It is conventionally assumed that the Eurozone crisis arose because Club-Med governments have been too profligate. If only they had been as cautious as northern European countries, the argument runs, they would have retained their export competitiveness. A recent carefully researched paper, popularly known as the RMF Report and compiled by academics at the University of London, SOAS, shows this view to be entirely without foundation. [1]
Inter alia, the Report investigates the relationship between Club-Med current account (external) deficits, government deficits and the countries’ total stock of debt. Club-Med governments have not been wildly profligate: Greece, Spain and Portugal all have government deficits lower than the UK, and with the exception of Greece, their net public debt-GDP ratios are running at 60% or less.
The key point, however, is that much of Club-Med debt is held by the private sector: nearly 90% of all debt in Spain, 85% in Portugal and over 50% in Greece. Moreover, less than half of all Spanish debt has been contracted abroad (in contrast to Portugal and Spain where the overseas proportion is much higher). Secondly, a far higher proportion of private debt is relatively short-term, meaning it will need to be refinanced sooner than much of the public debt.
In Spain, private profligacy has mainly to do with a sharp rise in private investment resulting from the housing boom. In Portugal and Greece, by contrast, private investment growth was much less important; in essence, private savings have contracted to finance rising consumer demand. Nor is there anything surprising in these patterns—until 2008, the UK experienced both a private housing boom and a private savings collapse to sustain consumer demand.
All-round austerity starting with government deficit reduction has become the official answer to the problems of the Eurozone. But as the case of Ireland demonstrates, severe cuts reduce aggregate demand and induce further economic contraction, thus lowering government revenue faster than expenditure.
The main argument used by Eurozone deficit hawks—since devaluation is no longer possible—is that public cuts will restore the competitiveness of Club-Med countries. Once again, the problem is that where everyone practices fiscal retrenchment, aggregate demand throughout the Eurozone contracts. Because so much of the Eurozone’s trade takes place within it (ie, is ‘intra-trade’), what may benefit one country taken singly cannot benefit all simultaneously. Competitive wage-cutting has much the same effect as beggar-thy-neighbour devaluation did in the 1930s. And with the poor performance of the US economy increasing competitive pressures in the rest of the world, Club-Med countries cannot easily increase net exports outside the Eurozone.
In effect, we face three possible Eurozone scenarios.[2] The first is a decade of very low growth and high unemployment all ‘round. The danger is that in a decade’s time, Europeans will be so thoroughly disillusioned with the European project that it will fall apart politically.
The second scenario is default—whether partial or full. A partial default or debt restructuring exercise will, minimally, involve losses for creditor banks in Germany and France and necessitate further bailouts. Maximally, debtor-led full default would lead some Club-Med countries to leave the Eurozone, entailing the possible demise of the single currency. Alternatively, growing German resistance to ‘bailouts’ and a serious falling out with Paris over its export-led growth model might lead Germany to quit the euro and revert to its beloved DM.
The third scenario is fundamental reform of the Eurozone: the establishment of a genuine European Treasury with a substantial budget and fiscal powers and reform of the ECB, starting with the emission of federal Eurobonds. It is becoming increasingly clear that if the euro is to be saved, this is the path Europeans will need to adopt. By contrast, universal fiscal retrenchment enforced by levying fines on ‘profligate countries’ fails to address the real issues. But will European political leaders listen?
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[1] See Lapavitsas, C et al (2010) ‘The Eurozone between austerity and default’, RMF, University of London, SOAS <http://www.researchonmoneyandfinance.org/media/reports/RMF-Eurozone-Austerity-and-Default.pdf>
[2] See http://www.skidelskyr.com/site/article/europes-debt-crisis-and-implications-for-policy/
#1 by Luis on October 4, 2010 - 5:23 pm
Sorrym, but Spain is the ninth largest world economy, the sixth largest world investor and the fouth largest eurozone economy, then how is it that those ignorant anglos call it a peripheral economy?
#2 by Felix on October 4, 2010 - 6:57 pm
Mr. Irvin, three questions, please:
1) Do you see the creation of an European Treasury issuing “Federal Eurobonds” without a change in the existing EU Treaties?
2) If no, what is your opinion of the likelihood of the member-state UK approving such a measure (either in a parliamentary way, or with a referendum), given it’s well known (at least perceived) euro-skepticism? How real and wide-spread is UK’s euro-skepticism?
3) If such a change will not be approved by UK or other euro-skeptic member-state, does it mean that EU would be in an evolutionary deadlock in your opinion?
Thank you
#3 by Roger Cole on October 5, 2010 - 10:41 am
Mr. Irvin suggests the possibility that the European Project could fall apart in a decade. It could happen much earlier than that. The same Irish political/media elite that bullied an intimidated the Irish people into reversing their rejection of the Lisbon Treaty are the same elite that supported the neo-liberal militarist ideology that caused the crisis and who are looking for cuts of €4 billion in one year and more to come and i don’t see any reason why the German people would want to come their aid by giving even more of their income via Eurobonds to help the Irish elite survive.
#4 by Betterworld Now on October 5, 2010 - 12:41 pm
I agree with Roger – the Irish budget in November may not be carried by a teetering government. Even if it is, the deflationary effects of cuts of 14bn over 3 years are politically unsustainable. The deadline of 2014 to return to the 3% of GDP current account deficit limit is becoming less realistic by the day as revenue collapses due to the deflationary effects on the domestic economy and the resultant job losses and fright-response collapse in consumer spending. The patient is getting sicker, more of the same medicine is unlikely to revive it. A new medicine is required.
So what are the ECB to do if Ireland fails to live up to its promises? Fine it, thereby adding to the problem and identifying ECB as the culprit (there is nothing like a German bogeyman to unite a nation)? Not fine Ireland thereby open the door to all comers to ignore the agreements? No, there needs to be a behind-the-scenes agreement that a fudge is required to save the Euro.
That fudge will involve the use of Special Purpose Vehicles to transfer debt off balance sheets, similar to the proposal of Ireland in 2008 to deal with its banking refinancing plan – a plan that was initially accepted by EU finance ministers and then rejected by the ECB.
A future Irish government could well decide that if the ECB is unwilling to put that fudge in place, then Ireland will purposely devalue the Euro (by unilaterally pushing out the date by which it will return to the Stability Pact rules) to reduce its debt burden.
Just the threat of that should be enough to wake the ECB from its delusions of imperial power.
#5 by Johnny Bravo on October 5, 2010 - 1:17 pm
Roger, people have suggested that the European Project could fall apart since before the European Project was created. Don’t read too much into it.
#6 by George Irvin on October 5, 2010 - 1:20 pm
@ Luis: I certainly do not think Spain is a peripheral economy in terms of economic weight!
@Felix: yes, sadly, the UK (under the previous Govt and the current one) has blocked and will continue to block serious iniatives for economic reform. Your message is that the political will for fundamental reform does not exist (either in the UK or elsewhere), and I fear you are right. But without serious reform, the porject will flounder!
#7 by Roger Cole on October 5, 2010 - 5:29 pm
The problem, Johnny, is that the people’s of Europe don’t know what the”European Project” actually is, and when they are asked and say no like the French and the Dutch, the EU elite carries on anyway. They just crushed us Irish into the ground and forced us to vote again until we got it “right”. If you think that’s a European Democratic Project worth keeping, I profoundly disagree. However it won’t be people like me you will get in the future but racists like the Dutchman Wilders. Some good ideas from Betterworld Now though. However the EU elite believe their imperial power is real and not delusional, especially as their new secret service expands. We live in interesting times.
#8 by DOCM on October 5, 2010 - 8:09 pm
There is one question which continues to plague me and to which I do not have a satisfactory answer, not being an economist (who have an answer to everything, including totally opposing ones).
It is clear that “demand” as an aggregate stimulates economic activity. But what is the situation if the demand is not based on actual income but on borrowed money?
It seems to me that the only sensible actors in this debate are the “markets”. People invest, they want a return on their investment and, if it is a bond (an IOU), they want their money back.
That well-known personality, the “man in the street”, recognises this. In Ireland, in particular, there is an awareness that it was a great party but also an underlying awareness that it could not last. This explains the quiescence of the Irish electorate.
But, as the former head of the Irish National Treasury Management Agency (the outfit that borrowed the money on behalf of the state)remarked recently, if I am not mistaken, money just does not disappear. All those who sold assets during the recent amazing property bubble still have the money (unless they invested it in Irish banks or dud Wall Street financial products). The Irish saving rate has doubled to 11%. It could not do so unless there were reserves of income.
Ergo, it all boils down to re-igniting confidence in the Irish consumer sector, an ignition which will not occur unless the government demonstrates clearly that it intends to stop digging the State’s coffers further into a financial hole. This would include returning social welfare payments and state sector incomes to a level equivalent to those in the UK, by way of example, cuts that would equate to between 30% and 40%. If the EU does not force the politicians, ever ready to buy the support of taxpayers with their own – the taxpayers’ – money, the IMF certainly will.
#9 by Anonymous on October 6, 2010 - 8:11 am
The fact of the matter is, DOCM, reinvigorating consumers’ confidence by returning to sound public finances in Ireland is sort of a catch 22 really. There be few possible scenarios to achieve that, all equally implausible:
1. Decrease government spending. That would result in decreased overall spending which in turn would further cut growth prospects, ending in decreased private spending and even larger public budget holes and so forth.
2. Increase taxes. That would make all the hard earned foreign investment to leave Ireland in a quest for an investment friendly destination (Central, South Eastern Europe? ) and again reduce growth and cause a further boom in public debt.
3. Combined tax rises and budget cuts. Wouldn’t even want to contemplate the horror of that.
Nope, Ireland couldn’t possibly make it on its own. The only viable solution is to fully centralise economic governance in Brussels and above all allow to scrap national pride and substitute it with European pride, such as that it wouldn’t be relevant whether Ireland’s economy is doing good or bad but where the European economy as a whole is heading. And you personally would need to go beyond the outdated “community method”. The time has come to change that into European nation method.
#10 by DOCM on October 6, 2010 - 9:44 am
@anonymous. Your reply does not explain the huge jump in savings in Ireland and the speed with which the private sector is reducing its debt exposure. There is also the point that Ireland has been here before back in the ’80s. At that time, the balancing of the public purse worked. Admittedly, there was no banking crisis on the scale of the present one. But then, again, only Ireland seems to be coming clean on the full extent of its banking problems. I wonder what the UK deficit would like like if the cost of government participation in UK bank bailouts was shown as it should be in the government’s accounts?
#11 by Roger Cole on October 6, 2010 - 10:54 am
As a person living in Ireland let me assure DOCM that the Irish political/media elite did argue that the “party” would go on for ever. At the last election in 2007, all the major parties, FF/FG/Labour said so, and offered even more tax cuts in a country that already had one the lowest tax take as a % of GDP in the EU. There is not going to be a fully centralised economic governance in Brussels, because as I said earlier, the German people are just not going to agree to give their money to the Irish elite to bail them out. After all, 40% of the wealth in Ireland is owned by 5% of the people. What Ireland needs is a wealth tax, an increase in the corporate tax rate etc, so our tax rates rises to German levels, and a much longer period to reduce our budget deficit. More than anything, we need a general election to remove the government whose total commitment to a neo-liberal militarist ideology caused the crisis in the first place, and polls suggest that such an outcome is a real possibility.
#12 by Anonymous on October 7, 2010 - 4:37 am
@#10 DOCM
I should’ve thought that’s self-explanatory. It’s up to people’s expectations. But here it goes: in a country of extremely low taxes – rightfully set so in order to attract foreign investment – the state has been continuously lacking sufficient income. On the contrary, the population has seen enormous improvement in their income level and living standards. Nowadays, people’s expectations of a grim economic situation makes them save rather then spend. And the problem boils down to the fact that Ireland is a country of rich people and a poor state. You would think that raising taxes could solve it, but it couldn’t (see previous comment)
As to your question on the UK bank sector condition, it has never been my position on this blog or otherwise to glorify the UK, quite the opposite. In fact, the UK is in even greater need of the medicine Ireland desperately needs – Europeanisation of its domestic politics.
#13 by Felix on October 7, 2010 - 4:23 pm
I just don’t understand why governments cannot provide the same “amount” of services at reduced costs due to lower revenues from taxes.
Why when they are buying -let’s say – 1000 new police cars for $50,000, why they don’t negotiate and say to the bidders: we can only pay $30,000 a piece, lower your production cost and meet our price. Or: “we are buying at $33,000 a piece but you provide free maintenance for 5 years”.
Why the governments cannot reduce the number of paper pushers and emphasize online services? Then constantly seek to reduce the cost of IT services. A government web portal should not cost $10M to create and deploy, it should not have $500/hour consultants seeking to mess things up to bill more hours. It should be a fixed project bid: “price not to exceed $1M”, delivery in 1-year, and penalties for delays. I’ve reduced costs for my company with “price not to exceed” scenario on projects.
The governments in general are not spending the little they have in the most optimal way! They always complain about lack of revenue, but do they really need so many building, so much staff? Why they do not fight constantly fight costs like every private company and family? Government are terrible at optimizing costs and being responsible spenders.
#14 by George Irvin on October 8, 2010 - 1:22 pm
@DOCM: Private sector savings in Ireland are increasing as households pay down debt and firms deleverage (read Richard Koo’s book on Japan). But with the public sector also trying to save (swingeing budget cuts), GDP is bound to fall and unemployment rise. As you say, much the same is happening in the UK. In a recession, ‘budget balancing’ mania simply makes things worse.
#15 by DOCM on October 8, 2010 - 2:08 pm
Thank you for your answer but it does not satisfy me as it is, in one sense, simply a statement of the obvious. What really matters is whether GDP will fall only to a point where an economy can re-ignite and start to grow again because consumption will be related to productive capacity and not borrowed money. The Irish case should be informative as the productivity mix exists. It has simply been skewed by an incompetent government.
I am not impressed by the RMF material. The authors are clearly working to make their conclusions fit an agenda, that of opposition to “neo-liberalism” (whatever that is). Their reasoning is also dubious e.g. “Moreover, austerity is likely to press wages down across the Eurozone thus exacerbating the competition advantage of the core, above all, Germany”. In fact, as the recent sectoral deal (3.5%) with IG Metall indicates, wages are, at last, beginning to rise in Germany.
The problem in Germany is also that of a skewed economy with a hyper-competitive industrial sector subsidising uneconomic and sclerotic sectors, aggravated by the lack of a minimum wage and the refusal of Germany to implement with equal fervour the four freedoms of goods, capital, labour and services. It has done everything to hinder any concession with regard to the last two (free movement of labour from 1 May 2011?) and now inventive ways are being found to continue to protect the jobs of German workers at the expense of everybody else’s e.g. minimum wages only in particular sectors to prevent so-called “social dumping”. These actions, not the level of exports which is due the excellence of German goods, are the problem (combined with excessive state subsidies).
The arguments that one hears from German politicians that the German trade surplus is due to the free operation of the markets both for goods and labour is total rubbish. “Structural reforms”, as they are euphemistically described, are what is required. If implemented, the German trade surplus will take care of itself. I am not, however, optimistic. As in any country, there are strong vested interests at stake and they seem likely to win out.
#16 by Marcel on October 12, 2010 - 4:39 pm
God I hope the project will flounder. I hate and despise the undemocratic EU that has been imposed on us and I hate the unelected politicians who prance around pretending to have a mandate from the masses.
Death to the undemocratic EU and to the Euro currency which cheated us Netherlands.
#17 by Marcel on October 12, 2010 - 4:41 pm
Mr Irvin is one of those believers in the obsolete economic ‘theory’ of structural government overspending to generate and prop up artificial demand. The problem of the last few years is artificial wealth. Inflated housing prices and stock prices, and inflated economies because of demand generated with borrowed money. Some fools think this can go on forever. I disagree. Time to balance out.