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Elephant traps for policy-makers: A reflection on the Eurozone Crisis

By Chris Ostrowski.

Writing about the crisis in the Eurozone is an intriguing and difficult task. The thesis I defended on the Sovereign Debt Crisis in July 2011 now seems dated as in the last three months events have moved forward at twice the speed and the nature of the crisis has changed from being one of Sovereign Debt to one of more deep rooted economic instability. The entire episode has been beset by political confusion as laborious attempts to find a solution seem to be forever behind the curve.

Rather than adding yet more column inches to the debate with an article which states that: "the only solution is…" it might be useful to reflect on what has made it so difficult to find a solution to the crisis and establish some guiding principles in the context of international political problem solving.

If the situation is to improve in the Eurozone (and the EU as a whole) in 2012 there are three elephant traps that policy-makers have fallen into over the past eighteen months that they must henceforth be avoided: Offering an overly simplistic diagnosis of the causes of the crisis, presenting one dimensional solutions which only address part of the problem, and attempting to 'short-circuit' democracy without developing the political tools necessary to deal with the crisis.

Beware the simplistic diagnosis:

When establishing the factors which caused the Sovereign Debt Crisis it is crucial to understand just how varied the circumstances are within the countries that have fallen victim to unsustainable Sovereign Debt. The cases of the two countries that were first affected by the debt crisis - Greece and Ireland - are so very different that it is impossible to offer a generalized diagnosis of what caused the crisis in 2010. A brief re-cap on the circumstances in both countries is a useful reminder of this.

In Greece the problems started after former Prime Minister George Papandreou announced that the actual level of the Greek deficit was 12.7%, not 6% as had been previously claimed, in the autumn of 2009. The markets were rocked by the dishonesty of the previous Greek Government and the cost of borrowing subsequently started to rise sharply. Things came to a head in May 2010, when it became apparent that the Greek State was unable to function because its cost of borrowing was too high. Greece's cost of borrowing had always been about 10 percentage points above that of Germany before they joined the euro, so it was illogical for their cost of borrowing to drop so sharply simply because they changed currency. A combination of market failure and dishonest accounting led to a cheap credit supply, some of which was misallocated (from an investment point of view) by successive Greek Governments. The Euro had been a sleeping pill for Greece.

Ireland, by contrast, rather than acting duplicitously, did everything 'right' - as far as the economic orthodoxy of the day was concerned. Ireland was considered by many to be the 'poster boy' of the European Union; the country ran a budget surplus in most years and they were not even close to breaching the rules in the Stability and Growth Pact, which had been flouted most seriously by Greece, but also by France and Germany in 2003. The Irish economy grew quickly from the 1990s to 2006 and they had created a 'successful' economy by setting low corporate tax rates and attracting a high rate of foreign investment. The crisis in Ireland could perhaps better be referred to as a conventional banking crisis, which in turn caused the State to become exposed to a degree which it could not afford when the Irish Government decided to cover every single loan made by every Irish commercial bank. In the blink of an eye, Ireland went from being in surplus to having an unsustainable level of Sovereign Debt similar to that of Greece, even though the debt the State was responsible for was private debt, not public. Rather than a sleeping pill, the Euro had been a vitamin booster for Ireland, encouraging borrowing and driving growth through the private sector.

However, listening to some politicians in the German and British Governments one might be led to think that the entire crisis was caused by feckless Greek Governments, when in reality this is only a part of the problem - there would still be a Sovereign Debt Crisis even if all EU countries had followed the rules in the Stability and Growth Pact, as whichever government was required to step in to cover the unsustainable debt in the private sector, would in turn be crippled by that debt. Politicians of the centre-right are unwilling to use Ireland (or Iceland) when seeking to diagnose the problem as this requires an admission of market failure and all that follows.

It is important to remember that many of the problems that caused the crisis in Ireland were policy errors and market failures that were replicated right across the developed world, and such a severe over-allocation of capital to sectors that returned so little (real estate and financial instruments) is not particularly uncommon in the history of capitalism. The cases of Greece and Ireland are linked not simply by the fact that they share the same currency, but by the fact their debt is held by so many other players across the EU and across the world.

Beware the one-dimensional solution:

As there is political blindness over what caused the crisis it is unsurprising that the solutions put forward often reflect this. So many of the long term potential solutions have been focussed on 'competitiveness', or reducing public spending in Southern Eurozone states. Though these issues are important they miss the fact that undercapitalized banks in Northern Europe which are exposed to the debt of Ireland and Greece are just as responsible for the economic instability as the undercapitalized countries of Southern Europe. In the same way, structural trade deficits within the Eurozone which have caused the competitiveness gap between the 'core' and the 'periphery' are as much the responsibility of the surplus countries (Germany) as the deficit countries (Spain). If I were to try and explain the problem in a nutshell I would probably put it something like this: You can't have a single currency area with structural current account imbalances and an undercapitalized banking system.

There is agreement on the most obvious solutions; there has to be proper oversight of national debt and deficit figures, so countries are not able to tell fibs about their levels of borrowing. Regarding the structural current account imbalances, a multi-dimensional solution will recognise that it is equally important for surplus countries to stimulate demand as it is for deficit countries to focus on exports, and this must be as prominent as the competitiveness and austerity agenda in 2012. A further dimension to the solution which has finally come to the fore in recent weeks is that the undercapitalized banks in Germany, France and Britain, which made bad loans, must be part of the solution, as they too are responsible for the crisis. In the future these banks must never be so exposed as to tip Governments into unsustainable debt.

Finally, regarding the 'nuclear solution' of the break-up of the Eurozone and a return to national currencies, it is hard to see how this would benefit the countries that are worst affected by the crisis. Devaluation would not suddenly allow exporters in Ireland or Southern Europe to compete with specialised German exporters, it takes decades to engender such a manufacturing program; instead Greece and Ireland would be devaluing against China, who themselves keep their currency artificially low. The devaluation tool is simply no longer the economic wrench it once was for European Finance ministers. In addition the colossal level of debt would cripple the new 'independent' countries with rates of repayments that would be far higher than they are now and far higher than any developing country. Of course it would benefit the tourist industry as it would be cheaper for Northern European tourists to take package holidays in the Mediterranean, but this is hardly a credible long-term solution – it would be a sticking plaster at best.

Beware the solution that 'short-circuits' democracy

The elephant trap that has lured more policy makers than any other since the crisis started has been the instinct to 'short-circuit' democracy. Though it is necessary for each nation to pool its sovereignty in some policy areas within the EU, there is nevertheless a strong economic argument against by-passing national democracies if one is seeking to find a credible solution. The complexity of the problems, as explained in the difference between Greece and Ireland, show that a single formula will not be appropriate as the problems are often so varied. During periods such as this it is more important than ever that those seeking to find a solution are in touch with the political and economic nuances within each country, as without these any solution will be impractical. It is seductive to produce a grand solution which by-passes the official EU channels with the accompanying political squabbling, but attempts to do this during the crisis so far have been damaging.

The first plan of this nature came in the spring of this year when France and Germany produced the 'Competitiveness Pact' that was designed to force all Eurozone countries to follow a strict program of reform on a wide range of policy areas including pensions, public sector pay and market reform; this, it was said, was the pact to 'bring Europe out of the crisis'. The most pertinent objection to the pact was that it recommended changes that were necessary in some countries but would be counter-productive in others.

For example, public sector pensions in Belgium are quite sustainable and not in need of reform, whereas in other countries they are crippling the public purse. The later agreement that become the 'Euro Plus Pact' recognised these differences after Heads of Government in the EU were able to contribute, thus avoiding a Franco-German diktat.

More recently the idea that 'technocracy' can provide the solution has also become appealing, though historically it has been very difficult to foster long term economic stability in a country just by installing 'experts'. Trying to "'GDP' a country" - as the IMF have found out - is almost impossible as only an elected politician who is accountable to the voters will have the agility and the accountability to implement reforms that are required. In addition, any technocrat, whether installed in Brussels, Athens or Rome will have an impossible research agenda if they are to design a comprehensive solution that is appropriate for the entire Eurozone. A temporary solution in which democratically elected parliaments install a 'non-political' head of government might be acceptable if it provides some temporary respite from the crisis, but if you try to short-circuit democracy too often the solutions will not work.

There will be many more agreements and fall outs as the key players attempt to reach agreement in 2012. The process of finding a solution to end the Eurozone crisis would be greatly assisted if policy-makers adhered to the following principles: avoid rhetoric that ignores the multiple causes of the crisis, propose solutions that address all the dimensions of the crisis and recognise that a long-term solution can only be found when democratically elected politicians work together.