Eurozone crisis and solutions

There was a severe economic and financial crisis between 2007 and 2009, probably the worst since great depression. The crisis was caused by too much easy money, too much leverage by households and financial institutions, excessive risk taking and lax supervision and regulation of the financial system leading to a boom and a bubble followed by a bust and a crash.
One the consequences of the crisis was that when the bust occured, there was a collapse of global economic activity. After the collapse of Lehman, the level of economic activity was falling at the same rate as in the case of the great depression between 1929 and 1931. For 2-3 quarters the fall in output, in employment, in production, in consumption, in investments, in exports and in imports was like the beginning of a new great depression.
What avoided it was the policy response. The policy makers in US, Europe, Japan, China and other advanced and emerging markets, after being behind the curve for a while, starting responding aggresively after the collapse of Lehman. The three main policy actions taken by these economies are

1. Monetary easing - reducing interest rates, printing money to provide liquidity to the economy and to the financial system.


2. Fiscal stimulus - reducing taxes, raising government spending because private demand was collapsing and if there was not public demand and simulus, this could have ended up like the great depression.


3. Rescue (bailout) the financial system - As financial institutions were on the verge of collapse, we decided to backstop and ring fence the financial system. This started to stabilise the financial markets and then the real economy.

So that was the way we achieved the stabilization and then beginning and resumption of economic growth. One of the consequences of the crisis was this crisis was that the crisis which started with too much debt and leverage in the private sector (households, banks and financial institutions , private corporations etc) morphed into one where there is too much public debt, deficits and leverage.
How we ended up in this situation of excess public debt has 3 reasons

1. During the crisis and recession, there were automatic stabilizers. As the incomes were falling, there was less tax revenues and as there was more unemployment, benefits like unemployment benefits were rising thus automatically increasing the defecits.


2. There was an active policy of trying to re-stimulate the economy (Keynesian policies) by trying to raise spending, raise subsidy and reducing taxes as way of boosting public and private sector.


3. The fiscal cost of bailing out banks, financial institutions, corporations and households became very large as the private losses were taken on by the government.
   So we started of with private debt but ended up having too much public debt and fiscal deficits that are difficult, large and unsustainable.

The consequences of the leveraging of the private sector and then the public sector are as follows

1. The recovery in advanced economies from the crisis has been sub-par, anemic and below trend. It has been a U shaped recovery where the growth has been very weak.In a typical recession it is a V shaped recovery with output falling and then recovering very fast.Any time the recession is caused by the financial crisis, the recovery is much slower than otherwise.


2. The question of soverign risks arising from too much public debt and defecit is becoming a widespread problem in all advanced economies and not just in the periphery of the Eurozone. The bond vigilantes have woken up in Greece, Ireland, Portugal, Spain and Italy. They have not yet woken up in countries like the United States, Japan or United Kingdom but even in case of US and Japan we have budget defecits of the order of 10% of GDP. We have public debt in the US that in few years will go up to 100% of GDP and in the Japan; the public debt at a gross level is already at 200% of GDP. In addition to public debt the other important phenomenon is that of an aging population that amount to contingent liabilities or implicit debt of the government deriving from social security systems, pension systems etc that are not fully funded. The other cost of an aging population is the rising healthcare costs. These are unofficial liabilities apart from the public debt. It is clear that unless this public debt problems are not resolved, eventually there is going to be a fiscal crisis even in the US and Japan. When we consider the Eurozone in particular, there are a number of caveats. There is a difference between what is happening in the core of the Eurozone, countries like Germany, France etc that are currently having sustained economic growth from the problems faced by the periphery of the Eurozone like Greece, Portugal, Ireland, Spain and Italy. Even in the case of these periphery countries, all of them cannot be lumped together.

However each of these countries in the periphery of the Eurozone also share a number of factors that are similar even if to a different degree.

1. All of them have a problem of having relatively large budget defecits and large stocks of public debt that are rising as a share of GDP. Of course there differences in the size of debt and defecits as a share of GDP e.g. Greece has a 15% defecit and public debt at 120% of GDP. Each of the countries has gradually cut spending and increase revenues to achieve long term fiscal sustainability.


2. The second similarity is that there are significant troubles with a number of banks and financial institutions. Again this cannot be generalized. The problems are greater in Spain and Ireland that had a real estate bubble that went bust. The problem is less in Portugese, Italian or Greek bank that did not have a housing bubble. In some cases a large portion of the public debt is also held by the banking system and as there is fragility in the government, we have a situation where a soverign risk can become a banking risk and vice versa as the banking losses have been socialized. If the banking system is not recapitalized, there will be a credit crunch as banks will refrain from taking risk and issuing new loans and this will not restore economic growth that will help placate the fiscal problems.


3. The third issue that is common to the periphery of the Eurozone is that in addition to the foreign liabilities of the government, there is also a large amount of foreign debt of the private sector. There were all countries that were running a large trade and current account defecit and when you have these defecits you have to borrow from abroad to finance this excess spending over income and therefore there is an increase not only in the foreign liability of the government but also in the foreign liabilities of the private sector. So these countries have to roll over private debt in addition to public debt and this is another source of vulnerability.


4. The fourth problem is that because of all the above problems, there is lack of economic growth. During the recession there was a severe reduction in output and unfortunately in PIIGS today either output is still falling or in cases where recession has ended , the economic growth is close to zero.


5. The fifth problem is the lack of structural reforms and therefore the potential for actual economic growth remains anemic.


6. The sixth problem that all of these share is the lost of external competitiveness that occured in last decade. This happens due to a number of factors such as

• Most of these economies almost 10 years ago were losing market share in the export markets to countries like China, emerging Asia, central Europe, Turkey that have lower wage and labour cost etc because many of the traditional exports of these countries used to be labour intensive and low value added products like textile, apparel and leather.


• Second factor for the lost of competitiveness was that for a decade the wages in these countries were growing more than productivity and so the unit labour costs are rising this leads to lower competitiveness which is also known as a real appreciation of currency.
  The final reason is the very sharp appreciation of the Euro that occured between 2002 and 2008.
  As a consequence of all of these, there was a growing trade and current account defecit in the periphery countries of the Eurozone.These problems are going to take a number of years to get resolved
  Whenever there is an excessive public and private sector debt, there are only four solutions to it.

1. Economic growth.


2. Save more to reduce debt.


3. Reduce the value of debt through inflation.


4. Orderly restrucuring of unsustainable debt becomes unavoidable and necessary of the 3 options above do not work. This can be painful and something that has to be avoided if possible.