After US Hegemony

Eurozone’s Woes

The Euro–the single currency adopted by 16 states–has been under siege for over a year beginning with the election of a new government in Greece in September 2009 which sharply revised the country’s public deficit from 6 percent of GDP to 12.7 percent. This led to a loss of confidence in the government’s ability to repay loans and raised the cost of borrowing, creating greater difficulties for the government to repay the 300 billion euro debt bequeathed to it by its predecessor in office. Normally, a government faced with high debts could devalue its currency and thereby increase the competitiveness of its exports and attract both foreign investments and tourists but the adoption of the common currency ruled out this option.

Eventually, the European Central Bank (ECB) and the International Monetary Fund (IMF) cobbled together a rescue package of €110 billion ($146 billion) in May 2010 in return for Greece implementing very severe austerity measures. European policy makers also set up a European Financial Stability Facility (EFSF) to create a safety net of upto €750 billion to preserve financial stability among member states of the common currency.

These floodgates came under renewed threat when German Chancellor Angela Merkel made a statement that in future financial crises, creditors must also share in the losses rather than only the tax-payers. As Ireland was the most indebted economy within the Eurozone, this caused interest rates on Irish bonds to spike causing a further crisis in confidence. Unlike the Greek crisis which was caused by high public deficits, the Irish crisis was caused by a collapse of its housing bubble.

Soon after the introduction of the single currency, weak economic demand in the main Eurozone economies–Germany’s real domestic demand in 2008 was only 5 percent higher than in 1999–fueled an asset price inflation-especially in Ireland and Spain. As the former taoiseach (Prime Minister) Garret Fitzgerald noted, the house construction rate in the Celtic Tiger in the last two decades was six times that of Britain–leading to an extraordinary housing bubble stimulated by the Anglo Irish bank and a host of overseas banks. When the bubble burst, instead of the banks’ creditors sharing the losses, the government assumed their payment obligations, nationalizing the Anglo-irish Bank and creating the National Asset Management Agency to take over large loans from other banks, effectively transforming private debt into public debt.

The ECB and IMF have once again cobbled together a rescue package of €85 billion ($115 billion) but this has not stopped a massive gap in the bond spreads (an increase in the cost of borrowing for the weaker members of the Eurozone, especially Greece, Ireland, Portugal, Spain, and Italy) and the fear is that if the crisis spreads to Spain and Italy, two of the largest economies, the EFSF would be inadequate and it would cause an enormous political conundrum: citizens of the stronger states will become increasingly unwilling to bail out the more ‘profligate’ states, and citizens of the latter would be unwilling to put up with increasingly stringent long-term austerity measures.

Spain is fortunate because a large amount of its government debt is owed to its own banks rather than to overseas banks. At the beginning of 2010, Spain’s public debt was only 53 percent of GDP, about 20 percentage points below that of the Eurozone average and half that of Italy’s. Last year, when the budget deficit stood at 11.1 percent of GDP, Prime Minister Jose Luis Rodriguez Zapatero also pushed through an austerity package that led to the government’s deficit falling by 47 percent in the first ten months of 2010. The problem for Spain is its high private debt–especially the heavy borrowing from overseas banks to fund home construction in the years up to 2008, Before the start of the recession, Gilles Moec of the Deutsche Bank estimated that private sector debt was 210 percent of GDP compared to 130 percent for Germany, France, and Italy.

If the extent of the impending crisis have left many to wonder about the future of the euro, the problem surely is not in the common currency. As Philippe Legrain wrote in the Financial Times there is a lot to be said for

enabling capital to flow from one member country to another without exchange-rate risk is a key advantage of the euro. If this were possible globally, emerging economies would not feel compelled to amass huge reserves to protect against crises and could be net recipients of investment instead.

What was the problem was that capital from the stronger members of the Eurozone was channeled to fund asset bubbles in Ireland, Spain, and elsewhere. Tighter regulations of cross-border investments can mitigate this problem. But more importantly, why are lenders coddled in cotton wool while taxpayers are burdened with huge debts they had done nothing to incur? Ordinary Irish citizens, as Paul Krugman, has underlined are:

bearing a burden much larger than the debt — because those spending cuts have caused a severe recession so that in addition to taking on the banks’ debts, the Irish are suffering from plunging incomes and high unemployment.

Earlier when Iceland and Kazakhstan faced financial crises, creditors shared in the pain. The external debt of Kazakhstan’s banking sector which had stood at 26 percent of GDP when the crisis struck in February 2009 had been cut almost in half by September 2010 by making creditors share in the losses and accepting various combinations of senior and subordinated debt. There is no reason to let banks off the hook. In Iceland, the crisis caused the election of a left-leaning government which also were able to get better terms.

If the current crisis enveloping the Eurozone leads to the election of more left leaning governments, and to a refusal to nationalize private debt and to greater regulations over the economy, it may be the final nail in the neoliberal coffin!