SEARCHING FOR CONSENSUS
In 2007, the financial meltdown in the USA triggered a global Great Recession, followed by the Eurozone crisis on the other side of the Atlantic. Almost a decade later, a full recovery in Europe remains elusive. While economists continue to debate alternative proposals to avert stagnation and spur growth, over the last few months the profession seems to have made real progress towards reaching a consensus on the causes of the crisis. Our first dispatch from the dismal science presents two dominant narratives. Though not fundamentally divergent, these differ in the relative importance attributed to the various factors contributing to the crisis. The main points of disagreement concern the role of the state, and the institutions comprising the Eurozone architecture.
In November 2015, a group of 16 “leading economists across the spectrum” released a “consensus narrative” report on the causes of the Eurozone crisis. The report was authored by, among others, Olivier Blanchard (chief economist at IMF until a month earlier), Daniel Gros (Director of the Centre for European Policy Studies), and Christopher Pissarides (Nobel Laureate and LSE Professor), and was subsequently endorsed by over 90 economists from academia, think tanks, government, and the private sector.
According to the “consensus narrative”, the common feature of those Eurozone countries worst affected by the crisis was not fiscal profligacy: this was only an issue for Greece, and to a lesser extent Portugal, but not for Spain and especially Ireland (where budget deficits ballooned only after the government bailed out failing banks). What united countries that got into trouble was rather persistent current account deficits, implying a significant loss of competitiveness. In this view, the crisis was the outcome of large capital flows in 2003-2007 from core to periphery member states, which might have financed productive industries, but were headed instead to non-tradable sectors of the economy (housing and government spending), which resulted in competitiveness loss via significant wage and cost increases.
The financial meltdown led to a “sudden stop” in cross-border lending, and drove bond yields up, as investors woke up to the risks of financing countries heavily dependent on foreign borrowing. The perception by the markets of these member states as insolvent, along with the absence of a lender of last resort at EU level, set in motion a sovereign-bank “doom loop”. As a result, both public and private debt in peripheral countries grew larger. Even worse, pre-existing rigidities in labour and product markets prolonged the painful process of “internal devaluation” leading to an export-led recovery.
Timing contributed to the (erroneous) perception that the causes of the Eurozone crisis were fiscal imbalances rather than macroeconomic ones. When in late 2009 the incoming socialist government in Greece revealed that budget deficit and debt statistics had been misreported by the previous conservative government, the news acted as detonator for financial markets: they swiftly raised their estimate of the risk that Greece might default, and hence the interest rates on Greek bonds. In this way, the country was caught in a public debt vortex. Market anxiety soon extended to other Eurozone member states facing current account deficits (e.g. Spain), leaving off the hook some of those facing high debt ratios (e.g. Belgium). When Ireland and Spain bailed out their banks, their debt ratios surged, setting in motion a “diabolic loop”. In retrospect, according to the “consensus narrative”, the real culprit of the Eurozone crisis were policy failures that allowed current account imbalances to grow, in combination with poor crisis management and a faulty design lacking proper shock absorber mechanisms, not the breaking of fiscal rules per se.
AN ALTERNATIVE VIEW
At the other end of the spectrum, four members of the German Council of Economic Experts begged to differ. In their view, the root cause of the Eurozone crisis was a pernicious combination of government errors with failures in regulation and supervision. At the domestic level, deviation from fiscal rules set off the crisis; at Eurozone level, ineffective sanctioning mechanisms and inadequate financial regulation enabled the build-up of public and private debt. The banking sector, insufficiently regulated and supervised, allowed excessive private and public borrowing, that was used to boost consumption rather than enhance productivity. As for subsequent crisis management, that was largely successful, as testified by the fact that most countries eventually recovered.
Clearly, this stands in stark contrast to the “consensus narrative”. The latter faulted crisis management in the Eurozone for contributing to contagion, bailout programmes for being “too little, too late” to appease financial investors, and pro-cyclical fiscal policies for trapping peripheral economies into deep and protracted recession. Lars Feld and coauthors reject debt mutualization and insist that current Eurozone institutions, by eliminating moral hazard and establishing market discipline, are already well-equipped to provide an effective response. In a nutshell, the root cause of the crisis in their view was not current account imbalances but government failure and the flawed regulation and financial supervision of banks.
ADJUSTING THE NARRATIVE
Their account was promptly disputed by Peter Bofinger, a lone voice in the German Council of Economic Experts. He had found the “consensus narrative” correct but incomplete, arguing that wage moderation in his country exacerbated the structural imbalances at the roots of the Eurozone crisis. But he really took issue with his German colleagues’ “surprising acquittal of the market”. Feld et al. acknowledged that in Spain and Ireland “increased private borrowing … motivated by excessive risk-taking” had taken place, but let private investors and bankers off the hook. “For economists who normally hold the principle of Eigenverantwortung (personal responsibility) in high esteem”, quipped Bofinger, “this is an astonishing assessment”. After all, “no banker was forced by the state to lend money and no investor was forced to spend money for unprofitable projects”.
The above exchange perfectly highlights the different approaches to the underlying causes of the Eurozone crisis. The two diagnoses agree that financial flows from banks in core countries to non-tradable sectors in the periphery undermined competitiveness there, but disagree on what actually caused the crisis. The “consensus narrative” emphasises current account deficits and inadequate fiscal and monetary capacity at Eurozone level, while the majority view of the German Council of Economic Experts stresses fiscal profligacy at domestic level and insufficient regulation of banking at Eurozone level.
The two views coincide in the importance they assign to completing the banking union. But the policy implications stemming from each are significantly different in other respects. The German economists would essentially like to see more of the current policy of austerity and structural reforms, while the “consensus narrative” authors advocate an activist policy to address the “legacy debt” problem and to ensure greater risk-sharing between Eurozone members.
But readers wishing to know more about solutions to the Eurozone crisis as discussed by prominent economists will have to wait for our next dispatch from the dismal science.
Photo Credits CC aesthetics of crisis
Also published on Medium.