Lecture 18 the Euro Crisis

DraftInternational Political Economy #18

The Eurozone Crisis

William Kindred Winecoff

Indiana University Bloomington

October 31, 2013

W. K. Winecoff | IPE #18: Eurozone Crisis 1/25

DraftThe Set-up

Interconnectedness has its downsides.

In particular, exposure to crises that originate elsewhere.

The US crisis led to contagion that infected Europe.

But if that hadn’t happened, Europe would probably have hada crisis fairly soon anyway.


DraftA Bit of History

The European project begins after WWII, as an attempt to not makethe same mistakes as after WWI.

No reparations from Germany.No British Empire to exclude Germany from.Partial accommodation of Germany’s rise by UK and France.


DraftWhy the Change?

1 Because the post-WWI period was awful.

2 Because the US refused to go back to the old system.

3 Because the USSR was threatening (& Germany could be a bufferstate).

4 Because Germany had been cleaved in two.


DraftThe Arrangement

A security alliance on the continent:

NATO was intended to “keep the Russians out, keep theAmericans in, and the Germans down”.

Neither Germany nor Russia could dominate if US maintained a presenceon the Continent.

This provided space for order, democratization (S. Europe notdemocratic yet), and economic integration:

No imperial competition.Global trade agreement (GATT).Regional partnerships too.

I.e., Use backdrop of hegemonic security to build institutions and fosterinterconnectedness.


DraftThe Project

French Foreign Minister Robert Schuman (1950): create an economiccommunity so mutually beneficial that it would “make war not onlyunthinkable but materially impossible”.

Treaty of Paris (1951) creates the European Coal and Steel Community(ECSC): Germany, France, Benelux, Italy.

Treaty of Rome (1957) creates the European Economic Community(EEC) (1957): same six form a regional trade agreement.

European Atomic Energy Community (EURATOM) (1957): sharenuclear energy (rather than all pursue nuclear capability, thus setting offpossible security dilemmas).

Each of these institutions build interconnectedness, which increases overtime as new members join.


DraftA European Monetary Union?

First proposed in 1929, to promote economic cooperation and prevent“beggar thy neighbor” exchange rate policies, but not implemented.

Not needed in 1950s, b/c of Bretton Woods system of pegged exchangerates.

Proposed again in 1970, as Bretton Woods system wobbles.

Snake: pegged exchange rates, but with some flexibility.Collapses in 1973 when US dollar is allowed to freely float.Deutsche Mark zone (1977): some countries peg to Germancurrency. Why?


DraftEuropean Monetary System (EMS)

New semi-pegged exchange rate system (1979): shared credit, aregional monetary fund, and exchange values calculated with a basket ofEuropean currencies.

Membership broadens beyond previous six.

Deutsche Mark becomes leading currency; low inflation (ie potential forrecession).

1992 crisis: UK and Italy leave.


DraftThe Euro

Successor to EMS, begins in 1999. Most of the continent joins or plansto, but UK abstains b/c of experience with EMS and concerns aboutlosing national sovereignty.

Not just an exchange rate mechanism: a common currency.(I.e., you can’t just devalue if you get in trouble.)Part of a broader Common Market designed to facilitatetrade and economic cooperation.

But same problems as before: different countries have different interests.

Germany doesn’t want to be shackled to weak economies.


DraftThe Bargain

Europe supports German re-unification.

German central bank (Bundesbank) gets disproportionate influence inEuropean Central Bank (ECB).

Inflation-fighting credibility.

Maastricht Criteria:

Inflation no more than 1.5% higher than average of threelowest inflation members.Fiscal deficits of no higher than 3%.Debt of no more than 60% of GDP.

I.e., eliminate the need to devalue along with ability to devalue.


DraftWhat Does German Re-unification Mean?

Two things:

1 Germany becomes most important European economy forforeseeable future, and a key bridge from Western Core toemerging East.

2 But half of Germany is all of a sudden very poor andunderemployed.

How to get jobs in a hurry? Increase ‘X’.

Germany becomes exporting giant within Europe.

Once Euro comes into force, this means that GIPSIs get to consumemore than they previously had:

Germany: increase S, increase X.GIPSIs: increase I (esp real estate), increase M.

Sound familiar?


DraftThe Problem

Macroeconomic imbalances:

Public debt in GIPSIs was fairly low (except in Greece), butprivate debt increases, as Germany runs trade surpluses andsends finance to periphery. Real estate booms in Spain,Portugal, Ireland which are intermediated by financialinstitutions.

Financial interconnectedness increases; many German and French banksmake lots of loans to GIPSI borrowers.

GIPSIs owe to foreigners. Ability to repay is questioned.


DraftHuge Deficits


DraftConvergence, Then Divergence


DraftDebt Crises Spiral

If you can’t borrow, then you have to cut spending/raise taxes: austerity.

If you can’t roll over debt, then you have to be even more austere.


DraftThe Result

U.S. crisis destabilizes EU financial sectors and leads to lower growth.Public budgets suffer:

Immediate actions (bank bailouts).Automatic stabilizers (unemployment insurance).Lower tax revenues (from decreased economic activity).Capital flight.

Because euro is not an OCA, policy response diverges from that in US.


DraftDivergence Responses

US vs. EU:

Fed floods US economy with cash; ECB doesn’t.Fed/Treasury immediately recapitalizes banking system;ECB/EFSF only halfway does.US pursues countercyclical fiscal policy; EU pursues fiscalausterity.


DraftWhy the Divergent Responses

US transfers vs EU transfers:

TX to FL vs. Germany to Greece.Political union vs. no political union.Nation-state vs. loose confederacy.

German taxpayers don’t want to bail out Greece; Greek taxpayers don’twant austerity just to pay back German banks.


DraftWhat to Do?

To pay back foreigners, you need to produce more than you consume:increase X, increase S. Use surplus to reduce indebtedness.

One way to do this is to depreciate exchange rate. But this is impossiblein a common currency.

Another way is for ECB to loosed EMU monetary policy: spur jobs inGIPSIs, but higher inflation in Germany.


DraftThe Problem of Politics


DraftRegional Hegemony?

Germany’s not in a Depression... they don’t need stimulus.

They don’t want inflation, as it makes them poorer and had devastatingconsequences in their history.

1920s hyperinflation − > rise of National Socialism.

GIPSIs owe money to Germany and France, and those countries want tobe repaid.

But that means even more austerity. How much can GIPSIs take?


DraftWhat’s the Endgame?

I don’t know. But here are some options:

1 GIPSIs default.2 GIPSIs leave euro and devalue to earn export money.3 Germany/France forgive some (more) of the debt, and/or

ECB provides (more) low-interest loans.4 Nothing: muddle on, and have a long, slow, grinding,

excruciating recovery process. Lost generatation (or more).

Unlike 1930s, these countries are all democratic. So democratic politicswill decide what happens.

Note: this is bargaining. We’ve seen it before:


DraftThe European Prisoner’s Dilemma

EuroCoreEuroGap

Extend Finance Force Austerity

Pay Debts2

2

3

0

Default/Devalue0

3

1

1


DraftA Test of Institutions?

The European Union was designed/intended to promote precisely thiskind of cooperation.

Will it hold up? This is the toughest test it has faced.

So far they’ve held it together... but it’s been close. And the crisis isn’tover it.


DraftP.S.

A handy interactive tool to see who owes what. A bit outdated, but stilluseful:

http://www.nytimes.com/interactive/2011/10/23/sunday-review/an-overview-of-the-euro-crisis.html?_r=0




Documents

Lecture 18 the Euro Crisis