REVISITING THE EUROPEAN CRISIS: WHOSE CRISIS AND WHO SHOULD PAY?
Niriksha Shetty
Department of Economics
Honors Candidate
Graduation Date: 10th May 2013
30th April 2013
Abstract
Proponents of austerity have argued that the ‘fiscal profligacy’ of periphery
Eurozone economies is responsible for the current crisis. This paper explores the
underlying economic and political forces behind the process of European
integration to provide an alternative analysis of the crisis. Using a Post-Keynesian
and Political Economy framework, this paper argues that the crisis is a
manifestation of the underlying conflict between labor and capital, exacerbated by
the structural flaws in the design of the Eurozone. It provides evidence that
German export-driven policies played a fundamental role in creating trade
imbalances between the core and periphery countries, further exacerbated by
fiscal and monetary policy constraints imposed on member nations. This paper
concludes that the current austerity reforms do not address the fundamental
problems of the Eurozone, but rather attempt to shift the burden of the crisis onto
the workers. Ultimately, the outcome of this class struggle will determine how the
Eurozone will emerge out of this crisis
Keywords: Eurozone, Sovereign Debt Crisis, Germany, GIPS
Niriksha Shetty
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Revisiting the European Crisis: Whose Crisis and Who Should Pay?
I.
Introduction
The creation of the Eurozone was motivated by a desire for greater economic stability and
political harmony among member nations. Austerity measures have been implemented across the
region, but evidence shows that the policy response in Europe has been relatively unsuccessful in
dealing with the crisis. Five years into the global recession, Eurozone economies are plagued
with rising unemployment, high government debt, political instability and economic stagnation.
Proponents of austerity have argued that it was the ‘excessive’ deficit spending by periphery
economies- particularly the GIPS (Greece, Ireland, Portugal and Spain) governments’- that
triggered the recession in Europe. This argument led to harsh spending cuts that aimed for a
revival in market confidence and economic growth.
Post-Keynesian economists have argued that it is the separation of the fiscal authority from
the currency issuing authority that led to the current crisis. The development of intra- Eurozone
macroeconomic imbalances and along with the imposition of policy constraints on member
governments pushed the public sector into deficit spending. The current austerity reforms fail to
address the lack of aggregate demand- a fundamental problem in the Eurozone. In order to
address these structural flaws, Post-Keynesian economists have proposed the creation of a fiscal
union in the Eurozone. A political economy analysis provides evidence that the advent of
neoliberal policies at a supranational level has reinforced the class power of the capitalist.
Austerity reforms have intensified this class conflict, by shifting the burden of what was
essentially a financial crisis, onto the workers. Backlash from the working classes is evident with
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the spread of anti-austerity pressures across the region. The outcome of this class conflict will
play a fundamental role in determining how the Eurozone will emerge from this crisis.
This paper is structured as follows: Section II outlines the motivations behind the creation of
the Eurozone. Section III critiques the economic theory that structured the design of the
Eurozone, analyzing the role of both Germany and the periphery in the build-up to the crisis.
Section IV evaluates the policy response to the crisis, exploring how the labor-capital conflict is
shaping the progression of the crisis. Finally, Section V explores alternative policy options and
Section VI concludes.
I. The Formation of the Eurozone
a. Historical Timeline
Following the culmination of the Second World War, attempts were made to facilitate
greater integration among European states to ensure peace and political stability in the region.
Under the Treaty of Rome (1957), a precursor to the European Union- the European Economic
Community (EEC) was established. The EEC included the creation of a common market, and the
adoption of a common agricultural policy, with monetary stability initially provided by the
Bretton Woods System (Mourlon-Druol 2011, 2). 1 With the collapse of the Bretton Woods
system, policymakers began to explore alternatives, eventually establishing the European
Monetary System (EMS) in 1978. The EMS was supposed to reduce exchange rate volatility, by
fixing a bandwidth of 2.25 percent within which exchange rates could fluctuate against each
The Bretton Woods System involved an agreement among member nations to peg their
currency against the dollar, which was in turn linked to gold. Established in 1944, it also
involved the creation of the International Monetary Fund (IMF) and the International Bank
for Reconstruction and Development (now known as the World Bank). Designed to provide
monetary and exchange rate stability, this system came to an end in 1971 with President
Nixon putting a stop to the convertibility of the US dollar into gold.
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other (Wyplosz 1997, 4). The EMS paved the way for further monetary integration, culminating
with the ratification of the Maastricht Treaty on 7th February 1992 (Paulo-Mongelli 2008, 14). In
1999, eleven countries adopted the euro as their official currency- forming the Eurozone (PauloMongelli 2008, 15). Greece joined the Eurozone in 2001.
b. French and German Influence
Created on the pretext of improving economic stability, the Eurozone was primarily a
political project governed by the interests of political leaders and their vision for the future of
Europe (Feldstein 1997, 3). Political considerations of two major European powers, namely West
Germany and France influenced the formation of the Eurozone. Given the relatively large size of
the West German economy, competitive exports and low inflation policy, the Deutschemark was
considered the strongest currency among the EMS members. Due to this, all other currencies in
the EMS began to center around the Deutschemark (Wyplosz 1997, 5). This met with initial
resistance from other nations since they were forced to carry out disinflation in order to bring
their currencies in line with the Deutschemark- losing control over national monetary policy.
While the disinflation helped these countries gain credibility, they were apprehensive of a
“Germanization of European monetary policy” (McCann 2010, 34). However, in the years
following its inception, the EMS had been relatively successful in reducing exchange rate
fluctuations. The removal of controls on the movement of capital, goods and people through the
Single European Act of 1986 called for greater convergence (Eichengreen and Frieden 1993, 5).
The Delors Committee was created in 1988 to facilitate further monetary integration- a process
that culminated with the ratification of the Maastricht Treaty.
With the fiscal burden created by unification, Germany witnessed concerns of rising
inflation. In response to this, the Bundesbank (German Central Bank) raised interest rates
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(Eichengreen and Frieden 1993, 5). Worries about the ability of other EMS members to deal with
Bundesbank monetary policies led to speculative attacks against currencies in the EMS- resulting
in the currency crisis of 1002. Both, Italy and the United Kingdom withdrew from the EMS in
September 1992- a setback to European integration (Eichengreen and Frieden 1993, 5). When
the French government attempted to reduce interest rates, speculators attacked the franc, forcing
European authorities to look for alternatives. While the EMS bandwidth for currency fluctuation
was widened, the evident weaknesses in the system intensified the demand for a single currency.
Feldstein identifies two key motivations for French and German support for a monetary
union. First was Germany’s belief that it was meant to lead this process of European integration
given its economic might, strategic location and power. Secondly, France desired a greater say in
the integration process, desiring a position at par with Germany within the monetary union.
Thus, it came down to a clash between France’s “aspiration for equality” and Germany’s
“expectation of hegemony” (Feldstein 1997, 29). It is clear from the negotiation process that
Germany held the bigger say in determining the formation of the Eurozone-reflected in the
adoption of price stability as the primary goal by an independent central bank- the European
Central Bank (ECB). Member countries were also required to meet certain convergence criteria
before entering the Eurozone.2 With the push of French and German leaders, the movement to
create a unified Europe gained momentum, with other countries not wanting to be left behind.
c. Transforming labor-capital relations in the Eurozone
In the years leading up to the adoption of the euro, the history and culture of member nations
had played a fundamental role in shaping its political economies. Evidence of this can be seen in
Entry requirements into the Eurozone required members to meet key convergence
criteria. These included lowering inflation, meeting the SGP Requirements, abstaining from
devaluation of currency under EMS and bringing nominal long-term interest rates in line
with other member counties. For further details, see Maastricht Treaty’s Article 121 (1).
2
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the different labor-capital relations in these economies. In Germany, emphasis was placed on
wage coordination and generous social benefits (Hancke et al. 2007, 47). Wage bargaining was
carried out at the sectoral level, with emphasis placed on training and education through
increasing collaboration between trade unions and employers’ associations. Immigrants usually
occupied the low-skilled jobs, while the German labor force (predominantly male) was trained
for the higher-skilled, well-paying jobs (Hancke et al. 2007, 47).
In Ireland, the government adopted “social partnership model” where the government, trade
unions and employers associations signed three-year agreements, determining wage growth in
the private and public sector (Barry 2003, 12). These social pacts also included agreements on
other economic and social issues such as taxation, labor market policies and welfare benefits.
The state provided welfare assistance only as a last resort. Emphasis was placed on ensuring
competitiveness of the Irish economy- a move supported by the trade unions. Public sector trade
unions were much stronger than their private sector counterparts. However, trade unions in
Ireland were not as strong as Germany- with competitiveness taking precedence over wage
increases. On the other hand, the economies of Greece, Portugal and Spain were characterized by
emphasis on family support with marked inequalities in the provision of benefits (Batic 2011,
147). The unemployed, poor and low-skilled workers remained outside the purview of the
welfare state. In the post-war era, greater importance was given to building “ a mixed economy
domestically, involving strict regulation of capital and labor markets and the development of
welfare systems” (McCann 2010, 25) Known as the golden age of European capitalism, social
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democracy models ensured that workers were protected by national governments. These policy
measures continued until the crisis in the 1970’s- paving the way for a new economic order.3
There has been evidence of a move towards neoliberalism in response to the crisis of the
1970’s – particularly with the price stability replacing full employment as they goal of national
governments. The move of the social space from a national to a “supra-national” level provided
greater opportunity for coalition of capitalists (Papadopolous and Roumpakis 2010, 15). States
began to compete with one another in a drive to become more capital-friendly, attempting to
harmonize labor across the Eurozone. For countries with traditionally strong labor unions, this
often meant a shift in the power balance in favor of the capitalist. As governments attempted to
meet economic convergence criteria for entry into the Eurozone, austerity measures were
implemented across the region. The creation of institutions at the European level facilitated this
drive towards convergence, while trade unions lost power. Here, we see the capital-labor conflict
shaping the economic relationships that came to govern Eurozone economies in the years leading
up to the crisis. However, the outcome of this political project was the creation of a system with
significant structural flaws.
II. Economic Theory behind the Eurozone
The formation of the Eurozone had backing in neoclassical economic theory, particularly in
Robert Mundell’s famous work- ‘A Theory of Optimum Currency Areas’. Mundell identified
complete factor mobility as a defining feature of an optimum currency area (OCA). He claimed
Marx extensively discusses the role of crises as a manifestation of the inherent
contradictions of capitalism. The rising conflict between capital and labor eventually
creates a situation where the existing system can no longer exist. The crisis paves the way
for a change in the existing economic relationships- a move that is determined by this
labor-capital conflict.
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that the adoption of a single currency in an OCA would eliminate exchange rate fluctuations and
lower transactions costs, improving efficiency in the region (Mundell 1961, 665). This notion of
efficiency stems from the neoclassical view of money as a medium of exchange- thus, the fewer
the number of currencies, the more efficient the process of exchange (Davidson 1972, 101).
Two defining features in the Eurozone are also grounded in neoclassical theory- the creation
of an independent central bank and sound government finances. The European Central Bank
(ECB) was set up to meet the goal of price stability. The provision of the Stability and Growth
Pact (SGP) was to serve as a deterrent to “excessive” deficit spending by member states. The
Eurozone was supposed to benefit the entire region, with the elimination of exchange rate
fluctuations translating into increased trade, economic convergence and stability. However, this
paper provides certain evidence that the outcome is otherwise.
Worries of rising sovereign and private debt in the Eurozone escalated in 2009. Greece
became the first Eurozone economy to seek external assistance in May 2010. Ireland plunged
into a debt crisis in December 2010, followed by Portugal in April 2011, with worries soon
spreading to the larger economy of Spain. The magnitude of the crisis is highlighted in Figure 1,
which depicts unemployment across Germany and the GIPS. As seen in Figure 1, unemployment
in Spain crossed the 20 percent mark in 2010. Similarly, unemployment across Greece, Ireland
and Portugal has witnessed a rise since the crisis hit the region in 2009. In contrast, German
unemployment remained relatively low, and even dropped in the years after the crisis. This
supports the claim that the expected economic convergence that proponents of the Eurozone
expected to see has not occurred. In fact, macroeconomic imbalances between the core and the
periphery have been exacerbated through the process of European integration.
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Figure 1: Unemployment by Country
25.0
Germany
(including
former GDR
from 1991)
Ireland
Unemployment Rate (%)
20.0
15.0
Greece
10.0
Spain
5.0
2011
2010
2009
2008
2007
2006
2005
2004
2003
2002
2001
2000
1999
1998
1997
1996
1995
1994
1993
1992
1991
1990
0.0
Portugal
Source: Eurostat
a. Central Bank Independence
The ECB, an independent supra-national body, functioned as the central bank for Eurozone
economies. The ECB set the inflation rate for the region, usually at around two percent to ensure
price stability. Neoclassical economists believe that an independent central bank such as the ECB
would serve to eliminate an “inflationary bias” that might occur if monetary policy were in the
hands of political power (Federal Reserve Bank of St. Louis 2009). Central bank independence
would ensure low inflation and price stability-moving the Eurozone economies toward greater
economic convergence. However, the apparent disparities in the economic health of Eurozone
economies have brought into question this ‘one size fits all’ monetary policy.
The uniform monetary policy can be criticized within the neoclassical framework itself.
Prior research (Nechio 2011) incorporating the Taylor rule shows that the target interest rate set
by ECB differs dramatically from the recommended interest rates for individual nations
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prescribed by the Taylor rule.4 This has significant implications given that Eurozone nations
differ from each other in terms of output and employment. For instance, if inflation is high in one
member country in the Eurozone, the ECB can respond by raising interest rates in a move to cut
back on investment and spending. However, this will have negative repercussions for other
countries that are suffering from unemployment. If complete factor mobility, as expected in
Mundell’s notion of an optimum currency area (OCA) existed, then the labor force could move
from areas with high unemployment to areas with high inflation. Thus, unemployment would be
self-correcting in the case of an OCA. However, the fact that we have divergent economic
performance across Eurozone countries shows that this self-correcting mechanism is not at work
here. It is apparent that the demands of the periphery economies such as the GIPS are different
from the core such as Germany, which occupied a relatively healthier economic position. The
expected economic convergence between member nations has yet to take place, making the
implementation of a single monetary policy by an independent central bank ineffective.
b. Exchange Rate Constraints and Intra-EU Trade
The lowering of transaction costs allowed for greater trade between member countries but
there is evidence to show that all economies have not benefitted equally from this system. While
German exports supported its economy through the initial crisis, the rising trade deficit in the
periphery economies contributed to the economic collapse in the region. With Germany
cementing its position as an export powerhouse and other countries losing the option of currency
devaluation, trade imbalances between the core and the periphery increased. Currently the
world’s second largest exporter, Germany’s exports rose from 24.8 percent of GDP in 1990 to
The Taylor Rule is a monetary policy rule that considers actual inflation, employment and
economic growth differentials of nations in order to provide policy recommendations on
the interest rate response that monetary authorities should adopt. It was developed by
economist John Taylor, and aimed to foster both stability and economic growth.
4
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47.5 percent of GDP in 2008 (World Bank 57). Germany witnessed a rising current account
surplus, since the early 2000’s – a marked difference from the rising current account deficit in
the periphery (Refer Figure 5).5 The current account surplus of Germany reached a high of 5.2
percent of Gross Domestic Product (GDP) in 2010. (World Bank 57) Two factors have played a
key role in boosting the trade surplus in Germany- the competitiveness of German exports and
the role of the euro.
Competitiveness of German Exports
The success of Germany’s export-led growth model can be attributed to the competitiveness
of its exports. A measure of competitiveness is Unit Labor Costs, which the OECD defines as
“the average cost of labor per unit of output, and is calculated as the ratio of total labor costs to
real output” (OECD website). Unit labor costs provide a representation of how competitive an
economy is in terms of the costs it incurs, as it depicts the amount of compensation a worker
receives in exchange for producing a commodity.
Figure 2 demonstrates that Germany’s Unit Labor Costs (ULC’s) have stayed relatively
constant, and began to decline after 2004 until the crisis. Wage growth in Germany was
extremely sluggish, preventing a rise in ULC, making its exports more competitive (Moravscik
2012, 59). On the other hand, ULC in the GIPS economies has been growing at a much faster
rate than Germany, since 2005. As GIPS labor costs rose in comparison to Germany, their
exports lost competitiveness.
A country’s current account balance refers to the net trade in an economy along with
transfer payments and income flows between economies. One of the major components of
a current account is the trade balance. Usually when a country exports more than it
imports, it is running a trade deficit- often accompanied by a current account deficit. This
would mean that its foreign sector is running a surplus, since income from exports
outweighs expenditure on imports.
5
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Figure 2: Unit Labor Costs, OECD Index (2005=100) by Country
115
105
95
85
Germany
75
Greece
65
Ireland
Portugal
55
Spain
45
35
1990 1992
Source: OECD
1994
1996
1998
2000
2002
2004
2006
2008
2010
Wage suppression and low inflation policies helped Germany retain export competitiveness.
Low domestic prices meant that German exports became relatively cheap. Figure 3 shows that
stagnant growth in unit labor costs witnessed in Germany is mirrored by relatively stable
inflation, which stays below the periphery economies until the crisis hits the region in 2008.
Given the German emphasis on maintenance of price stability, it is noteworthy how German
exports have benefitted from the low inflation policies.6
Germany’s preference for low inflation policies is deeply ingrained in German history and
culture- a product of the hyperinflation witnessed during the Weimar Republic period. The
creation of the ECB is based on the model of the Bundesbank, reflecting Germany’s staunch
views on anti-inflationary policies.
6
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Figure 3: Inflation Rate by Country
19
Germany
16
Greece
13
Ireland
10
Portugal
Spain
7
4
1
-2
1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011
-5
Source: OECD
The German Economic Miracle
The passage of key labor market reforms in the early 2000’s allowed Germany to suppress an
increase in Unit Labor Costs, as discussed above. Prior to unification, West Germany was known
for its competitive exports and relative economic strength. With the unification, policymakers
sought to bring about wage convergence between East and West Germany. As wages rose in East
Germany, there was a rise in unit labor costs and unemployment given the low-skilled labor
force and lower productivity. Unified Germany became relatively uncompetitive, leading to
lower economic growth. The economic situation in Germany called for reform, exacerbated by
fundamental problems with labor market institutions in Germany.
According to neoclassical theory, given flexible labor markets, the low skilled workers
should have been adopted into the labor market, shifting the labor supply curve to the right. This
would result in a fall in real wages, restoring the economy back to equilibrium. However, this did
not happen in Germany, as evident by the rising unit labor costs in Figure 2. In the neoclassical
framework this would be attributed to the rigidity of the labor market, which meant an absence
of flexible prices and wages, thus preventing the adjustment to equilibrium. The German labor
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market included generous unemployment benefit packages, along with social assistance
payments that imposed a fiscal strain on the government (Lena and Jochen 2006, 6). Emphasis
was placed on protecting the unemployed rather than encouraging job activation policies. It was
argued that this created disincentives for people to seek employment, emphasizing the need for
greater “flexibility” in German labor markets.
German Labor Market Reforms (Hartz Reforms)
The incident that triggered the revolutionary labor market reforms was primarily political
in nature. A scandal erupted in 2002, when the Federal Labor Office was accused of
manipulating major data that overstated the success of its job placement program. A commission
under Peter Hartz, Volkswagen’s Personnel Director at the time, was set up to address
unemployment and labor market rigidities (OECD 2009, 223). This led to the implementation of
key labor market reforms in Germany- popularly referred to as the Hartz reforms. Released in
four parts, the Hartz reforms were designed to increase labor market flexibility. Neoclassical
theory argues against inflexible labor markets, which prevent the automatic adjustment of wages
and prices in the event of a demand shock- leading to unemployment. Flexible labor markets
ensure that an increase in unemployment would automatically result in a reduction of real wages,
until the market regained equilibrium. The reforms would increase labor market efficiency by
encouraging part-time employment, providing greater incentives to work and introducing equal
treatment of part-time and full- time employees (Lena and Jochen 2006, 8).
The first set of reforms, Hartz I and II, were introduced in Germany during the December
of 2002. Key elements of these reforms included emphasis on self-employment, encouragement
of part-time jobs, reform of the organizational structure in order to help German workers actively
find employment, stricter conditions to refuse jobs, and the establishment of training and
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placement vouchers (OECD 2009, 226). The unemployment benefit period for older people was
reduced to 18 months from 32 months (Eichhorst and Marx 2009, 12). The creation of
“Minijobs,” (Eichhorst and Marx 2009, 13) where subsidies from the government were provided
along with a low- income part-time job, encouraged workers to seek employment. Workers were
also exempt from paying taxes on their second job- another incentive to seek part-time
employment. Active job seeking was encouraged by the establishment of “staffing agencies”
across the country, helping workers seek short term contracts following the introduction of
flexibility in the labor markets (Eichhorst and Marx 12). The Hartz III in October 2003 involved
a significant cut in unemployment benefits, especially upon refusal of a job. Hartz IV in July
2004 reduced the duration for which the unemployment benefits were administered (OECD
2009, 233). Also known as Agenda 2010, the Hartz IV reforms were of particular significance.
The Hartz IV reforms shortened the unemployment insurance period to one year,
extended upto 18 months for people over the age of 55 (Breuer et al. 2011, 108). It merged
unemployment assistance and social assistance into one package, which provided benefits to all
unemployed, after the expiration of the one-year unemployment benefit period. This assistance
was to be financed by tax revenues, and involved strict qualifying criteria and most importantly,
created a stipulation for the unemployed to actively seek work (Hemerijck 2013, 185). The
Agenda 2010 reforms made it easier for firms to set up short-term employment contracts,
motivating workers to seek part-time jobs rather than a single long-term contract.
In order to introduce further flexibility in the labor market and counteract unemployment
during a downturn in the economy, an additional stipulation of ‘opening clauses’ was added.
According to this clause, workers were able to extend their work hours during periods of greater
demand, without an increase in salary. As a result of this practice, they could afford to work
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lesser hours during a recession, when labor demand is low, but they still received income in the
form of subsidies from the government in exchange for the aforementioned extra labor (World
Bank 57). “Moderate wage agreements,” were implemented across industries, which prevented a
significant rise in workers’ wages (World Bank 2012, 57). In the collective bargaining process,
German labor unions had to forgo wage growth in order to ensure that unemployment was
controlled. This also tied in with the government’s attempt to curb inflation, by ensuring wages
grew at a slower rate than productivity. Wage moderation was aggressively pursued by the
German government, which prevented significant rises in wages. There was no national
minimum wage, and wages were determined through collective bargaining at the sectoral level.
Through the 2000’s, the German government put pressure on the trade unions, preventing them
from arguing for higher wages (World Bank 2012, 57).
Impact of the labor reforms on the Germany Economy
Some studies ( (Lena and Jochen 2006) have deemed the Hartz reforms to be a success.
Having reached its peak in 2005, Germany’s unemployment rate continued to decline, and it still
fares much better than the periphery economies. The spike in 2005, pushing it to a high of almost
12 percent was primarily a result of a large number of workers returning back into the labor force
due to the cut in benefits engineered by the Hartz reforms, pushing up the unemployment rate
temporarily (Breuer et al. 2011, 108). Following the implementation of the labor market reforms,
Figure 1 shows that unemployment has been on a decline, falling to a low of 5.5 percent in 2011.
The reduction in unemployment benefits lowered government expenditure on the social
safety net. Social assistance expenditure fell by 3 percent of GDP between 2004-07 (Breuer et al.
2011, 107). However, the Agenda 2010 reforms caused labor market related expenditures as a
percentage of GDP to go up from 1 percent in 2004 to 1.25 percent in 2007, primarily due to
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increased pension contributions (Breuer et al. 2011, 107). The reforms have also been criticized
for increasing inequalities in the German economy. The rise in part-time employment has been
accompanied by a greater incidence of lower-paying jobs (Carlin and Soskice 2009, 77). The
repressed wage growth and an increase in the low wage employment could be an explanation for
the depressed domestic demand seen in Germany. This is supported by data, which states that
employment in the low-wage sector grew at almost three times the rate of regular full-time
employment from 2005-2010 (Marsh and Hansen 2012).
The Hartz reforms created a dual labor market. First was the ‘core’ labor market with
relatively high wages, which satisfied only a small segment of employment requirements.
Employers then resorted to the secondary labor market, characterized by several part-time jobs
with low wages (Hancke, et al. 2007, 82). This secondary labor created a ‘reserve army of labor’
where a large number of people seeking a limited number of jobs allow employers to keep the
wages low without affecting the supply of labor. The presence of this reserve army allowed the
capitalists to exploit the worker by suppressing wages, extending working hours and lowering
job security. The Hartz reforms allowed capitalists to retain their class power, and increase
profits. This dual labor market created conflict within the working class, which prevented them
from uniting in protest against the exploitation by capitalists. Here, the role of the State in
supporting and promoting capitalist’s interests is apparent in the drive towards greater labor
market flexibility and reduced welfare state measures.
The role of the euro in spurring Germany’s export engine
The adoption of a common currency had significant impact on the trade balances of
Eurozone economies. The euro was expected to foster trade between the member economies and
lead to economic improvement for all nations. In a flexible exchange rate system, a rising current
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account surplus in Germany would have been offset by a currency appreciation. Similarly, a
rising current account deficit in the GIPS would have led to depreciation of their currency. Thus,
flexible exchange rate regimes involve a self-corrective mechanism that would eliminate the
trade imbalances among the Eurozone economies. However, with the adoption of the euro, these
corrections did not take place. Germany was allowed to pursue a rising current account surplus,
at the expense of rising trade deficits in the periphery. It has been estimated that Germany’s real
exchange rate today is at 2/5th of the value it would have been if it used the Deutschemark
instead (Moravscik 2012, 59). Aggressive wage moderation policies allowed Germany to import
aggregate demand from other countries that are part of the same monetary union. On the other
hand, GIPS exports lost competitiveness against German exports- a clear indicator of the absence
of institutional mechanisms to correct the macroeconomic imbalances in the Eurozone.
Loss of Competitiveness in the Periphery
A common trend across the periphery economies in the years leading up to the crisis was
the rising current account deficit (Refer Figure 4). Rising unit labor costs as seen in Figure 2,
rendered their exports uncompetitive. In Greece and Portugal, unit labor costs rose by almost 15
percent to that of Germany, and in Spain by a phenomenal 35 percent relative to Germany
(Higgins and Klitgaard 2010, 5). The periphery economies witnessed significant increase in
imports, while their exports lagged behind German exports. Wage moderation in Germany
lowered domestic demand, affecting imports from periphery countries.
Figure 4 shows that Germany’s current account surplus has increased since early 2000,
further rising with the labor market reforms. Germany’s current account surplus reached a peak
in 2007, crossing over 150 million euros just before the crisis hit the region. Figure 4 also shows
that even in the period following the crisis, Germany’s current account surplus has stayed
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Niriksha Shetty
relatively high. In the same period that Germany posted a current account surplus, the chart
shows that the GIPS posted current account deficits, with Spain performing the worst.
200,000
Figure 4: Current Account Balance by Country
Germany
(including
former GDR
from 1991)
100,000
Ireland
50,000
Greece
0
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
Millions of Euros
150,000
Spain
-50,000
Portugal
-100,000
-150,000
Source: EuroStat
c. Fiscal Policy Constraints in a Monetary Union
The emphasis placed in the Eurozone on sound government finances is apparent with the
implementation of the Stability and Growth Pact (SGP) in 1997. According to this pact, member
states of the Eurozone were to limit their debt to 60 percent of GDP and deficit spending to three
percent of GDP. The conventional argument is that deficit spending in the periphery was
responsible for the crisis. However, Figure 5 indicates otherwise. Spain posted a budget surplus
from 2005- 2007, with its debt-to-GDP ratio falling from 50.3 percent in 2000 to 26.7 percent in
2007 (CEPR 2011). Similarly, from 1997-2007, Ireland ran a budget surplus of around 1.6
percent (Stancil 2010, 2) Figure 5 shows that until the crisis hit in 2008, Spain and Ireland
Niriksha Shetty
19
remained well above the three percent SGP limit. In comparison, Germany violated the three
percent rule more than once between 2002-05.
5.0
Figure 5: Excessive Deficit Procedure (3% SGP Limit)
0.0
Percentage of GDP
-5.0
Germany (until
1990 former
territory of the
FRG)
Ireland
Greece
-10.0
Spain
-15.0
-20.0
Portugal
-25.0
SGP Limit
-30.0
Source: Eurostat
-35.0
While core countries such as Germany followed an export-led growth model, the periphery
was pushed to follow a credit-growth model. Stockhammer claims that the increasing reliance on
external credit in the periphery economies can be attributed to the following factors. The
expected convergence implied with the adoption of the euro led to a fall in interest rates,
providing easy access to credit. (Stockhammer 2011, 10). Large current account surpluses in core
countries resulted in a flow of capital from the core to the periphery, which financed the credit
booms (Stockhammer 2011, 10). The periphery economies were characterized by rising current
account deficits accompanied with household and public debt. Thus, the credit growth model is
simply an outcome of the current account imbalance between the core and the periphery.
Niriksha Shetty
20
The absence of mechanisms in place to address the competitiveness issue in the Eurozone
highlights the structural flaws in the formation of the Eurozone. One particular group of PostKeynesian economists, namely the Neo-Chartalists (Wray, Kelton, etc.) view this problem using
the sectoral balances approach. The sectoral balances approach divides the economy into the
foreign sector and the domestic sector (including the public and private sector). Since one
sector’s expenditure is necessarily another sector’s income, it means that a deficit in one sector
must be matched by a surplus in the other. Thus, it is impossible for all the sectors to save at the
same time. If a country runs a current account deficit, its foreign sector is running a surplus,
which necessarily means that the domestic sector is in a deficit. This can mean either a private
sector deficit or a public sector deficit. If the domestic private sector is running a surplus, it
means that the current account deficit must be offset by a government deficit that is greater than
the current account deficit. On the other hand, if the government sector tries to balance its budget
when a current account deficit exists, it is forcing the private sector into a deficit. For instance,
assuming that the Greece ran a current account deficit of 10 percent of GDP. Assuming this
current account deficit was unchanged, and it adhered to a 3 percent government budget limit,
the private sector would be forced into a deficit to the tune of 6.9 percent of GDP.
The sectoral balances approach points to two important conclusions. First, contrary to
conventional belief, government spending is not necessarily a discretionary variable. The private
sector will usually try to save during a recession, automatically pushing the government into a
deficit. Second, government deficits and current account deficits are necessarily related. As
Germany kept its wages low, its exports became competitive and it absorbed aggregate demand
from the periphery, which boosted its employment rate. In contrast to this, exports in the
periphery economies lost competitiveness, which led to rising current account deficits and
Niriksha Shetty
21
unemployment. It was as if Germany was exporting unemployment to the periphery, and
importing aggregate demand. Thus, referring to the recession in the Eurozone, as a “sovereign
debt crisis” is misleading- it was the current account imbalances and not the fiscal profligacy by
governments that led to the crisis.
While monetary policy constraints point to significant flaws in the Eurozone design,
Keynesian economists have emphasized that fiscal policy is a more effective economic tool.
Post-Keynesians argue that fiscal policy is a more effective tool to address the problem of
aggregate demand, unlike monetary policy where, to quote Keynes, “there is many a slip
between a cup and a lip” (Keynes 1936, III) Neo-Chartalists claim that it is the divorce between
the currency issuing authority and the fiscal authority that is at the crux of the Eurozone’s
problems. The neoclassical approach views money as a commodity, which serves as a medium of
exchange, which eventually came to be replaced by fiat money. Contrary to this, Neo-Chartalists
argue that money has always been a liability, and not a commodity. While everybody can issue
liability not everybody can get this liability accepted. The government is then in a special
position because it able to impose and enforce taxes. The authority of the government to collect
taxes validates its authority to issue liabilities. Therefore, governments do not need to borrow to
spend. Rather, they can spend by issuing their own liabilities.
Monetary sovereignty, which is defined as the ability of the government to issue its own
currency that is not pegged to another currency or metal, determines the extent of a country’s
fiscal policy space. Neo-Chartalist economists state that if national governments do not have the
authority to issue their own currency, they are left with only two means to raise money- taxation
and borrowing. However, both these measure impose constraints on the ability of governments to
use fiscal policy as a tool to address a lack of aggregate demand in the economy. Taxation is
Niriksha Shetty
22
extremely limited since social and political factors impose a ceiling on how the tax rate can go.
The increase in tax rates will inevitably lower aggregate demand, eventually translating into
unemployment and lower output. On the supply side, an increase in taxes will demotivate
businesses. Thus, the role of taxes to increase liquidity is a restrictive option. The difference
between government spending and taxation is usually made up by issuance of bonds- forcing
governments must turn to capital markets for borrowing.
Describing the disconnect between a supranational monetary policy and national-level
fiscal policies as ‘Euroland’s original Sin,’ Papadimitriou and Wray claim that the current
structure is akin to national governments dealing in a “foreign currency- the euro”
(Papadimitriou and Wray 2012, 1). Capital markets recognize the lack of monetary sovereignty
in these economies, and budget deficits are penalized by high interest rates. With the recession
hitting the Eurozone in 2008, we can see the widening yield spread between long-term
government bonds of the GIPS and Germany in Figure 6. On the other hand, if the national
governments had currency creating capabilities then markets would realize that the government
could never go bankrupt. Thus, a separation between the currency issuing entity and the fiscal
entity is a major structural flaw in the Eurozone that must be corrected.
Niriksha Shetty
23
Figure 6: Spread between GIPS Debt and German Debt
25.00
20.00
Greece
15.00
Ireland
Spain
10.00
Portugal
5.00
0.00
Source:
Eurostat
-5.00
III. Onslaught of the crisis and the policy crisis
a. Policy Response
The initial response of policymakers to the economic troubles in Greece was to provide
strong fiscal assistance in the form of fiscal packages. A stimulus policy was first adopted in the
G20 summit in Washington DC in November 2008, with a call to provide necessary impetus to
aggregate demand. (Afonso, et al. 2010, 23) Stimulus spending was then adopted by the
Eurozone, with the launch of a European Economic Recovery Plan (EERP) within two weeks of
the G20 announcement. The EERP provided fiscal stimulus to the EU countries to spur growth
by increasing aggregate demand. As the crisis spread, rising panic led to governments across the
Eurozone adopting austerity packages in a bid to protect itself from rising interest rates.
Austerity measures were implemented across Europe with the support of the European
Central Bank’s (ECB), European Commission (EC) and the International Monetary Fund (IMF),
commonly known as the ‘troika.’ Austerity became a precondition for external assistance from
the troika. With the political backing of Germany, along with initial support from Sarkozy’s
Niriksha Shetty
24
French government and the Dutch- austerity was hailed as the savior of the economies in the
periphery and was implemented with much fervor across the Eurozone. One of the motivating
factors for the austerity propaganda could be the exposure of German and French banks to debt
in the GIPS countries. This is evident in Figure 7, where the significant exposure of the core
country banks to the periphery economies can be seen. For instance, German private banks had
high exposure to Spanish and Irish debt. If Germany allowed these economies to fail, their
private banks would also be affected and the government would have to step in to rescue them.
On the other hand, austerity measures in the periphery ensured that the brunt of the crisis would
be borne by the GIPS themselves.
Figure 7: Exposure of Banks by nationality to GIPS
300.0
Greece
Billions of dollars
250.0
Ireland
200.0
150.0
Portugal
100.0
Spain
50.0
0.0
Germany
Spain
France
Italy
Other Euro
Area
United
Kingdom
Source: BIS
The current Eurozone crisis can also be viewed as a manifestation of the contradictions of
German capitalism. As Germany practiced wage moderation, its economy grew on the basis of
rising exports. However, this also made it reliant on other Eurozone economies for export
markets, which led to capital outflows into the periphery. Thus, there is sufficient evidence to
Niriksha Shetty
25
prove that German played a key role in the development of macroeconomic imbalances in the
region, drawing attention to German hypocrisy in determining the policy response.
Blaming the GIPS for the poor economic situation in the Eurozone, austerity was
advocated as a dose of bitter medicine that would allow the periphery economies to correct their
‘mistakes.’ The implementation of austerity in the periphery was a product of political
consideration rather than economic theory. In order to protect the exposure of German banks, the
policy discourse blamed the “excessive spending” by the periphery economies for the crisis. In
the context of the class struggle, austerity became a means for the capitalist class to shift the
burden of the crisis to the workers. This is an example of the “state-finance nexus” where the
capital class uses the state (the supranational European institutions) in order to serve its interests
(Harvey 2010, 122). Thus, austerity has led to further exploitation of the worker, while the
financial sector- originally at the heart of the crisis- has been bailed out.
Austerity was first enforced with the Greek government seeking external assistance.
Following this, Ireland, Portugal and the Spanish banking sector all asked for financial assistance
from the troika and other EU members. This assistance was provided by the Eurozone’s crisis
resolution mechanisms (including the temporary European Financial Stability Facility, and the
more permanent European Stability Mechanism), the International Monetary Fund (IMF) and
through bilateral loans. In the second assistance package to Greece, private investors also agreed
to a debt haircut of 53.5 percent (DGEFA 2011, 47). All offers of external assistance were
conditional to the implementation of severe austerity measures.
A common feature of the austerity packages was a cutback in public expenditure which
included a pay freeze in public sector wages. Public investment fell and labor market reforms to
increase flexibility were introduced. Pension reform was one of the major austerity measures
Niriksha Shetty
26
enforced across the periphery. In Greece, proposals were introduced to extend the average
retirement age to 65 years, increase retirement age for female workers, and to lower the pension
sum to reflect average salary earned rather than salary at time of retirement (DGEFA 2010, 18).
In Ireland, there was a one-euro reduction in the minimum wage to 7.65 euros (The Telegraph
2010). On the revenue side, emphasis was on raising revenue through indirect taxes. Across the
periphery there was an increase in Value Added Tax (VAT) rates, as well as on excise duties on
tobacco and alcohol. Corporate tax rates were left unchanged for the most part. In a unique
move, the Spanish government introduced a higher tax rate for the rich.
The vulnerabilities of Spanish private banks, particularly their exposure to real estate
called for a restructuring of the Spanish banking sector and stronger capital adequacy
requirements. In June 2012, the Spanish Government requested financial assistance for its
banking sector. A 100 billion euro package was provided by the European Stability Mechanism,
a permanent institution set up to provide assistance to members of the EU, replacing the EFSF
and the EFSM. (DGEFA 2012, 30)This aid was subject to various conditions including stress
testing and introduction of additional capital buffers. The package also stipulated that weak
assets in private banks would be separated and transferred to an external asset management
company in a bid to improve the health of the banking sector (DGEFA 2012, 55).
While only three countries asked for a bailout i.e. Greece, Ireland and Portugal, the worry
of rising interest rates had economies across Europe slashing their budgets and introducing selfimposed austerity measures. For instance, in the United Kingdom the government has passed a
series of budget cuts since 2010 with harsh austerity measures, even though it was nowhere near
the brink of collapse like Greece and Ireland. Adoption of austerity measures had many
motivations- it was a precondition for external assistance, a signal of recovery to capital markets
Niriksha Shetty
27
and also to increase competitiveness of exports by lowering wages. The success of these
measures and their impact will be examined in the next section.
b. Evaluation of Austerity
Austerity as a policy response is grounded in neoclassical theory. Neoclassical economists
argue that deficit spending by the government would increase the demand for loanable funds
pushing up interest rates. This would crowd out private spending, particularly private investment
(Konzelmann 2012, 7). By reducing government expenditure and raising taxes, austerity
measures would lower deficit spending. This was expected to lower interest rates and encourage
private sector spending in the Eurozone. The implementation of austerity policies was expected
to improve market confidence, which would lead to economic growth. Terming this argument,
the ‘confidence fairy,’ Krugman argues that expansionary austerity policies will not work simply
because any confidence improvements will be overshadowed by the depressing effects of such
harsh spending cuts (Krugman 2012).
As the Eurozone continues to reel under an economic recession, there is some evidence to
show that austerity has been unsuccessful. The cutback in public spending resulted in severe
economic growth contraction. In Greece, GDP declined by more than 20 percent in the last five
years, contributing to the rising debt-to GDP ratio (Thomson Reuters 2012). In Spain, over 2.9
million people have lost their jobs since the recession. Alarms were raised when Spanish
unemployment crossed 25 percent in 2012, with youth unemployment at 47 percent (The
Economist 2012). Portugal witnessed seven consecutive periods of economic contraction as GDP
fell and unemployment rose to a high level of 15.6 percent in the first quarter of 2012. (Caldas
2012) On the other hand, the Irish economy witnessed a 0.9 percent growth in GDP in 2012- a
fact that is often highlighted to describe the ‘success’ of austerity. However, this does not
Niriksha Shetty
28
consider the entire picture, as unemployment continues to stay high at around 15 percent (Cronin
2011). Another major concern that the spending cuts have brought in across the GIPS is the mass
exodus of the young labor force from these economies, given the high unemployment and lack of
job opportunities. Many workers from Portugal are moving to Latin American countries. Spain
and Germany negotiated a deal in 2011 that allows German firms to provide jobs to unemployed
Spanish workers in select sectors (Bordreaux 2012).
Additional justification to show that austerity does not work came from one of its
strongest proponents- the IMF itself. In a recent working paper, IMF officials admitted that they
made errors estimating the fiscal multiplier effect of austerity and emphasized the need to
exercise caution while implementing austerity policies (Blanchard and Leigh 2013). There has
been strong debate in policy circles to look for policy alternatives. The detrimental effects of
austerity look even more disturbing if we take into account the population groups it has affected.
c. The Distributional Impact of Austerity Policies
Austerity policies affected sections of the society that were dependent on welfare payments
from the government- the poor and the unemployed. Theodoropoulou and Watt conducted a
study of austerity packages across eleven Eurozone across countries to determine the effect of
changes in government expenditure and taxation on income distribution. They argued that
austerity packages across the GIPS were regressive, with lower income groups feeling the burden
of reforms to a greater extent. This was because austerity measures led to an increase in indirect
taxes and a reduction in social assistance, having significant impact on lower income groups.
This study also found that public sector workers and people approaching retirement were hit hard
by the pay cuts and reduction in benefit periods. (Theodoropoulou and Watt 2011, 23).
Niriksha Shetty
29
From a Post-Keynesian perspective, this crisis is an aggregate demand issue. The drive to
lower wages becomes a way for countries in the monetary union to steal aggregate demand from
each other, creating a no-win situation for everyone involved. The fall in domestic demand as a
result of austerity and wage suppression becomes immediately apparent in Figure 8, where the
decrease in domestic demand following 2008 is noteworthy. It also shows us how Germany’s
domestic demand has remained lower than the GIPS in the years of the Hartz reforms, further
supporting the Post-Keynesian argument. Clearly the burden of austerity was passed on to the
more disadvantaged sections of society.
Figure 8: Growth in Real Total Domestic Demand
15.0
Germany
10.0
Greece
Percentage
5.0
Ireland
Portugal
0.0
1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012
Spain
-5.0
-10.0
-15.0
V.
Source: Eurostat
Alternatives to Current Policy
This paper demonstrates that it is not fiscal profligacy by periphery economies but the
structural flaws in the Eurozone that has created the current crisis. When viewed as a crisis
engendered by rising government debt, austerity arguments are able to gain some moral and
economic ground for argument. However, it is clear from Section IV that the European debt
crisis resulted from key flaws in the design of the Eurozone, stemming from the creation of
current account imbalances between member nations.
Niriksha Shetty
30
a. Why competitive disinflation by lowering wages is bad for the periphery
A drive towards rebalancing the trade accounts in the region has resulted in competitive
disinflation, with periphery economies slashing wages in a bid to follow Germany’s lead and
increase competitiveness. The implications of the periphery economies cutting back their wages
to follow the German model would be dire for the Eurozone as a whole. The conditions under
which Germany carried out wage moderation were relatively easier. However, disinflation
policies in the midst of a recession will dampen aggregate demand further. If all countries begin
to depress wage growth it is likely to trigger a ‘race to the bottom.’ Given that almost half of
Germany’s exports are absorbed within the Eurozone itself, this would not only affect the health
of the periphery economies, but also be detrimental to the Germans.
One alternative is for Germany to accept higher wages and increase domestic demand to
allow the periphery to improve its current account position without creating another fiscal
downturn (Stockhammer 11). If wages rise in Germany, it is likely to increase domestic demand.
This will increase demand for imports in Germany, reducing Germany’s current account surplus.
In order to reduce the competitiveness gap between the core and the periphery, Germany must
accept rising unit labor costs, where wages grow in excess of productivity for a certain period of
time (Stockhammer 10). The establishment of such a rebalancing mechanism will ensure that
Eurozone economies reach greater convergence, lowering the impact of demand shocks and
prevent the recurrence of a crisis of such magnitude.
b. Redesigning the Eurozone?
Many critics have called for a structural change in the design of the Eurozone. NeoChartalist economists argue that the loss of monetary sovereignty inevitably results in a loss of
fiscal policy independence. The crisis that spread across Europe has been referred to as a
Niriksha Shetty
31
sovereign debt crisis- with a key concern being the worry of national governments defaulting on
their debt. However, economies across the Eurozone, particularly in the periphery have been
suffering from chronically low aggregate demand, even before the crisis – reflected in the high
unemployment rates. National governments have been unable to address this situation due to the
lack of control over their own finances. Perhaps, these economies need to move towards a fiscal
union in order to be able to exercise fiscal policy to stimulate demand. Thus, there is a strong
need for greater economic integration to steer the Eurozone out of a crisis. Fiscal centralization
will serve as means for government to spend money in order to stimulate economic recovery by
increasing aggregate demand.
c. Class conflict and the European Crisis
The advent of austerity policies has played an important role in shifting the burden of the
crisis from the financial sector to the worker. While economic stability and political harmony
might not have been achieved in the Eurozone, there is evidence to show the use of neoliberal
policies throughout the integration process has shifted the balance of power in favor of the
capitalists. This crisis can then be viewed as a vehicle to further this political agenda- with
austerity policies further ‘immiserating’ the worker. As wages are lowered across the Eurozone,
capitalists are able to extract greater surplus value from the worker, driving up profits. However,
austerity policies have started facing backlash across Europe as anti-austerity protests gain
momentum. Thus, class conflict, which has been an underlying force throughout the process of
Europeanization, plays a key role in the evolution of the crisis. This struggle between capital and
labor will govern how the European economy moves out of this crisis.
VI. Conclusion
Niriksha Shetty
32
This paper demonstrates that the process of European integration and the current crisis
are a result of a political project based on the vision of a unified Europe. However, the
underlying structural flaws in the design of the Eurozone has led to greater divergence between
the Eurozone economies, rising political turmoil and economic instability. Thus, neither the
expected political or economic harmonization of Eurozone economies has occurred.
Policymakers will need to address the constraints imposed on national fiscal policy in order to
ensure that they are able to use government spending to stimulate aggregate demand. On the
other hand, the crisis has allowed greater exploitation of the workers, particularly through
austerity policies. In the context of a class conflict, the policy response to the crisis has served to
reinforce the power of the capitalist class. As the working class continues to resist the harsh
austerity measures through protests and political upheavals, this ongoing conflict between labor
and capital will play a fundamental role in redefining economic relationships in the Eurozone.
Niriksha Shetty
33
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