how it has been handled.
To start with, if the crisis is the result of inexorable forces beyond the control of the periphery countries, it’s not appropriate to wag fingers or punish those countries through the bitter medicine of insufficient assistance. This crisis should not be turned into a morality story.
But more importantly, since the periphery of the eurozone bore the bulk of the systemic risks inherent to the common currency area, while the benefits were shared by both the core and the periphery, it’s deeply unfair that the burden of solving the crisis has been placed so overwhelmingly on the periphery countries through the debilitating austerity measures demanded by the core countries. The core eurozone countries like France and Germany were in the driver’s seat when it came to setting up this system, and they were happy to take advantage of the common currency when it was to their benefit. They now need to recognize that the responsibility for fixing this mess should really rest largely with them.
Kash Mansori is an economist and consultant who provides analysis of financial and economic issues on his blog The Street Light.
19 comments
Kinda, maybe. But this piece makes the common mistake in macro analysis of confusing financial flows and real flows. Money flowing in for the purpose of real investment is one thing. If well spent, it boosts employment and income permanently. Money flowing in that finances consumption in excess of income is another. From the standard point of view, they are both "capital flows" that balance trade deficits. But the implications are very different.
- roidubouloi
October 11, 2011 at 12:23am
This is an accurate and useful analysis, but roi's right. This isn't just a financial problem, it's a political problem, and everyone in the PIGS knows perfectly well that the entrenched, inbred elites in government and banking benefited enormously within systems where no one pays taxes except hourly workers, and now it's going to be up to the Little People to pay for everything. The fundamental problem alluded to by Mansori is the gap between authority and responsibility. Unelected euro bureaucrats and complicit national governments conspired to foist responsibility for the euro onto a largely unwilling European population. They had the lovely internationalist ideal, as usual, but forgot that without political legitimacy they couldn't enforce the rules no matter how nicely they were designed. No enforcement, no rules. Like most socialist-internationalist ideas, this one was designed with the prior assumption that men are angels, therefore designed to fail. How badly the failure will hurt remains to be seen.
- Robert Powell
October 11, 2011 at 10:40am
Ah, roid, I knew I could count on you to unravel the over-simplification in this post. You are saying that without knowing the respective shares of capital flows from "real investment" vs. from consumption finance, you can't fully absolve the peripheral countries, as this post tends to do. Thanks.
- JackR
October 11, 2011 at 11:19am
I tend to agree with Robert Powell's analysis of the financial meltdown happening in Europe. The euro elites bypassed any legitimate validation by the people in the creation of the euro zone. Now they are dealing with the rebellion of these citizens, especially in the daily protests and demonstration in Greece, as this country heads for default. They just assumed the citizens in the PIG countries would abide by their dictates for a solution to the dilemma and draconian measures imposed upon them. So it's a crisis of political legitimacy, and the euro elites have only themselves to blame for their "prior assumption that men are angels."
- rewiredhogdog
October 11, 2011 at 12:09pm
To characterize adoption of the euro as a benefit for the European core and periphery countries alike, but only a risk for the periphery is downright bizarre. Would we even be having this conversation if this was actually true? It would be more accurate to describe the countries in the periphery as reaping more of the benefits as well as more of the risks of euro adoption. The high net capital inflows into the periphery in the decade prior to 2008 doesn't simply mean that the resulting low interest rates begged for higher sovereign debt. Certain governments may be uncommonly shortsighted, but this doesn't make them automatons. In fact, high net capital inflows and the enormous benefits that flow therefrom makes high sovereign debt, or in the case of Spain and Ireland, massive government expansion, less excusable. It may be in the global interest for the euro core to bail out the periphery, but this has nothing whatsoever to do with author's simplistic economic justice argument. The periphery was not set up for failure. History handed them a wonderful opportunity and they failed miserably.
- jkodak
October 11, 2011 at 1:07pm
I disagree with jkodak. Fundamentally, the "periphery" isn't set up the same way, and doesn't necessarily share the same values as the "core," and, why should they? From what I understand also, the cost of living, property values etc in countries like Spain is now adversely affected vis a vis the people who actually live there. You can see this on (confession) cable TV shows about people buying houses abroad. Gentry from other countries spending extra money buy houses that the local population can't afford now. Then the locals are blamed for being lazy. Give me a break. And, what about democracy? This uber-government, pseudo-government - how much input do the people really have in it? This has always concerned me when people declare that global government is the solution to all our problems. Please understand, I'm no "states rights" advocate, here in the US I think this gets ridiculous, the Civil War has been over for ages already so please. But, that doesn't mean Washington should be deciding local village housing prices for example - those have to be relative to the local economy don't they? And, people are different in towns, villages, farms, different parts of the country - is that so terrible? We have to account for this, understand and respect it, and if there are sharp distinctions in America - culturally, regionally and economically - what about in Europe which is hardly as uniform as the US? It seems that in Europe, people in charge maybe overlooked some basic principles, both economic and political, when they instituted the Euro? I wonder if it's too late to change without a disaster that will primarily hurt the "little people"? Thing is it will probably hurt us "little people" here too, regardless. That said, I think in Europe there have been a lot of benefits from the EU, there was at least some prosperity in various countries as a result of it, but it seems to have been temporary and has had a high, perhaps unbearable cost. What's the point of having a little money, buying a horse and having to send her to the slaughterhouse? Shattering, truly, and that's a fact also for people in Greece, etc, who are going to live on what? Their country is just plain poor, it isn't set up like Germany, it doesn't have the resources of a France or a Germany in any case - what are we saying? Everybody into a Malaysia style factory or else?
- Sophia
October 11, 2011 at 1:52pm
Good article. Capital flows isn't the full story but it's an important part that is often conveniently left out for more tabloid soundbites like "the lazy Greeks" who actually work more weekly hours than most other European nations. One minor point is the PIIGS. It really should be just - PIGS. Ireland is a very different case. Not least because we have that "good capital flow" that Roi talks about. Here's a stunning fact: At $55bn (€41bn), US multinational output in this country exceeds Brazil, China, India and Russia COMBINED. So, you really have to look at US FDI inflows into Ireland that dwarf European investment. (Including the ESF cash, which was paid back in full with fishing rights.) Puts that 20 Billion that Geithner fucked us over for to keep AIG off his back into perspective.
- IggyPop
October 11, 2011 at 6:59pm
"the entrenched, inbred elites in government and banking benefited enormously" Our entrenched, inbred elites in most of the public sector, especially those on 50k+ would shock you Robert. Our doctors, nurses, police and teachers are among the highest-paid public servants in the world. University lecturers, judges and hospital consultants earn twice as much as their European counterparts while Ireland also has the highest-paid electricity workers in the world. All while we're borrowing 18 Billion a year to keep the lights on! We're a perfect example of what happens when you have successive governments that buy off the public service unions. And our bankers are just crooks. Not one of them is faces charges in court. Not one.
- IggyPop
October 11, 2011 at 7:21pm
This is more of a Newsweek Article. Not quite up to TNR Standards.
- CRS9TNR
October 11, 2011 at 8:13pm
Mr Mansori’s article demonstrates a typical penchant of the left for cuddling those who have behaved badly and must now face the consequences of their actions - while at the same time deflecting responsibility onto other parties whose principle crime is the depth of their pockets. Lets us for the moment imagine that Mr Mansori’s theory is correct. Namely, that the failure of countries like Greece has very little to do with their wanton fiscal policy, years of uncontrolled spending, lavish union pensions and benefits, uncompetitive practices, over-committed social welfare programs, inefficient tax collection, and the infamous cooking of the public books. As difficult as this may be, lets us imagine that this is so. Mr Mansori then asserts that the real blame lies with the obscene influx of capital into “periphery” European states like Greece from “capital-rich” so called “core” countries like France and Germany. This argument could only be valid if the core countries coerced the periphery ones to accept the capital through force or fraud. The fact is no such coercion took place. The principle actors in the European debt crisis are nation states and it is at the highest levels of government that bad decisions were made. The so called periphery governments had a duty to understand economic realities, the risks involved in high leverage financing, and to steer clear of the very situation they now find themselves in. I believe that the concept of “negative current account balance” was known prior to the periphery states taking on loans which led to their undoing. The periphery countries are clearly responsible for their own financial affairs and their respective debt debacles. So why is the left so anxious to blame the lenders, whom now face economic damages due to potential default by their delinquent borrowers? Why is the left demanding that the healthy states make further economic outlays to rescue their ailing neighbors? When you cut through the intellectual smokescreen, the bottom line is because the lender countries are relative wealthy, and in the leftist mindset, the wealthy should be parted from their wealth. At the very least, they must share it with those that need it – as one famous leftist phrased it - “From each according to his ability, to each according to his needs.”
- Nicomachus
October 12, 2011 at 1:12am
You make a great point about the public service unions Iggy. Since they represent a large and reliable pool of votes, they essentially have the power to pick their own bosses. Pols can cater to their needs and demands while kicking the can down the road for accountability, ultimately passing the bill on to taxpayers. Even our great champion of labor FDR was opposed to them, but at this point they are perhaps the most important part of the Democrat coalition.
- Robert Powell
October 12, 2011 at 2:36am
No need to blame the lenders. They should just suffer the consequences of their feckless lending, meaning that Greece should just default and take itself out of the Euro if necessary. No one coerced French and German banks into buying Greek debt. If they decided they had no need to pay attention to the fundamentals of credit, too bad. The "core" is not trying to bail out the periphery. The "core" is trying to bail out its own financial sector and make the Greeks pay for it, as they did to the Irish, but worse.
- roidubouloi
October 12, 2011 at 11:37am
That is to say, the right is engaging its penchant for cuddling up to the banks, as usual, and trying to rescue them, at public expense, from the consequences of their fecklessness.
- roidubouloi
October 12, 2011 at 11:39am
Exactly right Roi. Well said. Pity such straight forward thinking is beyond sophisticated, full time journalists. Suppose everyone's got a mortgage to pay.
- IggyPop
October 12, 2011 at 1:53pm
I hate to be a Clintonesque triangulator, but aren't both sides of the debate partly right: That is, no one forced Greeks to go on a borrowed spending spree, so they are largely responsible for their problems. I have personal friends from Greece who confirm that ratio of "productive, hard work" to "government jobs and handouts" is sub-optimal. On the other hand, the speculative boom in Spain was largely beyond the control of the Spanish people or government, so is it fair to blame the Spanish for their current problems, especially considering that their government was running a surplus before the crisis?
- NateG
October 12, 2011 at 11:59pm
In short, it appears that careless capital flows can wreak havoc on a nation's economy, regardless of whether that nation is, on the whole, behaving responsibly or not. But it does seem like the relatively more irresponsible nations (e.g. Greece) have found themselves in worse straits than the relatively more responsible nations (e.g. Spain).
- NateG
October 13, 2011 at 12:06am
roidubouloi, I completely agree, we should allow the market to punish bad judgments.
- Nicomachus
October 13, 2011 at 12:54am
Greece should default andleave the Euro if need be. It should have no need external debt other than trade credit.
- roidubouloi
October 13, 2011 at 6:16pm
The market only works when it's allowed to. Of course those who made bad lending decisions should face the music. But one caveat--roi suggests "the right" is engaged in cuddling up to the banks. In fact, most of the euro politicos involved are absolutely creatures of the left. More evidence, if more were needed, that the traditional "right-left continuum" is obsolete.
- Robert Powell
October 15, 2011 at 11:35am