The Euro Crisis
What institutional and structural problems in Europe were responsible for the Euro crisis? What can be done?
Although catalysed by the Global Financial Crisis (GFC) of 2007-2008, substantial responsibility for the Euro crisis can be attributed to the institutional and structural problems entrenched in the design of the European Economic and Monetary Union (EMU). The crisis led to subdued growth and record levels of unemployment in the economies of Greece, Ireland, Italy, Portugal and Spain – collectively known as the GIIPS – and the wider eurozone. The beginnings of the crisis were in the sovereign debt problems of these countries, the causes of which varied from successive unsustainable government deficits in Greece, to bank guarantees and bailouts shifting private debt into public hands in Ireland and Spain. What these sovereign debt crises had in common, however, were the structural and institutional problems of the EMU, which both created the conditions for, and prevented the recovery of, the wider Euro crisis.
This essay will outline these problems. First, institutions and structures in the political economy will be briefly defined. Secondly, the inability of a united monetary policy to cater for the differences between northern and southern European varieties of capitalism will be examined. Thirdly, the structures and institutions hindering a swift and effective economic recovery will be outlined. Finally, the viability of proposed recovery approaches will be evaluated.
II STRUCTURES AND INSTITUTIONS
For the purpose of this essay, institutions in the political economy will be understood as the rules, procedures, norms and conventions, whether formal or informal, that affect the behaviour of groups and individuals (Hall & Taylor, 1996). This includes, inter alia, the formal rules of the EMU and the European Central Bank (ECB), and the degree of pan-European solidarity in the eurozone. Economic structure will be understood as the basic make-up of an economy or market and includes, inter alia, the combination and relationship between different production sectors, the level of labour market flexibility, resource availability and political change (Jackson, Rogerson, Plane & Huallachain, 1990).
III VARIETIES OF CAPITALISM
A substantial problem facing the eurozone is the inability of a unified monetary policy to cater for distinct northern and southern European varieties of capitalism (Hall, 2014). In the northern European model of capitalism, economic growth is driven primarily by exports. The share of Gross Domestic Product (GDP) made up by exports in the northern European economies of Austria, Belgium, Estonia, Germany, Lithuania, the Netherlands, and Slovakia were all above the EU average of 44.6% in 2017, while the southern European economies of Greece, Italy, Portugal and Spain were all below the EU average1 (The World Bank, 2017). Hence, institutions in northern European countries are geared towards improving international competitiveness, including wage setting through collective bargaining, strong investment in education and vocational training, and healthy inter-firm relations conducive to research and innovation (Streeck, 1992). In the southern European model, on the other hand, economic growth is demand-led; institutions in these countries are less effective at enhancing international competitiveness. Although labour unions are strong, they compete for the right to represent workers and are unable to coordinate wage levels (Hancké, 2013). Furthermore, lower investment in education and training leaves a larger proportion of the workforce unskilled – encouraging firms to base their comparative advantage on cheap labour as opposed to innovation (Glatzer, 1999).
These variations pose problems for the ECB, which must set a monetary policy that is suitable for both types of economies. Because of the large size of the German2 and other northern European economies relative to the rest of Europe, the ECB’s monetary policy tends to favour these export-led economies (Feldstein, 2012).
A Northern European Economies
In the northern European export-led economies, wage setting is achieved through collective bargaining, with the export sector as a wage leader (Iversen & Soskice, 2013). Knowing that an increase in wages will drive all wages up, making exports less competitive, the collective bargaining of the export sector keeps wages at a sustainable level. This wage setting approach requires the central bank to take an inflation-averse stance to monetary policy, where excessive wage increases are responded to with increases in interest rates (Grüner & Hefeker, 1999). If monetary policy were more geared towards growth and unemployment, the central bank might respond with interest rate cuts and devaluations. This would lead to a collective action problem, however, as each union would have nothing limiting their capacity to demand higher and higher wages. This is because monetary policy aimed at increasing aggregate demand (in response to wage increases) would always ensure unemployment did not rise too high. The result would be suboptimal, however, as the threat of unemployment is the one thing usually restraining excessive wage demands (Yellen, 1984). If monetary policy removed this threat, excessively high wages would increase labour costs, making exports – the primary driver of the economy – less internationally competitive (Iversen & Soskice, 2013).
Thus, monetary policy in northern European countries is best when it focuses less on unemployment (i.e. it is unaccommodating), making it clear to unions that if raise wages rise too high, they will suffer high unemployment in their sector. This trade-off between wages and employment prevents excessive wage claims and protects the economies’ international competitiveness on the export market (Iversen & Soskice, 2013). This cautious approach is also seen in fiscal policy, the government making clear that budgets should be constrained, and that inflationary wage-setting will not be counterbalanced with a Keynesian, fiscally induced increase in aggregate demand (von Hagen & Hallerberg, 1999). This model only works for export-led economies, however, as non-accommodating macroeconomic policies reduce domestic demand – the primary driver of growth in demand-led economies.
B Southern European Economies
The exercise of inflationary-averse monetary policy has adverse effects for southern European demand-led countries. Upon the introduction of the EMU, countries like Greece – whose borrowing was previously subdued by high interest rates – now had access to cheap debt. Despite heavy borrowing, the cost of debt did not appreciably increase because an increase in interest rates would be at odds with the monetary policy favoured by northern European countries (Feldstein, 2012). The ‘no-bailout clause’3 was meant to counteract this effect by encouraging “markets to discipline sovereigns, by pricing their debt according to their credit risks” (Moghadam, 2014). Markets nevertheless seemed to not believe the ‘no- bailout clause’ would be upheld, and priced southern European bonds assuming a bailout (Arghyrou & Tsoukalas, 2011).
Consequently, the GIIPS amassed concerning levels of debt to fuel their demand-led economies. When these countries had control of their own monetary policy, this model of demand-led growth was feasible as the negative side-effect of inflation could be offset via devaluation (Hall, 2014). As part of the EMU, however, this option was no longer available – and the consequences soon became evident. Inflation increased labour costs, in turn decreasing international competitiveness. The ECB now faced a dilemma as it “could have used its monetary instruments to reduce rates of inflation in southern Europe, but doing so would have risked contraction in the north” (Hall, 2014, p. 1228).
In deciding its course of action, the EMU referred to its institutional underpinnings. These largely reflected the national economic doctrine of northern European countries which favoured cautious, non-activist economic management that ensured monetary stability (Allen, 2005). This contrasts with the economic doctrine of southern European economies that favoured a more Keynesian, activist approach to economic management (Culpepper, Hall, & Palier, 2006). In the end, the ECB pursued a non-accommodating policy that allowed inflation and debt in southern Europe to continue to rise unabated. When the GFC exposed the parlous levels of debt in the GIIPS, investors “recognised the error of regarding all eurozone countries as equally safe” (Feldstein, 2012, p. 108) and interest rates on government bonds rose sharply. This set off a vicious cycle of investor fears over the solvency of countries like Greece, which further increased interest rates, which further exacerbated the fear of insolvency.
Thus, the structural variations between northern and southern European economies, underpinned by their respective growth strategy, wage setting and training/educational institutions meant that the eurozone faced asymmetrical macroeconomic shocks and was not a viable single currency area. As the magnitude of the Euro crisis became apparent, policymakers searched for a solution (The Economist, 2010). At this stage too, however, it became apparent that the eurozone possessed structural and institutional deficiencies hindering its economic recovery (Boone, 1997).
1 Two notable exceptions to this trend exist: In the northern European economy of Finland, exports are below the average, making up only 38.6% of GDP, while in Ireland (not a southern European economy, but part of the GIIPS) the figure is above average at 120% of GDP.
2 In 2017, Germany’s GDP was 3,277 billion euros, only 9% smaller than the combined GDP of the GIIPS, which was 3,557 billion euros (Eurostat, 2018).
3 The ‘no-bailout clause’ refers to article 125 of the Treaty on the Functioning of the European Union, which states that “[t]he Union shall not be liable for or assume the commitments of central governments, regional, local or other public authorities, other bodies governed by public law, or public undertakings of any Member State, without prejudice to mutual financial guarantees for the joint execution of a specific project” (European Union, 2007).