The Eurozone's Malaise

How the EZ's internal imbalances are a consequence of uncoordinated national fiscal policies in a single currency area and not due to immoral behavior

I can't recommend reading Michael Pettis' writing enough if your goal is to understand why and how deficient EZ demand acts as a weight on the US as well as the rest of the world (see here, here, and here).  Here is passage from his latest post: 

"The authors show for example that anyone who had a reasonable understanding of the current and capital account pressures of the 1920s whose inconsistencies doomed Germany should have been able to understand why downward pressure on German wage growth, in the several years before the global crisis was set off in 2007 by the US subprime crisis, would ultimately force huge internal imbalances onto Europe during that time. More importantly, this understanding should have been enough to convince European policymakers that unless Germany responded to the crisis by reflating domestic demand sufficiently to generate large current account deficits, it would be all but impossible to prevent a decade of anemic growth and extraordinarily high unemployment in peripheral Europe."

 To add to this, here is another sample from February 2015:

"At the turn of the century Berlin, with the agreement of businesses and labor unions, put into place agreements to restrain wage growth relative to GDP growth. By holding back consumption, those policies forced up German savings rate. Because Germany was unable to invest these savings domestically, and in fact even lowered its investment rate, German banks exported the excess of savings over investment abroad to countries like Spain."

In a closed economy, Germany's wage restraints which attempt to force down its household share of GDP would have likely produced a rise in domestic household, corporate, and/or government leverage or a slowdown in German NGDP and higher unemployment.  The latter scenario would have called for the Bundesbank to institute accommodative monetary policy.  Prior to the crisis, the ECB did just that.  Problematically, this produced a policy stance that was inappropriate for the periphery EZ economies. 

The ECB's stance, although appropriate for Germany, incentivized capital to flow to the periphery EZ economies in search for yield, distorting their economies in the same way fickle capital flows have in emerging markets.  German and French banks as well as other global asset managers were able to borrow (issue debt) at low rates in their core countries while using this funding to purchase higher yielding financial assets and bank debt in countries like Spain or Greece.  Seeing as they all shared the Euro, currency risk was perceived to be nonexistent.  Moreover, regulations treated EZ government debt equally as risk free assets. 

These capital flows caused interest rate spreads between core and periphery countries to converge.  Flush with relatively cheap funding from abroad, Greek and Spanish banks were able to lend more freely to their domestic economies spurring NGDP growth, economic activity, and employment in the process.  This boosted aggregate demand not only domestically, but also in core countries as Germany's export oriented economy was well positioned to take advantage of this elevated demand.  Thus, Germany was able to escape weak domestic demand induced by their domestic policies by increasing exports to the rest of the EZ.  In essence, gross capital flows helped produce persistent current account surpluses in Germany as other EZ countries ran current account deficits.  The consequences for EZ economies outside the core were far from benign.  The flow of capital and risk perception associated with this lending consequently caused inflation and wages to diverge between the core and periphery resulting in the much lamented relative loss of competitiveness.*  This credit and debt expansion from core to periphery also helped fund soaring real estate (Spain, Ireland) and financial asset markets.  The reversals of these trends would later reinforce the collapse in aggregate demand as it left a legacy of private, financial, and public debt that was difficult to service once domestic income and employment declined in those areas.   

The financial crisis exposed these structural flaws and imbalances within the EZ.  The banking system became fragmented as interbank lending between core and periphery banks was disrupted leading to the Target2 imbalances we are witnessing today (giving rise to ECB's ELA).  NGDP throughout the EZ contracted, but much more so in the PIIGS.  Prior to the pre-crisis expansion, the rise in leverage was masked by elevated GDP.  Once the economies slowed, debt/GDP ratios started to rise especially in countries (Spain, Ireland) that sought to rescue their banking systems by essentially converting private debt into public debt.  The current Greek finance minister has routinely expressed how the various bail out programs to troubled countries were a backdoor rescue of imprudent French and German banks who lent to their Greek and Spanish counterparts.  Private debt became public debt some of which has become the official debt held as financial assets on the balance sheet of the group formally known as the Troika.  Lending from the official sector came with conditions that worked to depress household share of income in a somewhat similar manner as to what occurred in Germany during the pre-crisis expansion.  Unlike in the case of Germany, these measures proved disastrously counterproductive as they did not give rise to an export boom but instead amplified the economic contraction.  To make matters worse, the fiscal limitations in the EZ already reduced the capacity for some nations to fight off the effects of the recession.  This almost all but guaranteed that unemployment in troubled areas would persist; inhibiting the repayment of bubble era debts as it reinforced the aggregate demand shortfall. 

As capital flows reversed, interest rates diverged as spreads between the periphery and core blew out.  Unfortunately, the currency could not serve as the release valve forcing troubled nations into the slow and painful process of internal devaluation.  Currency depreciation in the face of labor and product market rigidities would have helped to restore competitiveness, but that was never an option that could be used to rectify imbalances within the monetary union.  It was explained that troubled countries needed to improve competitiveness by reducing nominal labor costs as well as other indirect costs to employers so as to induce business investment in these regions.  As Greece shows, this adjustment can prove to be disastrous unless there is a boost in domestic demand or investment emanating from the core countries.  In order for the likes of Greece or Spain to rebalance without creating a shortfall in economic activity and employment, core nations must reverse (wage) policies which result in persistent current account surpluses.  Had Germany not been part of the same monetary system as Greece, the markets would have forced this adjustment by causing an appreciation in the German FX rate relative to the rest of the EZ.  A depreciation against a German currency would have enabled struggling countries to reduce their labor costs relative to Germany's without having to resort to nominal wage cuts and high unemployment that have worked to worsen debt dynamics.  At their expense, Germany's export oriented economy has greatly benefited by being part of a common currency that has allowed it's FX rate to be undervalued not just within the EZ, but globally.

It's also fair to say that German monetary ideology has greatly hampered the ECB's ability to conduct policy in a way that would be appropriate for all of the EZ.  If monetary policy was too loose for the periphery prior to the crisis, it has been too tight after even if the stance can be justified by the economic performance of the core countries.  The ECB under Trichet raise rates prematurely in 2011, a policy that eventually had to be reversed after much damage had been done due to the subsequent European Sovereign Debt Crisis.  Importantly, it also foreshadowed that the ECB would always be late to act, hesitating due to German pressure.  Although Mario Draghi deserves credit for his "whatever it takes" speech and attitude, in reality the ECB only just instituted a bond purchase program after years of economic malaise that caused inflation to come in below their mandate.  Arguably, the experimentation with a negative deposit rate, which aligns with the precipitous Euro depreciation, has done more to boost broader EZ NGDP at the expense of the region's trading partners as accounting profits from abroad can now be repatriated at a more favorable Euro FX rate.  Unfortunately, it does little to correct the imbalances found within the EZ as an internal revaluation is still needed.  Although this more aggressive policy stance seems to have produced at least a mild EZ economic rebound, I can't help but wonder if this came at the expense of the rest of the world as it has coincided with weaker than expected US economic growth in the first half of 2015.  Ideally, the hope is that eventually this EZ policy mix will produce a sustained European economic recovery that will boost aggregate demand throughout the global system rather than result in perpetual counterproductive EZ current account surpluses.  

Structural Issues

Although there were warnings prior to 2007, the GFC and EZ Sovereign Debt Crisis exposed the Eurozone's structural flaws.  Without a proper lender of last resort or a politically supported fiscal transfer mechanism, capital outflows and current account imbalances left distressed countries with very limited options when faced with the crisis.  Unlike in the US where automatic fiscal stabilizers kicked in when the recession hit, the Maastricht Treaty restricted the ability of EZ governments to enact expansionary countercyclical fiscal policy.  Furthermore, unlike the Fed, at the onset of the crisis the ECB was inhibited from acting as a true lender of last resort that could freely buy government and bank debt if deemed necessary.  Therefore, individual governments were at least implicitly held responsible for backstopping their own banking sectors, but this resulted in ballooning public debt levels in nations that did so.  As this intensified the risk of government default, capital flight worsened in what was a self-reinforcing feedback loop.  Therefore, when the crisis took hold, capital flight and the tightening of EZ cross-boarder interbank lending could never adequately be offset by expanding the public balance sheet without creating solvency risks for the member states that attempted to do so.  In essence, the structure of the Eurozone tied the solvency of the national banking systems to governments that do not possess their own independent central banks.  This was an inherent contradiction within the infrastructure of the Eurozone going into the crisis.  

To make matters worse, without a proper EZ lender of last resort, the failure of one sovereign's banking sector threatened the solvency of banks from abroad as their balance sheets overlap.  This is especially the case in the Eurozone where bank lending still plays a larger role than capital market funding.  The failure of Greek banks would have inevitably imposed large losses on their French and German counterparts which would have required saving by the French and German governments.  This was not politically possible as it would have caused a deteriorating in the German public balance sheet.  Consequently, it demonstrated that EZ public balance sheets are very much intimately intertwined.   This unfavorable situation for Germany and France was only avoided when the Greek government accepted a bailout by official sector creditors (ECB, EC, IMF).  This amounted to a backdoor bailout of the core's banking system , other private-sector creditors, and Greek oligarchs all at the expense of the Greek people.  This episode demonstrated the disjointed nature of a single currency area that connects public and bank balance sheets between Eurozone nations, but one that does not feature an empowered politically independent lender of last resort or a EZ wide fiscal policy (common treasury and Euro bonds).  A lack of true political solidarity prevented the coherent economic and financial integration needed to deal with such turbulence.  

This has lead to prolonged recession, animosity, and disunion which still threatens the future of the Eurozone.  As this excellent post by Bloomberg Intelligence points out, Eurozone policymakers have made strides in correcting some of the Eurozone's structural flaws.  However, as the piece also reiterates, there is still much more work to be done.  After year of traumatic crisis and austerity policies that have failed to generate growth, the task of making the Eurozone feasible and prosperous in the long run is now made more difficult.  With euroskepticism on the rise, any further integration that requires a loss of sovereignty may not be politically possible.  Only time will tell whether this is the case or not.  

*A rise in unit labor costs in the EZ periphery nations relative to the core (loss of competitiveness) was a consequence of capital inflows and not the cause of the subsequent crisis and slump.  Therefore to attribute the EZ crisis to a divergence in unit labor costs between countries within the common currency bloc is a dangerous misdiagnosis of the underlying problems.  See here for more.