Paradigm Lost: The Euro in Crisis

Originally published by the Carnegie Endowment for International Peace in Moscow
Participants: Uri Dadush, Sam Greene

The euro crisis, which strikes at the heart of the world’s largest trading block, is driven primarily by two elements – problematic sovereign debt in Greece, Ireland, Italy, Portugal, and Spain (GIIPS), and fragile European banks, which hold a large part of that debt. Monetary policy in the euro area and in industrialized countries more generally, remains expansionary and, if anything, pushes back the time when tightening can safely occur. Carnegie’s Uri Dadush spoke about the euro crisis at the Carnegie Moscow Center during the presentation of his new report, Paradigm Lost: The Euro in Crisis. The report was co-authored with a number of scholars, including Sergei Aleksashenko of the Carnegie Moscow Center. Carnegie’s Sam Greene moderated the discussion.

The Deeper Causes of the Euro Crisis

While ballooning public debt may be the clearest manifestation of the euro crisis, its roots go much deeper. Dadush explained that the crisis can be traced back to a loss of competitiveness, associated with the adoption of the euro in GIIPS countries, and to the misallocation of resources.

• The adoption of the euro in GIIPS countries was accompanied by a large fall in interest rates and a surge in confidence as domestic institutions and incomes were expected to converge with those of Europe’s northern core economies.
• Domestic demand surged, bringing up the price of non-tradables relative to tradables and of wages relative to productivity.

• Growth accelerated, driven by domestic services, construction, and an expanding government, while exports stagnated as a share of the GDP and imports soared amid abundant foreign capital.
• Following reunification, Germany was transformed into the world’s largest exporter, and all of Europe’s northern economies reaped the benefits of the expanded market and decreased competition offered by the GIIPS nations.

However, the growth model in the GIIPS countries was inherently flawed; eventually, the domestic demand bubble burst. As a result of the crisis, governments must shrink, Dadush asserted. High costs preempt any efforts to resort to export markets for growth, limiting the ability of GIIPS nations to offset the crisis by creating a trade surplus. GIIPS countries are stuck in a low growth equilibrium – and potential domestic battles over the limited resources will only accelerate the onset of crisis.

Risks and Challenges

The budget deficits of Greece and other GIIPS countries pose the most immediate risk, Dadush asserted. These governments grew rapidly from year to year.

• From 1997 to 2007, Greek expenditure increased nearly 4.5 times faster than German expenditure.
• Ireland’s expenditure grew 7 times faster than Germany’s over the same time period.
• In 2007-2009, the Greek budget deficit increased by 8.5 percent as a share of GDP, while the Irish budget deficit increased by 14.4 percent. Germany’s budget deficit, in contrast, increased by 3.5% over the same period.

According to Dadush, when deciding on measures to stabilize the economic situation in the EU, the European Monetary Union needs to recognize and understand a number of problems that have become more acute as the euro crisis has unfolded, including:

• The existence of wide differentiation in incomes and economic structures among EU countries;

• Equilibrating mechanisms to counterbalance the effect of the crisis, such as labor mobility, fiscal transfers, and shared financing, are relatively weak in the Eurozone;
• Rigidities in labor and product markets;
• The loss of monetary and exchange rate autonomy.

Remedies

Exiting the crisis will require the aggressive use of available tools and the regulation of monetary policy, Dadush argued. He made the following recommendations:

• Restructure Greek debts;
• Cut deficits in troubled countries. Debt must be stabilized as a percentage of GDP in three years; and competitiveness needs to be recovered by a figure of 6% over three years;
• Maintain low policy interest rates in the Eurozone; promote a lower euro; and push Germany and other fiscally stronger economies to adopt an expansionary policy with a stimulus worth 1 percent of the Eurozone GDP;
• Encourage the International Monetary Fund and United States to provide support.