By John D. Stephens
Beginning in 2008 and deepening in 2011 and 2012, five countries in the European periphery—Portugal, Ireland, Greece, Spain (unflatteringly known as the PIGS)—and, to a lesser extent, Italy, experienced deep economic crisis. All five countries are members of the Euro area, known as the Eurozone. That they share a common currency is both one source of their crises and a block to one solution. The crisis was (and is) deepest in Greece, as government budget deficits reached 16% of gross domestic product in 2009 and total government debt climbed to 134% of GDP the same year, well beyond the limits prescribed by the European Union Stability and Growth Pact (SGP).
Myths and Real Causes
As a condition for bailing out the Greek government with loans, the International Monetary Fund and the European Central Bank forced it to slash government spending and government employment and sell off government enterprises, such as ports. Northern European members of the Eurozone (Austria, Germany, Benelux, and the Nordic countries), led by Germany, backed this austerity, but this “solution” was based on the assumption that the cause of the crisis was profligate government spending. Indeed, this claim that excessive social welfare spending was the root cause of the problem was echoed in the international financial press. It is a false analysis.
There is no question that the Greeks were living beyond their means. In the three years prior to the 2008 crisis, Greek government deficits averaged 6% of GDP, double the SGP limits, while government debt averaged 115%, almost double the 60% limit prescribed in the SGP. By contrast, the Spanish and Irish governments ran budget surpluses in those years, and their total government debt was well below the SGP limit. Moreover, the Nordic countries—Sweden, Denmark, and Finland—who are three of the only four EU members that have never breached the SGP, are the really big welfare spenders in the European Union. Thus, it is a myth that excessive welfare spending is the root cause of the Eurocrisis.
What, then, are the causes of the crisis? The first is the financial crisis in the United States, which spread to Europe because of open financial markets. In the first three decades after the Second World War, the so-called “golden age” of growth, many advanced industrial countries limited cross-border financial flows, in such ways as capping the amount of money that could be taken out of a country or limiting the purchase of stocks by foreigners. These capital controls were gradually eliminated in the 1970s and 1980s. In the years prior to the crisis, the housing and construction sectors in Ireland and Spain were booming, and foreign funds flowed into those countries. This led to a huge buildup of private debt. Spanish and Irish banks borrowed abroad to invest in booming housing and construction. When the bubble burst, the banks were left holding a mountain of debt that they did not have the resources to cover, not only in residential housing but also in commercial building and real estate. Many banks in both countries failed, and the governments were forced to bail out the banks. Government debt then soared, especially in Ireland. Thus, speculative investment and bad decisions by private investors were a second component of the crisis.
Third, the low-interest-rate policy of the European Central Bank fueled overheating of the economies of Spain, Greece, and Ireland. This policy was appropriate only for the core of the EU—Germany and France—which had very low growth rates early in the decade. Overheating pushed up wage rates in the construction sector, which spilled over into the rest of the domestic economy, making manufacturing wages internationally uncompetitive. The normal corrective for such a situation is devaluation, which lowers domestic labor costs by lowering the value of the national currency. Such a solution was and is impossible because Spain, Greece, and Ireland are part of the Euro area.
Finally, the Eurozone is not what economists term an “Optimal Currency Area” (OCA), an area in which it makes sense to have one currency. Economic cycles are not synchronized across the Eurozone as they are in an OCA, making macroeconomic policy appropriate for some of its members but inappropriate for others.
For comparison, the United States is also not an OCA, but the American political economy has other features that make up for it. First, labor mobility is high, so that workers move from depressed regions to booming regions. This does not happen in the Eurozone, despite radical differences in unemployment levels and the absence of legal barriers to labor mobility. In 2011, youth unemployment was 44% in Spain and under 10% in Austria, Germany, and the Netherlands, yet there was no significant movement of Spanish youth to these countries. Second, in the United States, the tax system, social security, and unemployment compensation systems act as automatic stabilizers in that more income, social security, and Medicare taxes are collected from the booming states and more unemployment, welfare, and food stamp transfers are paid out in the depressed states. Despite the fact that U.S. social policy is miserly, these transfers are significant, whereas no such transfers exist in the EU. Indeed, one long-term solution for the Eurocrisis is to create such transfers. The proposals are not for common social policy but for low-interest loans that depressed countries could draw on.
In the meantime, the northern European countries, led by Germany, continue to push austerity for the crisis-ridden countries. Austerity can work for the northern European countries, which generally run trade surpluses and can export their way out of economic recessions, but it is not a solution for the European periphery (other than Ireland), because these countries usually run trade deficits. They must recover on the basis of demand generated domestically, and this requires increasing government spending, which violates the current SGP limits and, without left-wing governments in power, is not even on the agenda. The truth is that the biggest beneficiaries of the Eurozone have been the northern European exporting countries, because the common currency prevents appreciation of their currencies, which, before introduction of the Euro, would have undermined their competitive situation. Political leaders in northern Europe know this, but do not acknowledge it to their electorates. It is understandable that the northern Europeans are reluctant to bail out Greece, a country riddled by corruption, pork-barrel politics, and bad economic management. Spain, by contrast, is a well-governed political economy that deserves the help of those who have benefited from the Eurozone economic arrangements.
John D. Stephens is a professor of political science and director of European studies at the University of North Carolina at Chapel Hill. He is the author or co-author of five books, including Development and Crisis of the Welfare State (2001) and Democracy and the Left: Social Policy and Inequality in Latin America (2012), both co-authored with Evelyne Huber.
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In retrospect, the Eurozone should have never been that large. It should have been limited to the export oriented countries of Northern Europe and France and possibly Italy (more for historic reasons as an original member of the Common Market). The questions is what to do now. If the Northern European countries and France want to keep the Euro in its present form they are going to have to be willing to transfer more resources more or less automatically to crisis ridden countries. You can ask why would they be willing to do that. The answer is that they benefit from from the Euro because it prevents their trading partners from devaluing. If they are not willing to do that, then I think the Southern European countries should leave the Euro. There would certainly be short to medium term costs but in the long run, they will be better off.