Misdiagnosing the Eurozone crisis (updated)

Pradumna B. Rana has an article on Misdiagnosing the Eurozone crisis: Perspectives from Asia available at VoxEU.org. He argues that the Asian financial crisis of the late 1990s shows what can happen when economists misdiagnose a crisis. His article explains that the Eurozone crisis may have been made worse by over-simplifying it as a debt crisis. Rana suggests that the large institutional changes now afoot – the shift from Eurozone I to Eurozone II – are finally addressing the root causes, but they may be too little too late.

Rana also looks at the root causes of the crisis,

The EZ [Eurozone] is experiencing multiple and often overlapping crises. Greece, the southern EZ, and Ireland are experiencing a fiscal crisis mainly because of overspending by the public sector in the form of unsustainable wages and pensions. Ireland and now other countries are facing a banking crisis because of public sector guarantees to banks which financed the property bubble. Most countries in the region are also experiencing a competitiveness crisis vis-à-vis Germany, which has successfully enhanced its economic efficiency through structural reforms. But what were the root causes of the crises and what is being done to address them?

The root causes of the EZ crisis were the flaws in the design of the monetary union (Kirkegaard 2011, Bergsten 2012). The EMU, launched in 1999, comprised the euro (the single currency) and the European Central Bank (ECB) for a common monetary policy. It did not contain a fiscal union, and other institutional mechanisms for coordinating structural policies. Both the Werner Report of the 1970s (European Commission 1970) and the Delors Report of the 1980s (European Council 1989), which served as the blueprint, had developed a three-stage roadmap comprising closer economic coordination among members, binding constraints on member states’ national budgets, and a single currency.

But in their haste and eagerness to accomplish a full and irrevocable European unity, the ‘founding members’ had felt that the two convergence criteria enshrined in the Maastricht Treaty – a 3% limit on annual fiscal deficit and a 60% limit on gross public debt to GDP ratio – would be adequate for the purpose. In practice, these thresholds were neither binding nor fixed. The Eurozone was, therefore, launched as an experiment between a set of countries that were quite diverse and far less integrated than required by the optimum currency theory of Professor Robert Mundell (1961). It was hoped that a monetary union would lead to an economic union. But this did not happen.

The institutional flaws have now been identified and are being fixed. A key design flaw in the Eurozone was the absence of the lender of last resort in government bond markets (De Grauwe 2011, Wyplosz 2011). When a country issues sovereign bonds in its own currency there is an implicit guarantee from the central bank that cash will always be available to pay out the bondholders. The absence of such a guarantee in a monetary union – where bonds are issued in a currency over which individual countries have little control – makes the sovereign bond markets prone to liquidity crisis and contagion, very much like banking systems in the absence of lenders of last resorts.

Given the problems, e.g. moral hazard issues, that a lender of last resort can cause in normal banking markets, one has to ask if similar problems would not occur with government bond markets?

Update: Daron Acemoglu and James Robinson ask Is Europe Saved?

We think not. The problems underlying the European crisis were institutional. What we are seeing now are mostly short-term fixes, not true solutions to these institutional problems.

The roots of the crisis lie in the difficulty of operating a currency union without centralized fiscal authority. But that’s not all. The problem was made worse by implicit guarantees to markets concerning the sovereign debt of all euro-zone countries, which enabled Greece, Italy, Portugal and Spain to borrow at sharply lower rates than before. This then enabled the dysfunctional political economy in Greece, Italy and Portugal (and to some degree in Spain) to persist with borrowed money and transfers.