The Euro: an alternative moral tale

                Part of the austerity mindset that I talked about in the context of the Irish referendum is the belief that transfers from creditors to debtors are unfair (HT MT) because they result from the feckless behaviour of the debtor. There is a clear parallel with the attitude to benefit recipients within a society, which Chris Dillow talks about here. I do not want to get into the economics or politics of attitudes of this kind, but just claim that they are important in influencing policy, a position I think David Glasner supports here. Instead I want to confront this mindset with an alternative moral tale. Let’s talk about the Core countries and the Periphery, because I want to look at why they became creditors and debtors.

                When the Euro was formed, its fiscal architecture was embodied in the Stability and Growth Pact (SGP). This architecture was the construction of the Core, not the Periphery. In political terms, it was the price that the low inflation countries of the Core laid down for their participation in the Euro. That fiscal architecture was all about containing deficits, and said nothing about using fiscal policy to control domestic demand. To many economists, this was something of a surprise. Much of the academic work leading up to the formation of the Euro had stressed the crucial role that countercyclical policy could play in reducing the consequences of asymmetric shocks in a monetary union. The SGP effectively ignored that work.

                Why? Perhaps because in the debate on the wisdom of setting up the Euro, the problem of asymmetric shocks (or asymmetric adjustment to common shocks) was the key argument used by the anti-Euro camp. So it was easier to deny that the problem would arise, rather than talk about how it might be reduced. However I suspect countercyclical fiscal policy was also ignored because many in the Core just did not believe in the kind of Keynesian world in which the policy worked. In that sense, we were seeing the forerunner to a belief in expansionary austerity. To put this in simple terms, the view was that any demand and competitiveness imbalances would be quickly self-correcting, as uncompetitive countries would lose exports, output would fall and inflation would decline. The Keynesian view that this self-correction might be slow, costly and painful, and that fiscal policy could reduce those costs and pain, was discounted.

                Much the same can be said about monetary policy and the ECB. This was designed by the Core. The ECB was independent of government, but also explicitly prevented from acting as a lender of last resort to governments.

                After the Euro was formed, interest rates came down substantially in the Periphery. There was a substantial amount of lending by the Core private sector to the Periphery private sector. This led to inevitable overheating in these periphery countries relative to the core. At this point the Core, and the bureaucratic apparatus that was essentially under the Core’s control, should have been sounding alarm bells. But instead they continued to follow the flawed fiscal architecture. In the case of Spain, as is well known, the budget deficit looked OK according to these fiscal rules, so the overheating there was allowed to continue. As a result, we got a housing and construction bubble. The aftermath of this is what countries like Ireland and Spain are dealing with now.

                So, the basic problem was one of excessive private sector borrowing in the Periphery, partly financed by excessive lending by the Core. The Core countries had set up a fiscal architecture that effectively ignored this kind of problem, and they did nothing to address their mistake in subsequent years.

                So who is to blame? Consider a parallel with the sub-prime crisis. Do we hold the low income households who took out mortgages they could not afford responsible for the financial crisis that ensued? Do we blame them for the Great Recession? Do we pity the poor financial institutions that lost money lending to these irresponsible people? I hope not. Instead we ask, how can the financial system have allowed this to happen? What was wrong with the architecture of regulation, and who was responsible for this?

                I think we should have the same response to the Euro crisis. What was wrong with the fiscal and banking architecture that allowed housing bubbles and the like in the Periphery, and who was responsible for this architecture?

                But in the case of the Euro, it gets worse. Even after the crisis, the Core countries continued with their anti-Keynesian mindset. As the immediate manifestation of the crisis was unwillingness by markets to lend to Periphery governments, then it was assumed the problem must be excessive borrowing by Periphery governments. Never mind that the problem in Ireland was in large part because the government bailed out its banking sector (and therefore lenders to that sector, some of whom were of course from the Core), and the problem in Spain was that it might be forced to do the same. (On Spain, read this from Yanis Varoufakis.) So the Core countries imposed sharp fiscal austerity on the Periphery, as the price for ‘rescuing’ these countries. It was conveniently forgotten that the reason these countries governments found it difficult or impossible to fund their deficits was because the common currency denied them their own central bank, and that the ECB had been designed by the Core such that it could not explicitly play that role. The terms of the rescue were hardly generous, because it was argued these governments needed to learn their lesson.

                It then got even worse. The austerity inflicted on Greece led the electorate there to believe that there was no hope down this path, and so the terms of their particular rescue needed to be renegotiated. Impossible, responded the Core. If you try to do that, you will have to leave the Euro. The damage that response has done to the operation of the Euro is immense, and entirely predictable. The gains from the ‘permanent’ abolition of exchange rate risk – gains that were central to the economic rationale for the Euro – are being unraveled.

                From this perspective, the actions of the Core from before the Euro was formed until the present day have been misguided and irresponsible. They risk destroying the Euro. It would not be the first time that the actions of a creditor had caused needless destruction. Bear this in mind when you next read about how the terms of Greece’s rescue cannot possibly be changed because of the message this would send to other Periphery countries. If the Euro is to survive, the Core has to stop thinking like the aggrieved party, and instead must recognise that it designed the system that, quite simply, created this crisis.