William Oman, Economist for Western Europe and Finance & Banking at RGE, argues that a flawed narrative holds back more than just the euro crisis debate.
What are the causes of the eurozone crisis? As basic as this question may be, European policymakers’ typical understanding of the causes of the crisis is incomplete at best. As a result, the approach to solving the crisis has been, and continues to be, inappropriate in several ways. If the crisis has one merit, though, it is that it can serve as a pedagogical opportunity to understand the deeper origins of Europe’s troubles.
Europe’s Great Deception: Disentangling Symptoms and Causes of the Crisis
Since 2009, a flawed crisis narrative has dominated both the media and politics. After the introduction of the euro in 1999, the dominant diagnosis goes, profligate Southern European countries took advantage of the low interest rates resulting from being thrown into a union with a credible, inflation-averse Germany to embark on private and public spending binges. This caused wages and prices to get out of hand and a decline in competitiveness of Southern European economies vis-à-vis their Northern European neighbors. Southern Europe then reaped the fruits of this irresponsibility when the global financial crisis broke out in 2008.
Given this diagnosis, many Germans understandably feel that “if we were able to do it, southern Europeans should be able to do it too.” In other words, if Germans tightened their belts, their Southern European neighbors should be able to do so too.
The conclusion—which is heralded by German policymakers, notably Angela Merkel—that follows from the flawed narrative is that Southern European countries need to slash public deficits and reduce labor costs, notably via “structural reforms” aimed at increasing the flexibility of their labor markets. The idea is that these measures will in time restore Southern European countries’ public debt sustainability and competitiveness.
Not only does this narrative distort European leaders’ thinking about how to get out of the crisis, it threatens the continent’s longer term prospects by providing justifications for negative-sum policies. Europe’s biggest problem isn’t economic or political—it is cognitive.
The dominant narrative, summarized above, ignores several aspects of the euro’s history. In particular, it turns a blind eye to two crucial elements of the eurozone’s institutional DNA: on the one hand, the initial differences in industrial structure that characterized Southern and Northern eurozone countries prior to the creation of the currency area and that made industrial divergence inevitable once these countries were thrown together in a currency union; on the other hand, the wave of financial integration that swept over the continent following the creation of the euro, and which accelerated the industrial divergence among the countries, despite European elites’ belief that it would do the opposite.
Blaming lazy and profligate Southern Europeans for their economic woes is convenient and plays to all kinds of clichés. To be sure, the governments of so-called periphery eurozone countries deserve their share of blame for the corruption and lack of regulation that allowed real estate bubbles to emerge in the 2000s. Yet the deeper origins of the crisis are to be found first and foremost in factors that were beyond periphery countries’ control. Namely, the huge financial flows that took place after the creation of the euro and the single financial market, and which national governments alone could do little to avoid. The development of eurozone financial markets must be set against the backdrop of the process of financial globalization that took place starting in the 1980s.
The data give a good idea of just how important these financial forces were in causing the euro crisis. They show that the debt that grew the fastest in the 2000s was not public debt, as many politicians and pundits would have you believe, but private—and particularly financial—debt. This debt fueled the housing bubbles in Spain and Ireland that wreaked so much havoc on these economies and, through contagion and the subsequent weakness of the entire European banking system, on the entire eurozone.
One chart (see below) clearly illustrates this: the most egregious sign of financial excess following the creation of the single currency is the astounding growth in financial sector debt in Ireland, which, by 2009, had grown to over 500% of GDP (Luxembourg was in a similar situation, although thanks to the absence of a housing frenzy, it did not suffer the same fate as Ireland).
(Source: National statistics, ECB / Note: Data are for 2009)
What is the flipside of these excesses, which grew between 2000 and 2008? The most important is the huge growth of Europe’s newly unified banking system. The cross-border financial flows from (mostly) German, French and British banks to banks and borrowers in Spain, Ireland and other countries helped Germany continuously improve its export competitiveness and Southern Europe to deindustrialize without facing a loss in living standards—until 2008.
A consequence of these dynamics is the economic success of Germany, reflected in its very low sovereign bond yields and unemployment and a very high current account surplus today. The country’s economic trajectory is in fact quite remarkable: in 1999, The Economist famously coined the expression “Europe’s sick man” to describe Germany; by 2013, the magazine had re-baptized Germany “Europe’s reluctant hegemon.”
What accounts for this upgrade? Three points should be made.
First, Germany benefited from improved price and non-price competitiveness. Germany has a centuries-old manufacturing tradition and so it started from a strong “structural” competitive position: it has a deep industrial base, a tradition of employer-trade union cooperation, high-quality vocational training programs, and extensive know-how, notably in manufacturing goods that face high demand from emerging manufacturing giants such as China (e.g., machine-tools).
Second, the integration of satellites (Eastern European economies) into Germany’s vertical production chain helped Germany increase its competitiveness. As Michel Aglietta and Thomas Brand explain in their recent book, Un New Deal pour l’Europe, two forces were at work. First, the “home effect” identified by Paul Krugman in 1979: a country that produces more manufacturing goods than its home market can absorb will tend to become a net exporter of that good. Second, the “lock in” effect: a country that develops an advantage will, through path dependency, tend to maintain and increase that advantage.
These two forces caused the re-industrialization of Germany and its satellite countries in Eastern Europe, as well deindustrialization in Southern Europe and France. These dynamics were largely ignored by European policymakers, especially in the Lisbon Strategy of the year 2000, which envisioned the free movement of capital leading to increased labor productivity and competitiveness in Southern Europe, rather than bubbles, inflation and deteriorating current accounts, as would make sense given Germany’s superior structural competitiveness.
Finally, European policy makers made a grave mistake by failing to endow the newly created currency union with strong regulatory capabilities at the pan-eurozone level. The Lamfalussy process indeed ensured that the coordination of national regulators would remain loose at best. Together with the deregulation of the financial system that preceded and followed the creation of the euro, the rules of the game were set to incentivize German banks to recycle German savings in Ireland and Spain. It should come as no surprise, then, that private debt surged and bubbles emerged in several periphery economies. One of the principal causes of the crisis, therefore, is not profligacy per se, as many politicians believe and argue, but rather the very structure of the eurozone financial system, and the lack of appropriate regulatory powers at the eurozone level.
The tragedy is that not only does the flawed narrative that permeates the euro crisis debate provide the justification for inappropriate policies throughout the region, it is gradually destroying the human capital and hopes of an entire generation of young Europeans—sapping the very foundations of Europe’s future prosperity.
This piece is cross-posted from Global Policy Journal with permission.