Financial and real crisis in the Eurozone and vulnerable economies.

AuthorDallago, Bruno
  1. Introduction

    The standard account of the international crisis is that it started in the United States and was due to lax regulation that fostered excess credit, financial and real bubbles, and financial disequilibria. In spite of massive government support to financial institutions in trouble, the crisis soon spread to the real economy and engendered a "great contraction".

    Initially, the European Union seemed to be in a rather safe position, with the exception of macroeconomically unbalanced small economies (Greece, Hungary, Ireland), where the crisis had already been apparent in 2008. The Eurozone was considered unassailable, thanks to the virtues of integration, the Euro, and the features of continental capitalism. The latter include lower financial depth and integration, prudent financial regulation, and cautious behaviour by financial institutions, in particular banks.

    Six years into the crisis the picture is dramatically different The Eurozone is now the problem for the world economy. Its financial situation is shaken, the Euro is in trouble, and the future itself of European integration is at stake. European policymakers are engaged in intense debate and trying to find solutions. Typically, policymaking concentrates on financial and monetary issues, with institutional implications. The success of financial and monetary stabilisation is seen as a necessary precondition for the revival of the real economy.

    It is of interest that the European Commission report on the first ten years of EMU stressed that disregarding non-fiscal dimensions such as competitiveness, credit booms and current-account deficits was a mistake (European Commission, 2008). However, financial issues have dominated debates and policy-making, and efforts have concentrated on the need to strengthen the financial situation and action of the Union and its member countries. Such critical issues as diverging productivity rates and levels within the Eurozone, the sudden reversal of capital flows between the north and the south of the Eurozone, or the divergence of real exchange rates and their consequences for the integration and sustainability of the Eurozone, are mostly confined to technical and academic debate with scant appearance in governments' concerns.

    This paper contends that concentrating on financial issues is a one-sided approach that on its own cannot explain, let alone solve, Europe's troubles. Although it is true that the current financial distress of various EU member countries is an impediment to their growth, this is so only in view of the present incomplete institutional and governance architecture of the Union, and particularly the Eurozone. However, if one takes a broader, longer and deeper perspective, it appears that the present financial and monetary crisis of the Union is rooted in the real economy and the institutional architecture. In its turn, the incompleteness of the latter reflects the fundamental lack of trust among member countries, which they seek to overcome by means of financial discipline.

    Moreover, concentrating on fiscal and monetary solutions to the crisis by means of restrictive policies is likely to be untenable in the medium-long run because of its depressive effects on the real economy, heavy social costs and political destabilisation, and long-term damage to the production system. Stabilisation policies magnify the impacts of neo-liberal policies implemented since the 1970s into increasing inequalities, decreasing mobility and opportunities. They polarize income and wealth distribution, thus destructuring the middle class and spreading poverty. These processes have negative consequences for domestic markets and prospects of economic growth.

    Although some of the problems are common to the entire European Union, it is within the Eurozone that they are manifest in their full significance. Indeed, the common currency removes monetary policy from the competence of national governments, and the Stability Pact strongly limits their fiscal policies. These constraints on policy-making exacerbate the effects of external shocks, to the disadvantage of vulnerable economies.

    According to the literature on economic vulnerability and resilience (Briguglio et al. 2009), economic vulnerability consists in the exposure of an economy to exogenous and usually external shocks, such as those arising from economic openness and export concentration in small countries. The opposite situation is that of economic resilience, which is the policy-induced ability of an economy to withstand or recover from the effects of such shocks. Although not exactly the same as the case identified in this literature, particularly as regards the causes of vulnerability, the case of weak economies within the Eurozone is similar in the effects. When hit by external shocks, these economies cannot freely use policy instruments to withstand or recover from the effects of such shocks; nor can they rely on collective support from Eurozone countries.

    Within the Eurozone, no country can freely devise its own monetary policy. However, asymmetric shocks (such as the Euro's appreciation or the slump in world demand) hit some (vulnerable) economies, not strong and resilient ones. The difference can be explained in different ways according to the kind of shock. In the case of Eurozone countries, two factors are particularly important: first, macroeconomic and particularly financial disequilibrium, which shakes the confidence of financial markets in the solvency of those countries; and, second, microeconomic and systemic inefficiencies which lead to weak competitiveness. (2) In both cases, the fundamental causes of disequilibrium and inefficiency are likely to be internal. Yet these economies will be at the mercy of markets until the countries concerned can solve their structural problems, which is rather difficult without policy sovereignty or external support.

    The next section describes the wider context from which the financial crisis stemmed. It briefly discusses the processes which favoured the increase of global imbalances and the onset of the crisis. Section 3 deals with the factors that make the Eurozone situation so troubled and explains why the Eurozone cannot work with the present institutional architecture when there are external shocks acting asymmetrically within it. Section 4 considers the traditional measures which could be or have been used to achieve financial stabilisation. The section shows that, although some of these options are useful, while others are unviable, they are anyway insufficient to deal with the composite and far-reaching nature of the crisis. Building on this framework, the fifth section explains why the present Eurozone institutional and organisational architecture is not viable. Section 6 concludes.

  2. The great contraction

    Perhaps the most important economic transformation of recent decades has been the boom of monetary and financial activities. The volume of currency transactions was 70 times the world trade of goods and services in 2008. It was 15 times higher than in 1990 (Schulmeister et al. 2008). Average trade elasticity to GDP was close to 2 during this period. However, there were marked differences among countries. In 2010 total bank assets amounted to more than 45 times government tax receipts in Ireland, more than 30 times in Cyprus and more than 25 times in Malta. In Spain, the Netherlands and France this share was around 15 times, and slightly less, around 12-13 times, in Portugal, Austria and Germany. The corresponding figure was less than 10 times in Greece and slightly above 7 times in Italy (Pisani-Ferry 2012).

    The growing integration and financialization of the world economy have had two different outcomes for the real economy. They have increased demand, employment, output and consumption, together with financial institutional innovation and market deepening and expansion, also thanks to increased international economic linkages. However, they have also created incentives for financial bubbles and, through these, real bubbles. They have magnified the international transmission of shocks and increased the vulnerability of economies to them. In this situation and through decreasing demand by indebted and impoverished consumers, the reallocation of public resources to rescue the financial sector, decreased public expenditures and credit crunch, the financial crisis was inevitably transformed into a "great contraction" of the real economy (Rogoff 2011, Stiglitz 2010).

    Although fiscal processes are important for explaining the world and European crises, financial instability and fiscal imbalances are also the outcomes of real and institutional problems. Thus the Eurozone troubles have roots in the world crisis, but they extend well beyond it and affect the institutional architecture itself of the Union and the Euro (Rosefielde and Razin 2012, Pisani-Ferry 2012).

    Four processes contributed to the initial onset of the global financial and economic crisis in the United States and other Anglo-Saxon countries. First, highly developed economies encountered increasing difficulties in maintaining high investment rates and productivity growth, particularly compared to BRICs, and they progressively lost market shares in international trade, with the partial exception of Germany (Dullien 2013).

    Second, deregulation and financial innovation based on the idea of efficient markets were implemented to counteract ailing competitiveness. These ended the post-war Bretton Woods compromise between labour and capital (Rodrik 2011) and created the premises for the largely unregulated unfolding of financial globalisation. This opened the way to large scale financial bubbles. The high mobility of financial resources required internationally coordinated macropolicies, which restricted the power of national policy-making.

    Third, high mobility of critical resources and policies designed to attract them led to...

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