ECONOMY OCTOBER 11, 2011
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.