Europe’s Debt Crisis and Implications for Policy

Keynote Speech at FT Conference in Amsterdam 

In its latest briefing note the IMF warned that world growth would slow in the second half of 2010 and the first half of 2011. Meanwhile the cost of Greek government debt has shot up again, despite the ECB rescue-package, and the IMF will soon inject another 2.5bn euros into the Greek economy. Finally, European trade unions are planning a winter of protest against cuts. These are just the latest glimpses of what is happening in the world economy.

The Causes of the Crisis

The turmoil in the Eurozone was caused by the global crisis that broke out in 2007.The deepest cause of the global crisis was the increasing dominance of the financial system in developed economies, as a result of its liberation from national regulatory controls. As Keynes pointed out in 1930s, the financial system is the most volatile element in the economic system, because most subject to uncertainty. Therefore the more dominant the financial system in any economy, the more unstable that economy will be. This analysis has come to be widely accepted, and inspires current efforts, puny though they have so far been, to re-regulate the financial sector.

But the Eurozone crisis is more specifically due to structural biases arising from the operation of the EMU. An analysis I have found particularly compelling has been offered by a network of radical economists called Research on Money and Finance.

They point to the sharp internal division which has emerged between the core, led by Germany and including Holland, and the periphery of Spain, Portugal, and Greece. (Ireland is a special case). Core and periphery are best considered regions rather than countries: France straddles both. This division has been reflected in the progressive loss of competitiveness by the periphery. The competitiveness of the core has benefited from pressure on workers’ wages which, in Germany, has meant practically stagnant real wages for well over a decade.

At the same time, macro policy in the periphery has been constrained by uniform monetary policy and rigid fiscal discipline. Thus the periphery has registered current account deficits, mirroring the current account surpluses of the core, above all, Germany.

Since late 2009, financial markets have been spooked by the extraordinary accumulation of debt by the peripheral countries of the Eurozone.

If one only read the financial press one could easily believe that the accumulation of peripheral debt was due to the growth of large public sector deficits. This explanation, which places the blame for the crisis on public profligacy, is grossly one-sided. The big expansion of debt before the crisis was in private debt, represented by the growing indebtedness of households and companies. Public debt only began to accumulate rapidly in response to the recession of 2008-9.

Respected analysts of British government finance have emphasised the ‘structural’ as opposed to the ‘cyclical’ element in the current deficit as the main index of the unsoundness of the UK’s fiscal position. This is now the dominant conventional wisdom. Only yesterday our Chancellor, George Osborne said in Parliament that the government was cleaning up the mess left by left by years of Labour government. This ignores the fact that it was the six quarters’ shrinkage of the British economy in 2008-9 –hardly Gordon Brown’s personal responsibility – which caused the government’s deficit to rise from an average of 2.5% of GDP from 2001 to 2007 to 10% in 2009.

The same ‘structural’ analysis has been applied in spades to the Mediterranean countries, and in similar disregard of the facts. Total debt (private and public) of Spain, Portugal and Greece stands at, respectively, 506%, 479% and 296% of GDP. It has increased between two and three times since the start of the euro in 1999.

Most of this is private debt. The ratio of private to public debt in Spain, Portugal and Greece is, respectively, 87:13, 85:15, and 58:42. The bulk of fresh debt created after the single currency started has been private, with public debt falling proportionately, as a result of the Stability and Growth Pact. Consequently, current account deficits have corresponded largely to private sector financial deficits.

These deficits were largely by bank lending from the core. The ratio of external to domestic debt in Spain, Portugal and Greece is, respectively, 33:67, 49:51, 51:49. The proportion of external debt has risen significantly in the last ten years. Both the Greek and the Portuguese public debt are largely external, as European financial markets have systematically overestimated the creditworthiness of peripheral states.

The key point made by the authors of the RMF is that peripheral debt has resulted in good measure from the unbalanced economic relations between Eurozone core and periphery. It was only the recession of 2008-9 which boosted public debt, turning it into the pivot of the Eurozone crisis.

Peripheral debt represents a major threat to European banks. In recent years core banks – mostly German and French –freed by liberation of capital movements have become heavily exposed to peripheral debt because of its high returns. In addition, all European banks face substantial solvency problems because of financing the purchase of large dollar assets with euro liabilities.

The intervention packages of May 2010 have been ostensibly directed to securing the solvency of the peripheral states, but were in practice aimed at restoring the solvency of the banks which had overlent to them. The ECB has provided liquidity to banks; it has also begun to acquire peripheral public debt with the aim of relieving the pressures on banks. State intervention has temporarily pacified markets but not decisively resolved the crisis. European banks continue to hold large volumes of peripheral debt of doubtful value while also facing funding problems.

To sum up, peripheral country indebtedness is largely due to the behaviour of the private sector since the start of the EMU. Unable to compete against the core, peripheral private sectors have borrowed heavily from European banks in the core. Consumption was boosted in all three countries, while a real estate bubble emerged in Spain. Furthermore, the domestic financial system in the peripheries found the opportunity to expand, thus increasing domestic financialisation and indebtedness. The result has been the accumulation of vast debts, partly external (and owed to the core), partly domestic (reflecting internal financialisation).

So how do we escape from the crisis? There are three escape scenarios: austerity all round, breakup of the eurozone, reform of the eurozone. Let me consider each in turn.

Austerity to the Rescue

The official remedy is austerity all round; the hair-shirt has become today’s favourite item of clothing. The idea that austerity is the royal road to recovery rests on two very shaky premises. The first, most familiar, is that the announcement and implementation of austerity programmes will so encourage the private sector that it will resume lending and borrowing, investing and consuming at close to the pre-recession rates This may happen. But sound economic theory tells one that the reverse is more likely to be true: attempts to reduce public deficits will slow private investment and consumption by reducing aggregate demand, and will therefore fail in their purpose. Keynes may have exaggerated when he said ‘Look after unemployment, and the budget will look after itself’, but he was more nearly right than today’s deficit slashers who say ‘Look after the budget and unemployment will look after itself’.

The more substantial premise is that the reduction of domestic demand in the peripheral countries will force their industries to become more competitive. This will reduce the structural imbalance between the southern and northern members of the Eurozone. However, a reduction of domestic demand does not automatically ensure a required readjustment of relative wages and prices. Domestic wages and prices are notoriously sticky. The only way of achieving the readjustment quickly is through a change in the exchange rate. But in the Eurozone devaluation is ruled out. Without the devaluation, the most likely effect of fiscal retrenchment will be a rise in unemployment. In principle this could be offset by an expansion of demand in the core. But the Eurozone has opted for austerity all round. This is likely to press wages down across the Eurozone, thus exacerbating the competitive advantage of the core, above all, Germany.

Thus the likeliest effect of austerity all round will be a rise in European-wide unemployment, and a persistence, even enlargement, of the current account surpluses and deficits in the Eurozone. In short, it will do nothing to solve the problem of peripheral indebtedness.

Nor is it plausible to believe that net exports will sustain growth across the Eurozone, given the weak condition of global demand. Austerity will also worsen income distribution across the Eurozone, particularly in the periphery, and shift the balance of power further against labour in favour of capital. In short what it offers is not a healthy recovery of private sector activity, but a series of further recessions on the back of a tepid recovery.

Default as a solution?

The lack of credibility of austerity to resolve the Eurozone crisis has led more radical analysts to advocate voluntary default by the heavily indebted peripheral states –i.e., unilateral cessation of payments by the governments concerned. Renegotiation of debt would follow with foreign lenders but also with domestic holders, particularly banks. There is a risk of becoming cut off from capital markets for a period. However, the experience of Argentina and Russia shows that debtor-led default can have positive results, if it is swift and decisive.

Debtor-led default raises the prospect of exit from the Eurozone. Exit would improve competitiveness through devaluation of the currency as well as removing the bind on monetary and fiscal policy. But it would also threaten domestic banking systems and disrupt monetary circulation.

The risks of debtor-led default have been spelt out by the Research on Money and Finance economists. The authors say: ‘Exit from the Eurozone would require – at least – public ownership and control over banks and other areas of the economy, extensive capital controls, reforming the tax system to include the rich and capital, introducing industrial policy, and thoroughly restructuring the state. In short, exit would provide the opportunity for a wholesale reversal of neo-liberal economic policy. For this reason, exit requires radical political and social alliances.’

It may be asked why a default need lead to exit from the eurozone. In principle, this need not be so. The deficits of the peripheral eurozone governments could be written off, written down, or ore-financed within the eurozone itself. There are two reasons why this is unlikely. First, it is highly improbable that the ‘core’ taxpayer will continue willing to take the losses implied in repeated writing down or re-financing operations. Secondly, default alone may buy time, but not solve the underlying problem of current account imbalances, which requires devaluation.

Reform of the Eurozone?

This would take the form creation of new central Eurozone institutions like a Treasury and a European Monetary Fund, whose inspiration would be expansionary rather than contractionary, but with the power to impose a sufficient fiscal discipline on the periphery and financial regulation on the core banks to prevent the build up of the vast debts which have precipitated the current Eurozone crisis. Such reforms are not currently on the cards. They require a political will to unification which is lacking. And if they do eventually come about it will be too late to solve the current competitive problems of the peripheral states.


Default is thus the likeliest eventual outcome. But since we have not reached the stage of a decisive confrontation between austerity and default, and since reform of European institutions is not practical politics, the Eurozone is likely to survive in a stagnant condition for several years to come. But a likelihood is not a prediction, and in an uncertain world, a succession of further crises and/or developments in the external world may resolve the issue one way or another.