Chapters 7 and 8 of The Euro Crisis

Chapter 7
The situation in southern Europe is mostly seen through the lens of Greece. The author claims that had Ireland asked for financial assistance first, then Greece would not be the center of the Euro crisis, but in fact it would be Ireland. Politically speaking, Ireland is a less attractive scapegoat because it involves a situation similar to that of the U.S.   Debt to GDP ratio was 54% of GDP in 1998 and came down to 25% in 2007.
Greece on the other hand missed the 1999 entry into Euro and joined Euro in 2001. Covered up debt and budgetary deficit was never below 4.5% (Ceiling was 3%) Public Debt was 129% of GDP (60% benchmark). Greeks used more pension money, had a lower retirement age, and did not spend EU grants well.

Euro Crisis revealed two flaws in the Euro Area framework.

First is assumption that threats to stability would come from Public Sector. Private sector is also major source of instability.

The second mistake was assuming that monitoring deficits year after year was enough to prevent a public finance disaster.  Financial crises often appear very suddenly and there needs to be a plan in place for when things go wrong.

The author goes on to say that blaming Greece for the crisis is an oversimplification of the problem: “Since the state is the insurer of last resort, its finances are vulnerable to all sorts of economic and financial shocks. Acknowledging this potential fragility and designing an adequate surveillance framework is more difficult than stigmatizing a small Mediterranean country for its (very real) turpitudes”

Chapter 8
Inflation rates across the Euro area  were very different, but the ability to spend was the same (interest rates). A Price differential occurred in non-tradable goods across the currency union, thus leading to differing rates of inflation. With the nominal interest rate being fixed for each country,  real interest rates began to differ as a result of the differences inflation.  This means that the ease with which households could borrow money depended on the inflation rate of the country they lived  in. When Spain adopted the euro in 1999, interest rates dropped as a result of accelerated convergence. This resulted in lots of credit and massive real-estate investment. The net effect was Spain’s external deficit widened from 4% to 10%. Divergence in Euro Area become a problem around 2005 and 2006. Even worse, the Central Bank of Spain could not do much to fix this because interest rates are set by ECB.

In short, European institutions did not hold up their end of bargain to monitor inflation rates and ensure that they were similar across the Euro Area.  Policy makers failed to act because they believed external deficits were not  big deal in a currency union.

Notes on Chapters 5 and 6 of The Euro Crisis and Its Aftermath

Chapter 5

In short, those who promoted common currency hoped it would eventually lead to common political institutions.   Euro-area members, however, kept their respective seats at IMF, G7, and other international organizations. So the members of the Euro did not completely unify themselves politically.  Economic policies do not have to be identical to be part of a currency union but counties do have to put more thought into unintended consequences of their economic policies.

European countries should have put more thought into whether or not joining the Euro was a good idea economically. The United Kingdom ran stress tests to determine whether or not it should join monetary union. Clearly the decision was political and the tests where just a way of checking a box, but more countries should have adopted an approach similar to that of the UK.

Chapter 6
France ran it larges current account surplus in its history when entering the Euro in 1999, while Germany ran a large deficit. Twelve years down the road and Germany was running a surplus while France was running a deficit. Why?

It took time for Germany to get back on its feet after reunification. East and West Germany formed a monetary, economic and social union. West Germany was economically competitive and East Germany was not. People in the East wanted to buy goods in the West. Infrastructure and capital stock had to be replaced. Germany chose to reinvent itself by removing parts of its economy which it knew it did not have a comparative advantage. It focused on thinks like technology that required a highly skilled labor force. People began exporting parts and importing partial goods as firms began to embrace globalization. This eventually resulted in destabilizing factors.

Germany  saved during the first decade of the Euro which caused problems. As a result of saving, demand in countries in the north decreased will demand in south kept increasing. Before long, countries in the north were financing countries in the south.

The other destabilizing factor was the interest rate policy. The monetary policy had to be set for the euro area as a whole, not individual countries. This means that a country like Germany who deserved a low interest rates was causing other countries like Greece to get the same low rate. In other words, the monetary policy was too expansionary for the countries in the south.

Indifference and Political Gridlock Could Result in Grexit

The other day in class, part of our discussion on Greece involved discussing whether or not Greek politicians were indifferent to their debt issues.  This Bloomberg article asserts that Greece will likely leave the Euro in part because its politicians simply do not care about their overwhelming debt.  The evidence for this  comes from a lecture given by Yanis Varoufakis in 2013 where he recommends Greece defaulting like Argentina did:

“My proposal was that Greece should simply announce that it is defaulting, just like Argentina did, within the euro in January 2010, and stick the finger to Germany and say `well, you can now solve this problem by yourself’.

What is more insightful is his attitude toward the consequences of Greece defaulting:

“The most effective radical policy would be for a Greek government to rise up or a Greek prime minister or minister of finance, to rise up in EcoFin in the euro group, wherever, and say “folks, we’re defaulting. We shall not be repaying next May the 6 billion that supposedly we owe the European Central Bank. My God you know, to have a destroyed economy that is borrowing from the ESM to pay to the European Central Bank is not just idiotic, but it’s the epitome of misanthropy. Say no to that. Put them in front of their contradictions. Make them face the contradictions of the euro zone themselves. Because the moment that the Greek prime minister declares default within the euro zone, all hell will break loose and either they will have to introduce shock absorbers, or the euro will die anyway, and then we can go to the drachma.”

However, it is not fair to place all the blame on Greece and the author does mention that leaders in the Euro area should put less pressure on Greece to pull itself together. The article suggests that this is unlikely when talking about German Finance Minister Wolfgang Schaeuble and his thoughts on Greek debt.

Ultimately, the Euro may be unsustainable because politicians in both parties simply refuse to work out a deal.

Irrational Investing

Interesting article about people in the Euro Zone not taking advantage of access to higher interest rates.

Debt to GDP Ratios Since the Financial Crisis

I found this short article and it kinda reminded me of what we said about Greece being the tip of the iceberg with regards to the Euro zone. However, this article only briefly mentions Greece and looks at debt since the Financial Crisis. It was interesting to see how global debt to GDP has increased since the Financial Crisis. Even more intriguing was how much China’s debt to GDP ratio has gone up in comparison with both the U.S. and Germany.