A brief explanation of the causes and effects of the Euro crisis, plus an assessment of the policy response

1. The Euro crisis in 10 minutes
SesamOne 2014-06-20
Lars Marius Garshol, larsga@sesam.no, http://twitter.com/larsga
1

2. 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
2
A disaster foretold

3. 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
3
Immediate effects
http://www.newrepublic.com/article/economy/95989/eurozone-crisis-debt-dont-blame-greece

4. 4
Same result for unit labor costs

5. 5
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

6. 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 grow6
2009: The rational response

7. 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 grinding7
2009: The actual response

8. 8

9. 9
A difficult name for the idea that cutting wages is
hard
Downward nominal wage rigidity

10. 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
10
The debt crisis

11. 11
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

12. 12
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

13. 13
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