By Joseph Cox, Chris Hildebrand and Chris Klein
When you think about European troubles these days, all you think is “debt.” Debt is certainly a large part of the problem, but it is by far from the only part.
The debt crisis centers around a handful of European countries, referred to as the “PIIGS”: Portugal, Ireland, Italy, Greece, and Spain. All of them have significant, but varying amounts of debt:
Greece immediately stands out: they have the largest debt-to-GDP ratio in Europe and the majority of their debt is held externally. This is partly due to irresponsible fiscal policies, but joining the EU brought an influx of foreign capital that exacerbated their debt problems. Meanwhile, Italy, Ireland, and Portugal all have debt-to-GDP ratios comparable to the United States, and Spain’s debt-to-GDP ratio is actually below that of the US. So why all the fuss about a European debt crisis?
The problem stems from capital flows more than fiscal prudence. Countries with large current account deficits – meaning net foreign investment in the country – prior to the crisis, have debt problems now. Now that it has become obvious that not all Eurozone countries have the same default risk, investors have started to charge the riskier PIIGS higher interest premiums – which in turn raises the costs of servicing their debts. Manageable debt at low interest rates turns very quickly into a nightmare at higher rates. Greece, for example, can now only roll over its debt because of the intervention of the “troika” of the European Central Bank (ECB), the European Financial Stability Fund (EFSF), and the International Monetary Fund (IMF).
The PIIGS have responded so far by implementing several rounds of austerity measures – reducing government expenditures, paring back safety-net programs, and increasing taxes – in order to reduce their budget deficits, control their debt, and signal to investors they’re taking the problem seriously in the hopes their interest rates will be lowered.
Unfortunately, these austerity measures have had negative consequences to growth rates. Fears of a lack of growth in part created the debt crisis. Growth is anemic compared with pre-recession averages, and the European Commission expects stagnate growth in the near term. As growth slows, so do tax receipts, and the problem, instead of going away, compounds itself. The possibility for a “debtor’s death spiral” can quickly become a reality.
While Ireland, Portugal, and Greece have big problems, they are small countries. Italy and Spain, on the other hand, are much too large for the same type of rescue to be successful without significant political and fiscal restructuring the entire EU.
Monetary policy in the Euro
The debt crisis in the European Union has provided a case study in the obscure economic concept of an “optimum currency area.” The member countries of the Euro area are extremely diverse in their productivity, unemployment, per-capita GDP, debt levels, and borrowing costs. During the height of the business cycle these differences were shrinking as everyone benefited from the open markets and stability of the Euro, but since the global recession these differences have dramatically intensified, as the two channels through which asymmetric shocks can theoretically be offset within the monetary union, labor mobility and wage flexibility, are virtually non-existent in Europe. Therefore it is difficult, if not impossible, for a single monetary policy to be appropriate for low-unemployment and low-debt countries like Germany, the Netherlands, and Finland; high unemployment, low debt countries like Spain; and low unemployment, high debt countries like Italy, let alone train wrecks like Greece.
This difficulty of appropriate monetary policy becomes apparent by comparing the proscriptive interest target for the European “core” and the “periphery”. The Taylor rule sets the Central Bank interest rate target given unemployment and inflation (note: the ECB does not have a dual mandate to maintain full employment, its only goal is price stability). In the core countries of Austria, Belgium, France, Finland, Germany, and the Netherlands the Taylor rule recommends an interest rate target of almost 4 percent, while in Greece, Ireland, Portugal, and Spain a target of negative 3 percent is appropriate. If the European Central Bank splits the difference then its monetary policy is too loose for the core, and disastrously tight for the periphery. Moreover, the ECB was created under a strict mandate precisely to avoid this scenario, so even if it was not constrained economically it may feel constrained politically.
The political dimension of the Euro
Angela Merkel squeaked an extension of the European Financial Stability Facility (EFSF) through the German Bundestag on Thursday. With only four votes to spare between needing to rely on minority party support, there is a genuine fear that Germans have eventually grown tired of footing the bill for their European partners. Although the threatened loss of party discipline would not have been large enough the vote itself, since the center-left opposition voted with the government, the fact that a group of Merkel’s own coalition considered withdrawing their support is bad news for the Eurozone.
After all, membership of the European Monetary Union (EMU) is voluntary. There is no supranational institution in EMU that can prevent any state from seceding from the (monetary) union. More immediately, the EFSF extension requires approval by the parliaments of all member states – which means that countries such as Slovakia and Finland, both with populations of approximately 5 million each, can further hold up the process. Thus, in order for the Eurozone to survive, the member states must continue to perceive membership as being in line with their national interests. In other words: the benefits of the common currency must outweigh its costs.
However, what sounds like a rational consideration is a deeply political issue. The main benefits of being part of a monetary union, the elimination of transaction costs and the reduction of exchange rate uncertainty, are hard to quantify and generally unobservable by electorates apart from when on holiday in another member state. The costs, on the other hand, are immediately perceivable, in particular during the recent financial and sovereign debt crisis.
For the troubled economies on the periphery, these costs come in the form of harsh austerity measures in times of asymmetric shock – without sovereign control of the currency – monetary policy is unavailable to counteract adverse output and employment effects and fiscal policy options are severely restricted by treaty obligations. For the economies of the European core, the costs come in the form of direct or indirect transfer payments to bail out or prop up the peripheral economies.
While unilateral withdrawal by one or more of the smaller peripheral countries would likely plunge the Eurozone into a deep recession, it is unlikely that it would threaten the very existence of the common currency. A refusal by the EMU’s greatest paymaster, on the other hand, could be a fatal blow to the Euro project.
It is not come that far yet, as chancellor Merkel’s victory demonstrates. However, there are first signs that even the Germans, who hold European integration as part of their political identity of overcoming their troubled history, are not prepared to defend the currency at any price.
The Euro project was primarily political, but the political project is now being undermined by the economics of the common currency. Core countries have come to resent the need for bailouts of the periphery. Meanwhile the extreme austerity imposed on the periphery has led to social unrest. Monetary policy cannot solve all of Europe’s fiscal and political problems, but policy innovation and leadership could at least prevent monetary policy from being a source of European problems.
Established in 1995, the Georgetown Public Policy Review is the McCourt School of Public Policy’s nonpartisan, graduate student-run publication. Our mission is to provide an outlet for innovative new thinkers and established policymakers to offer perspectives on the politics and policies that shape our nation and our world.