Understanding the Euro Crisis: How Did It Happen…and When Will It End?

Not really a “3 things I learned in Global Econ this semester,” but pretty close.  This student (with some suggested fixes from myself) wrote on one of the more recent things we learned – the causes of the Euro crisis – arranged around 3 main explanations.  And, they found some great graphs to illustrate it!


By 2007-08, the world had been hit by the global financial crisis, and the Eurozone was no exception.  Ireland was the first country to fall, with their crisis beginning in 2007, and is now facing some of the most stringent austerity measures to be implemented. Then, after a lot of speculation and uncertainty, Greece came next. These countries, along with the other PIIGS (Portugal, Ireland, Italy, Greece, and Spain) have not been able to bounce back from the crisis as their other EU counterparts Germany and France have.

Why not? Some reasons could be attributed to behaviors prior to the crisis.  These factors hint at some continued weakness of the Southern European area, and should make us question whether the signs of a recent Eurozone recovery may only be a temporary thaw.

So, let’s take a look at what caused this crisis.

Debts: Private, not Public

While debt was a major contributing factor to these countries, it was not public debt, as assumed.

Total debt in a few key Eurozone countries (from the BBC)
Total debt in a few key Eurozone countries (from the BBC)

It was actually an accumulation of private debt, as shown in the graphic from BBC News. Ireland, face with a similar debt crisis, converted all of the private debt to public debt, a move that the government could not actually afford.  In fact, Spain (yes, the “S” in “PIIGS” Spain) ran one of the most responsible government budgets in the Eurozone, keeping their annual borrowing limit below the 3% laid out in the 1997 agreement that set up the monetary union – a feat that even “fiscally responsible” Germany never achieved.

In fact, if you look at government debt in each of the original PIGS, only one of them exceeded the Eurozone average before the crisis officially began in late 2008 (as seen in the below images taken from Wikepedia’s “Eurozone crisis” page).

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The one exception, of course, was Greece, who had a habit of living beyond its means even before officially joining the euro (Greece also had a nasty habit of tax evasion, resulting in a major budget deficit).

The Trade Trap: Currency Exchanges and the Problem of Wages

When it came to international trade, the Euro acted as a great leveler for the countries that adopted it.  Those countries that previously had weak currencies (meaning that their goods were cheap in international markets) suddenly had a currency with a higher value, and those with a more valuable currency (whose goods were more expensive) still had a stable currency but one that was valued at least a little less.  What this meant for trade was that for poorer countries (e.g. Southern Europe), their goods and services suddenly became more expensive, while Germany’s manufactured goods suddenly became more affordable after they switched from the Deutsche Mark.  To quote from the BBC explanation of the Eurozone crisis:

“Germany became an export power-house after the eurozone was set up in 1999, selling far more to the rest of the world (including southern Europeans) than it was buying as imports. That meant Germany was earning a lot of surplus cash on its exports. And guess what – most of that cash ended up being lent to southern Europe.”

 

From the BBC article, "What really caused the eurozone crisis?"
From the BBC article, “What really caused the eurozone crisis?”

Added to this currency advantage, due to agreements with their unions, Germany held its worker’s wages steady in the years leading up to the financial crisis. That was not the case, however, with countries such as Italy and Spain (Greece as well), who allowed their wages to soar, resulting in less competitive exports for these countries. Another graphic from the BBC illustrates these wage increases:

 

From the BBC article, "What really caused the eurozone crisis?"
From the BBC article, “What really caused the eurozone crisis?”

The current policy fixes, including austerity measures and the new European Stability Mechanism, fail to address this inherent weakness in trade dynamics.

And then there’s Greece…

Greece has especially caused trouble for the Eurozone. The risk of defaulting on their loans resulted in billions of dollars in bailout loans for the country to use in order to pay back its existing loans (borrowing money in order to pay back borrowed money; it’s a vicious cycle). A condition of these loans has been austerity, which has brought the state of Greece’s economy even further into despair. This is causing more problems for the other weak countries on the Euro, as investors are afraid of another Greek-situation occurring.

It’s easy to blame the Greeks for irresponsible management – after all, not too many countries pay their workers on a 14-month annual salary! – but look closer, and you have to wonder about the sort of people who would lend to such a risky country.  Or, if they were going to lend, why not charge higher interest rates on the more unstable countries (like Greece), just so you can make at least part of your money back if that nutcase has to default?  Higher interest rates would have made loans more expensive, and maybe deter some of these countries from going into such high debt in the first place.

Wikipedia graph based on European Central Bank data.

Again, the answer rests in some of the inherent weaknesses of that common monetary union.  To put it simply (for a more detailed discussion of the cause and effect, I would highly recommend Paul De Grauwe’s “The Political Economy of the Euro“), ratings agencies over-rated these riskier countries because they expected Germany to bail them out if trouble arose.  As a result, investors saw less risk in lending than they should have, making them more willing to give loans (and charging lower interest rates) than they would have to a country of similar economic status who was NOT in the Eurozone.

Too bad that investor over confidence had to end someday, leading to massive interest rate hikes in later loans and a spiraling of government debt.

 

When will we see recovery?  Why don’t you ask Germany

While most of the PIGS are slowly but surely trying to recover, Greece continues to be under the watch of the EU, and the rest of the world.  So when will Greece finally improve? This is difficult to say; while it is impertinent that Greece does not default on its loans and stays on the Euro, Germany is actually benefiting from the unstable Greek economy.  Germany is actually saving billions of euros on paying debt due to low interest payments. A weak Euro also means that exports are cheaper, which has continued Germany’s export surplus.

From the Financial Times blog post, “Germany’s eurozone crisis nightmare”

While the powerhouse of the European Union is reaping benefits from the current state of the Euro, it might be quite the long road to recovery for the struggling nations in the Eurozone.

References

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