Winner of the New Statesman SPERI Prize in Political Economy 2016

Tuesday 6 March 2012

The Other Eurozone Crisis

                What follows is not a new story: many people have argued that the problems of the Eurozone are as much about private sector expansion, current account imbalances and misalignment, as they are about excessive debt. What follows is an attempt to present this argument in as clear and convincing a way as possible, and say why this matters.
One of the central pieces of macro I teach undergraduates is an adaptation of the Swan diagram. For non-economists this simply plots a demand curve and a supply curve in national competitiveness and output space. As competitiveness improves, exports increase and imports fall, because the demand for domestic output rises. More technically, it describes an economy made up of producers of differentiated traded goods sold in imperfectly competitive markets, so the aggregate demand curve has an obvious interpretation. I draw the supply curve downward sloping following the textbook I use, but it could equally well be vertical.
Here is the diagram applied to the periphery and some quite central Eurozone economies.

The formation of the Eurozone led to substantial monetary easing in these economies, partly because financial markets wrongly thought that they were subject to risk levels not much different from Germany. The following table looks at two measures of real interest rates (long and short). I’ve missed off 1998-9 because entry was anticipated, so it is not clear where to put these years. I’ve taken current (CPI) inflation away from nominal rates, but hopefully with averages like these using actual rather than expected inflation is not too great a sin. Data is taken from OECD Economic Outlook.

Average Real Interest rates in the Eurozone

Short (%)

Long (%)



Real interest rates fell everywhere in the 2000-7 period (global savings glut?), but the fall was more modest in Germany than anywhere else. Lower real interest rates shift the AD curve to the right. With sticky prices we initially move horizontally from the 2000 point to the new demand curve (competitiveness changes slowly). However, as we are to the right of the supply curve, we get inflation and a loss of competitiveness until we reach 2007. From this date onwards country specific risk begins to return, and the aggregate demand curve shifts back. We need to go back to something like the 2000 position, which requires a recession and an internal devaluation to restore competitiveness. Different countries are at different stages in this process. The country which is furthest on the road back to a sustainable position is probably Ireland (although there are some statistical problems), but in others the process is only just beginning. Given low inflation in Germany, and the difficulty of cutting nominal wages, this road may be particularly painful and long.
Are the falls in real interest rates shown above enough to explain the loss in competitiveness seen in most Eurozone countries relative to Germany? It could be that in many periphery countries, particularly those that experienced housing booms, the key factor was a shift in risk perceptions. This shift could have been triggered by lower interest rates themselves (as some have argued for other countries like the US), or other financial supply side factors (see here, but also here).  Which is true may be important because it is related to how sustainable the original shift in the AD curve was. In theory a persistent reduction in real interest rates could lead to a prolonged shift in the demand curve, and reduced competitiveness, with no reversal of the sort shown in this chart. This is equivalent to asking how sustainable are the pattern of current account deficits and surpluses that emerged in the Eurozone in 2007. As I argued here, the balance of evidence suggests that these imbalances were unsustainable. Here are current accounts over this period.

Eurozone Current Accounts (as % GDP)

The Eurozone position as a whole (not shown) has hardly changed. The swing to surplus in Germany after 2000 is dramatic. Although the current account positions in France and Italy have deteriorated, this is not nearly as large as the deterioration in the smaller countries. This may also be an indication that in the smaller countries the demand stimulus generated by lower interest rates may have been much greater (the rightward shift in the AD curve larger), perhaps caused by excessive risk taking (housing bubbles etc).
This story is all about monetary conditions. Monetary easing was greater in the periphery countries when the Euro was created, partly because policy had been tighter there before Eurozone entry, and partly because risk premiums disappeared. If you look at fiscal policy, on the other hand, you find no comparable pattern. Overall fiscal policy, as measured by underlying deficits calculated by the OECD, became a little tighter in the Eurozone as a whole over the 2000-7 period. As the Chart below shows, Spain actually tightened quicker than this average, and fiscal policy was broadly unchanged in Ireland and Portugal. Even in Greece, the story is more a gradual reversion to previous bad old ways, after a pre-entry tightening. So the shift in the AD curve was not, with the exception of Greece, a result of a fiscal expansion.

Eurozone Fiscal Positions (Underlying deficit as % GDP, OECD Economic Outlook)

This does not imply that fiscal policy was appropriate in those countries over this period. I argued in an earlier post that fiscal policy should have been much tighter, to offset the monetary stimulus. But it is important to distinguish between what actually happened (a monetary stimulus) and what might have been (countercyclical fiscal policy).
                This is a story about monetary conditions and aggregate demand. Of course it is possible in theory that reduced competitiveness relative to Germany could represent some sort of wage push. However, the strong growth experienced in these countries on Euro entry is consistent with the diagram above, and is less consistent with a cost-push shock. In addition, the labour share has not shown any marked increase in most Eurozone economies over this period (see here). The fact that wages rose ahead of productivity outside Germany reflects relative demand conditions (see here). None of this takes away from the need to deal with underlying structural problems in many of these countries – it just says demand shocks can occur, and in a monetary union their impact can be substantial and persistent. This is a very familiar story in terms of both the historical experience of fixed exchange rate regimes and the academic literature.
                This analysis tells us why many Eurozone countries would be in recession today, even if there had been no debt crisis. Why is this important? After all, the debt crisis is real enough, and the implications – recession in many Eurozone countries – are the same. It is important because it pinpoints the nature of the fundamental policy error that was made in the Eurozone. It was not that the Stability and Growth Pact (SGP) was ineffective – it was, but this did not lead to excessive fiscal expansion (Greece excepted) as the table above shows. The problem with the SGP was that it ignored countercyclical fiscal policy. (I argue here that the SGP’s focus on deficits actually encouraged governments not to do the right thing.) If countries had responded to their deteriorating competitiveness position relative to Germany by tightening fiscal policy, the unsustainable shift in the AD curve shown above would have been at least reduced in size. In addition, the market’s fear about fiscal sustainability would have been greatly reduced. On both counts we might have avoided recession today.
                The really sad thing is that the Eurozone is continuing to make the same mistake. Such a collective failure by policy makers is really difficult to comprehend, although I will discuss in a later post how this may be related to economic orthodoxy in Germany.

1 comment:

  1. Great Post Professor. Another positive loop effect was that, at least in Spain, Public employees and Labor Union regulated contracts had automatic revision clauses of "inflation + 0. something ", which IMHO may had contributed to the inflationary cycle in Spain.


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