Implications of the crisis for stability
and growth in the eurozone
Martin Wolf, Chief Economics
Commentator, Financial Times
World Bank Workshop on
“Inclusive Growth in Advanced Countries”
New York
8th October 2010
Implications of the eurozone crisis
• Economic orthodoxy argues that neither the exchange rate
regime nor macroeconomic instability should have long-term
implications for the nature and level of economic growth
• This is wrong:
– First, high volatility is a bad in itself; and
– Second, deep structural recessions driven by overvalued real
exchange rates, bankrupt financial systems, debt deflation and fiscal
crises are bad for economic growth.
– They can generate cumulative spirals of decline, with low investment,
emigration of the more enterprising and skilled and long-term
unemployment.
• This was always the risk in the eurozone. As a result of the false
stability of the first decade, this risk has now realised.
2
Implications of the eurozone crisis
• In essence, the eurozone is a gold-standard-type
system, characterised by:
– imbalances in the pressure for adjustment between surplus
and deficit countries;
– minimal internal fiscal transfers; and so
– pressure for adjustment on (rigid) labour markets.
• The more divergent the countries, the greater the risk
that restoring competitiveness will require outright
deflation.
• That is where the eurozone now finds itself.
3
Implications of the eurozone crisis
• With these points in mind, let me ask four questions:
– How did they get here?
– How did they tackle the crisis?
– How far can they fix the problems?
4
1. How did they get here?
• “It’s mostly fiscal”, says the International Monetary
Fund. “It’s mostly fiscal”, agree the Germans.
• Bad diagnosis gives bad medicine. The problem was
NOT solely or even mainly fiscal indiscipline.
• There was reasonable growth and contained fiscal
deficits prior to the crisis, notably in some of the
countries now in trouble, except for Greece.
• But this masked huge macroeconomic divergences:
– Huge private surpluses in Germany, the Netherlands and
Austria; and
– huge private deficits in Spain, Ireland, Portugal and Greece
5
1. How did they get here?
• What drove these cumulative divergences?
– The ability to borrow at lower rates than ever before;
– The failure of markets to impose penalties on divergence,
because they ignored what was going on in both private and
public sectors;
– The tendency, inside a currency union, for bubble-affected
countries to have relatively low real interest rates (short and
long term) and, vice versa, for the countries with weak
domestic demand and low inflation. So divergence was
cumulative.
• Then, when the private bubbles burst, fiscal deficits
exploded and anxiety about sovereign debt grew.
6
1. How did we get here?
THE GOOD, THE BAD AND THE UGLY
CURRENT ACCOUNT IMBALANCES IN THE EUROZONE
(as a share of eurozone GDP)
Source: IMF, WEO, April 2010.
3.0%
2.0%
1.0%
0.0%
-1.0%
-2.0%
-3.0%
-4.0%
1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012
Germany
7
Netherlands
Spain
France
Italy
Portugal and Greece
Eurozone
1. How did we get here?
LOST COMPETITIVENESS IN THE PERIPHERY
RELATIVE UNIT LABOUR COSTS IN MANUFACTURING
170
160
150
140
130
120
110
100
90
8
9
3
Q
Q
20
0
9
20
0
8
Ireland
1
20
0
8
3
Q
1
Q
Q
Italy
20
0
7
20
0
7
Spain
3
20
0
6
1
Q
3
20
0
6
Portugal
Q
Q
1
20
0
5
20
0
5
3
Q
1
20
0
4
Greece
Q
Q
3
20
0
4
20
0
3
Q
1
20
0
3
Q
3
20
0
2
Q
1
20
0
3
Q
Q
1
20
0
2
80
1. How did we get here?
THE GOOD, THE BAD AND THE UGLY
NUMBER OF BREACHES OF THE 3 PER CENT DEFICIT RULE
0
1
2
3
4
5
6
7
8
Greece
Italy
France
Source: Unicredit
Germany
Portugal
Austria
Ireland
Netherlands
Spain
Belgium
Finland
Luxembourg
9
9
10
10
Germany
Portugal
Ireland
Italy
Greece
Spain
01/09/2010
01/08/2010
01/07/2010
01/06/2010
01/05/2010
01/04/2010
01/03/2010
01/02/2010
01/01/2010
01/12/2009
01/11/2009
01/10/2009
01/09/2009
01/08/2009
01/07/2009
01/06/2009
01/05/2009
01/04/2009
01/03/2009
01/02/2009
01/01/2009
01/12/2008
01/11/2008
01/10/2008
01/09/2008
01/08/2008
01/07/2008
01/06/2008
01/05/2008
01/04/2008
01/03/2008
01/02/2008
01/01/2008
1. How did we get here?
FROM COMPLACENCY TO PANIC
EUROZONE SOVEREIGN BOND YIELDS
(per cent)
14
12
10
8
6
4
2
0
1. How did we get here?
ROAD TO THE FISCAL DEFICITS
NET PUBLIC DEBT
(ratio to GDP)
Source: OECD
120.0
100.0
80.0
60.0
40.0
20.0
0.0
1999
2000
2001
2002
2003
2004
2005
2006
2007
-20.0
Greece
11
Ireland
Portugal
Spain
2008
2009
2010
2011
1. How did we get here?
ROAD TO THE FISCAL DEFICITS
GENERAL GOVERNMENT BALANCE
(as per cent of GDP)
Source: IMF, WEO, April 2010
4
2
0
-2
-4
-6
-8
-10
-12
-14
2005
2006
2007
Portugal
12
2008
Ireland
2009
Spain
Greece
2010
2011
2. How well did they deal with the crisis?
• Given the background of the world financial crisis, the
exploding fiscal deficits of the weak countries triggered
growing concern;
• The Greek admission of cheating triggered panic;
• As spreads exploded, concern over the possibility of
default grew;
• A particular concern was over the effects of such
defaults on weak eurozone banks.
• So a bail out of Greece and a new financing facility
were hastily arranged.
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2. How well did they deal with the crisis?
• But the measures chosen – the bailout of Greece and
the new financial facility – deal only with the liquidity
problem (and that very imperfectly).
– They have not placated the markets.
– They do not address the insolvency problem, but insist that
there can be no debt restructuring.
– They do not address the problem of financial bubbles.
– They do not address the key imbalances problem.
– They do not address the competitiveness problem.
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2. How well did they deal with the crisis?
• Remember:
– The countries with the biggest private bubbles before the crisis
have the biggest fiscal deficits now.
– Competitiveness and growth are the big issues. Debt
restructuring, while likely in the end, for Greece, does not
solve this fundamental problem.
– Peripheral Europe needs a large real depreciation – maybe as
much as 20-30 per cent, given the changes in global
competitiveness driven by a rising Asia.
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2. How well did they deal with the crisis?
HOW TO SOLVE DEBT CRISES: DEVALUATIONS
REAL EXCHANGE RATES
150.0
130.0
110.0
90.0
70.0
50.0
S Korea
16
Thailand
Malaysia
Indonesia
Ja
n10
Ja
n09
Ja
n08
Ja
n07
Ja
n06
Ja
n05
Ja
n04
Ja
n03
Ja
n02
Ja
n01
Ja
n00
Ja
n99
Ja
n98
Ja
n97
30.0
Argentina
2. How well did they deal with the crisis?
THE CHALLENGE OF DEFLATION
CONSUMER PRICE INFLATION IN THE EUROZONE
7.0
6.0
5.0
4.0
3.0
2.0
1.0
0.0
-1.0
-2.0
-3.0
l-9
Ja 9
n0
Ju 0
l-0
Ja 0
n01
Ju
l-0
Ja 1
n0
Ju 2
l-0
Ja 2
n03
Ju
lJa 03
n04
Ju
l-0
Ja 4
n05
Ju
lJa 05
n06
Ju
l-0
Ja 6
n0
Ju 7
l-0
Ja 7
n08
Ju
l-0
Ja 8
n0
Ju 9
l-0
Ja 9
n10
Ju
l-1
0
Ju
Ja
n99
-4.0
Eurozone
17
Germany
Italy
Spain
Portugal
Ireland
Greece
3. How far can they fix the problems?
• We need to distinguish two classes of challenge:
– Getting the right diagnosis; and
– Solving the inherent economic and political problems of a
multi-country currency union.
• Unfortunately, Germany, the union’s dominant country,
persists with an unambiguously mistaken view of the
main problems:
– It is not about fiscal policy alone;
– and it cannot be fixed by a tougher and more automatic
growth and stability pact.
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3. How far can they fix the problems?
• Fiscal policy:
– The main culprits on fiscal rules were not the countries now in
difficulty, except Greece;
– No, it is the imbalances, structural imbalances and financial
bubbles, stupid.
• Growth and stability pact:
– Apart from its powerful pro-cyclicality, the fines cannot be
applied consistently across countries, and can only arouse
wild resentment and anger.
– It is a nuclear bomb.
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3. How far can they fix the problems?
• Fixing the inherent problems:
– Allowing debt restructuring;
– Finding some way of adjusting nominal pay easily;
– Providing substantial support for countries in difficulties; and
– Curbing both current account surpluses and deficits.
• But, behind this, we must remember that politicians are
domestically accountable. So, in a crisis, politics pulls
them apart, not together.
• It is all very well to tie oneself to the mast. But what if
the ship actually goes down?
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