The Euro crisis in 10 minutesSesamOne 2014-06-20

Lars Marius Garshol, larsga@sesam.no, http://twitter.com/larsga1

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The Euro was introduced in 1999– economists warned that the eurozone was not

an optimum currency area– likely to suffer from “asymmetric shocks”

Theory says eurozone should have had– labor mobility– capital mobillity and wage/price flexibility across

the region– fiscal transfer mechanism, to redistribute

money to areas suffering downturns– areas with similar business cycles

A disaster foretold

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Southern European nations formerly seen as unsafe for investment– after introduction of euro, seen as safe

Result is massive influx of investment from north– caused massive real estate bubble– drove up wages– huge increase in private-sector debt

Immediate effects

http://www.newrepublic.com/article/economy/95989/eurozone-crisis-debt-dont-blame-greece

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Same result for unit labor costs

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Financial crisis begins in the US, sets off a “Minsky moment”

– everyone wants to sell assets to reduce their debt– causes asset prices to plunge– means people have to sell even more assets– ...

Southern European real estate bubble bursts– investors flee– downturn in construction, no credit to be had, leads

to recession– salaries are not competitive, so exports cannot help

2008: The crisis begins

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Reduce interest rates– unfortunately, setting them to zero not enough

in this case– this is known as the “zero lower bound” (ZLB)

Increase government spending– would increase demand, get the economy going– would run up government debt, but much

cheaper in the long run, and actually causes less debt over time

Devalue currency– this would instantly make wages more

competitive– would help the economy grow

2009: The rational response

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ECB reduces interest rates as far as they can go

EU budget rules prevent increase in spending– in fact, economic downturn reduces gov’t

income, increases gov’t expenditure– therefore, budget rules force governments to

cut budgets– this causes the economy to plunge further

The currency is the Euro– south cannot devalue against north– wages must come down “naturally” instead– the only way to do this is years of grinding

unemployment

2009: The actual response

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A difficult name for the idea that cutting wages is hard

Downward nominal wage rigidity

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Southern European countries had substantial debt already in 2008– note that apart from Greece, they had run balanced

budgets for the last years

The crisis, and the response to it made this worse– investors were already panicking, and lost faith in these

governments

This meant they couldn’t sell their bonds– that is, to sell the bonds they had to accept much higher

interest rates– this quickly became unsustainable– result: repeated panics, followed by half-measures from

the EU, followed by new panics

The debt crisis

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New ECB leader Nov 2011– Mario Draghi

Changed policy in July 2012– held a famous speech in which he announced

the ECB would “do whatever it takes” to preserve the Euro

– he added “and believe me, it will be enough”

ECB now stepped in as buyer of last resort for government bonds– the debt crisis was effectively over– not so the euro crisis

The solution

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Unemployment is still high– over 25% in Spain and Greece, 10-15% in

Portugal, Ireland & Italy– appears to possibly be falling slowly

Growth not good at all– Eurozone GDP in Q1 2014 growing at 0.2%– inflation still too low

Basically, Europe is on track for a “lost decade”– could still fall into a new hole

Situation today

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The Euro crisis was caused by the Euro– made worse by the euro itself and bad

economic policy

Why was policy so bad?– the answer is not clear– some suggest politics overrode economics– others describe it as blunders made “because

the economics of the problem have not been thought through”

Either way the Euro crisis tells us nothing good about how the world is governed...

Conclusion