Click here to move on to Part 2 - The Competitiveness Problem.
Click here to move on to Part 3 - The Tough Road Ahead.
The characterisation of the unfolding saga in the eurozone in the financial press has gradually evolved from a liquidity crisis to a solvency crisis to what is now increasingly being viewed as a political crisis. Just over a decade after its formation, the European Monetary Union is facing questions about whether its very existence makes economic, fiscal, and political sense.
At this time, the ultimate fate of the euro is unclear. If anything is clear, it is that Europe faces months and years of difficult challenges as the 17 countries of the eurozone decide whether they have the wherewithal (and desire) to keep the euro intact. Furthermore, the eurozone does not exist in a vacuum, and the progression of events in Europe will inevitably affect markets worldwide.
To learn more about the roots of the crisis, what the situation is today, and the remedies, we invited two prominent experts who have been studying the euro union since its inception in 1999 to participate in this issue’s Morningstar Conversation. George Magnus is a senior economic advisor at UBS. Magnus was one of a handful of economists who warned of a pending global financial crisis as early as 2007. Edward Chancellor is a member of the Asset Allocation Team at GMO. Chancellor has written extensively on the topic of the current crisis, specifically examining the ways in which the eurozone’s predicament differs from historical sovereign defaults.
They both called in from London. Our conversation took place on Dec. 19, 2011 and has been edited for clarity and length.
Ben Johnson: Let’s first discuss the causes of the crisis. George, can we start with you?
George Magnus: Sure. This euro-system crisis is really, in essence, a good old-fashioned balance-of-payments crisis. It seems to be about budgetary discipline and fiscal issues, which obviously have plagued Europe since Greece first appeared on the scene a couple of years ago. But this is just a manifestation of the problem of an incomplete monetary union and coming to terms with the fact that imbalances between member states don’t disappear. And, of course, these imbalances have grown to rather large proportions; France and Italy actually have been chalking up external deficits, which are the largest they’ve been since the monetary union began.
So, I think that’s really what the underlying cause of the crisis is. The misdiagnosis of the crisis is leading Europeans into adopting a flawed agenda with inappropriate policy tools. I don’t really see that they are even close to coming to terms with this as yet.
Johnson: Edward, you’ve done a terrific amount of work examining historical sovereign defaults and trying to provide context for the issues facing Europe today. How is the current crisis similar to past crises and how is it different?
Edward Chancellor: First, I’d like to say that I agree with George’s analysis that this is a balance-of-payments crisis. There are a number of ways of referring to the periphery of Europe, as sometimes they’re called, in a derogatory way, PIIGS. One other way of referring to them was as CADs, which stands for current account deficits. It was a term coined by Bernard Connolly, who is a longtime euro skeptic. Connolly elaborated that idea of the problem within the eurozone long before this crisis, even long before the global financial crisis.
Now, one of the problems with a balance-of-payments crisis-and this is why it’s quite similar to previous sovereign debt crises-is that during the boom times, the periphery- which normally when we’re referring to the periphery, it’s probably a Latin American country like Brazil, Argentina, or Mexico- typically runs a current account deficit that’s offset with capital inflows or a capital account surplus. And then, during the bust, money flows from the periphery back to the core, and no one is funding the current account deficits. Countries that have fixed currencies typically then find themselves with a large amount of external debt, possibly in an uncompetitive position, and with capital outflows, and that is followed very typically by a default.
One sees that pattern recurring from the first Latin American debt crisis of the 1820s, periodically through the 1870s, again in the 1930s, and again in the 1980s. So, these are sort of 50-year-plus cycles.
What’s different today, as George pointed out, is that the periphery is actually part of the currency union with the core. In the past, if creditors in the City of London suddenly decided they didn’t want to lend to Argentina, it might bring down Barings Bank, but it wasn’t going to bring down the British economy.
The trouble with the currency union is that if the core of Europe decides that it does not wish to fund the periphery, it creates an existential problem for the European currency union. That, in turn, creates a very severe problem for the French and German financial systems. So, in that sense, it has many of the hallmarks of a typical sovereign debt crisis- feckless low savings, overborrowing, peripheral countries. But the difference is that the seriousness of this crisis is, in my view, a lot greater.
Johnson: So, we have a monetary union without any sort of fiscal policy coordination. Yet some of the remedies being put forth are trying to coordinate fiscal policy across the member states. Is this something that is even feasible, given the various interests involved and that the pain of creating any sort of common fiscal policy may not be shared?
Magnus: It’s theoretically feasible. There are instances where we know that it’s practically feasible. In the case of monetary unions, there are examples such as the United States, the United Kingdom, greater Germany post-unification, and so on. So, these things can be done. But it requires a degree of political integration, which happened in these cases and in others, sometimes violently and sometimes over long historical periods.
The problem that the Europeans have is that it’s a bit of a Catch-22. They’d almost have to have a political union in order to agree to a feasible fiscal union. And, of course, they can’t get a political union because there probably isn’t any basis for it.
So, I wouldn’t say trying to establish some degree of fiscal coordination and integration is a wild goose chase. But I don’t think that what Europe is trying to do at the moment is going to be particularly effective, partly because the fiscal union and fiscal discipline implications-which the Germans, in particular, are stressing— may be something that you have to have by way of institutional arrangements to deal with future financial crises. But I don’t think it resolves or even addresses the current, as Edward said, existential crisis in the eurozone.
In fact, it’s going to make it worse, because what they’re trying to do is to institutionalise what I call the “pro-cyclical austerity zone.” In other words, Europe is in a situation where European countries have similar problems to the U.S. and the U.K.-the credit system has malfunctioned, they’ve lost their growth drivers, and so on and so forth. But on top of those problems, the Europeans are now trying to institutionalise fiscal austerity and the kind of rigid observation of deficit and debt targets that will slip ever further into the future the more austerity the European countries are forced to, or voluntarily choose to, implement.
So, in effect, what economic policy inadvertently is doing is turning Europe into kind of an economic zone, which is likely to be characterised by rising unemployment, weak or no growth, and occasional economic slumps, one of which looms during the coming 12 months.
Chancellor: Think of Spain, a country that has around 23% unemployment and is still running a current account deficit, which suggests pretty strongly that it’s uncompetitive. It has a very enormous amount of private sector debt relative to GDP. Its nominal GDP has not contracted, unlike Ireland’s, which has gone through this deflationary bust over the last couple of years. Now, if Spain loses any sort of capacity to run a countercyclical fiscal policy, it is then set for a deflationary adjustment, while having a private sector debt/GDP ratio of around 400%.
When I wake up in a very depressed mood about the eurozone, the way the crisis is working out reminds me of the Gold Standard in the 1930s, when you had the Credit-Anstalt Crisis of May 1931, and that was followed by bank runs and runs on various currencies across Europe. The Gold Standard forced countries into reducing their deficits at a time when their banks were experiencing runs, and there was a severe deflation. If you look at the history books, that was not a good thing to do to the European economies.
But today’s crisis is even worse, because the great thing about the Gold Standard is that any country could decide, as Britain did in 1931, that it had had enough and leave with very little ill effect—in fact, with immediate recovery. But you can’t leave the eurozone, as [European Central Bank chief Mario] Draghi is now pointing out, without there being immense ill consequences for your own economy.
Click here for part II.
