4. Build-up to a crisis
IF THERE IS AN ORIGINAL SIN in the creation of the euro, it is, for many in Berlin and Brussels, the breach of the stability and growth pact in 2003. Germany and France colluded to block any official rebuke or sanctions for letting their budget deficits rise above the Maastricht ceiling of 3% of GDP. After a battle with the European Commission that ended up at the European Court of Justice, they negotiated a looser version of the pact in 2005 that, to critics, rendered it toothless. From then on, so the story goes, all semblance of fiscal discipline was abandoned. Today’s German ministers castigate their predecessors for leading the euro zone into sin rather than virtue. Yet this account offers at best only a partial explanation of what went wrong.
It is true that countries that tightened their belts to qualify for membership of the single currency relaxed their reforming effort after it started life in 1999. Many felt that it was enough to have proved wrong the doom-mongers in the UK and the United States who had predicted either that the euro would never arrive or that it would quickly break up (at one point in 1999, when it fell in value, it was christened a “toilet currency” by traders in London; others referred to the euro as the “zero”). Moreover, as Europe then entered a mild recession in 2001–02 there were others, beyond France and Germany that were in excessive deficit. In purely economic terms, though, the original stability pact was too rigid, pushing countries into procyclical austerity whenever they found themselves in a downturn. The reformed version made greater allowances for the impact of the economic cycle, and tried to strip out one-off measures through which countries sought to game the numbers.
Most euro-zone countries remained within the limits and, in subsequent years, the number of sinners gradually declined. The real failing of the pact was that an obsession with budgets, especially the annual deficits, blinded ministers and officials to more serious underlying problems in the euro zone. “The whole system was looking at the economy through the keyhole of fiscal policy,” says one Commission veteran. By 2007 the fiscal situation had seemingly never been better. All members of the euro zone were out of the excessive deficit procedure (EDP) by mid-2008, and so formally deemed to have their public finances in order though the credit crunch was intensifying. The Commission boasted that reform of the pact had promoted discipline and national “ownership”. Even Greece was released from the EDP in 2007, despite persistent doubts about the reliability of its figures. But, rather as with the enforcement of the pact, governments would not hear of the Commission being given the power to audit their national figures.
It is significant that, on the eve of the crisis, three of the five countries that would later have to be bailed out – Ireland, Spain and Cyprus – were virtuous by the standards of the stability and growth pact. They were running budget surpluses and had a stock of debt well below the Maastricht ceiling of 60% of GDP. Their problem was not a matter of poor enforcement, or of fabricated statistics, but of a misguided belief that controlling fiscal policy was all that really mattered. The crisis revealed the much greater importance of several other factors: economic imbalances, particularly in the current account of the balance of payments; private debt; and the role of the financial sector in financing external deficits.
The focus on fiscal rules had been justified by two beliefs. The first was that, in a single currency with a common exchange rate and monetary policy, fiscal sinners were less likely to be punished by markets that might otherwise speculate against a country in danger of running into problems of high inflation or debt. Profligacy in one country could thus drive up borrowing costs for all. The second, conversely, was that a euro-zone country that got into trouble would not be able to devalue or loosen monetary policy, and would not enjoy the sorts of automatic transfers that operate in federal countries, so the main tool to absorb a shock would be greater borrowing by the government: hence the need for sound public finances.
In countries with their own currencies, markets and policymakers closely watch the current account for signs of an economy getting out of line. The current-account balance is a measure of the balance of trade, foreign income and transfers. A deficit can be a problem if, say, it highlights a country’s loss of competitiveness and export share; or it can be benign, if it reflects greater returns on capital flowing into a country undergoing a period of fast catch-up growth. Current-account deficits must by definition be financed by capital inflows. Yet there was a widespread belief, echoed on occasion by the Commission and the ECB, that, in a single-currency zone with an integrated financial market, current-account imbalances did not matter any more than they did within federal countries like the United States.
In the early 2000s, years that became known as the “great moderation”, when money was cheap, euro-zone countries were able to build up large external imbalances (15% of GDP in Greece). Had they still had national currencies, this would surely have provoked a response from markets. Instead, everybody benefited from low interest rates. Thus was born the great paradox of economic and monetary union. In order for countries to survive within it, they needed to make deeper structural reforms to improve their competitiveness; and yet the pressure to push through those reforms was reduced by the benign mood of financial markets. Many had hoped the creation of the euro would force ossified countries like Italy to change their ways. Losing the ability to devalue meant that competitiveness could be recovered only by “internal devaluation” (that is, bringing down wages and prices relative to others), boosting productivity, or both. This meant liberalising labour and product markets, and promoting competition. But for countries used to high inflation and high interest rates before the launch of the euro, any loss of competitiveness could be masked for a long time by cheaper money.
By about 2005 it was apparent that national economies, far from converging as they had been expected to do, were pulling apart. The differences were no greater than the dispersion in growth rates in American states, but they were worryingly persistent. Some were growing fast with high inflation, among them Ireland, Greece and Spain. All were enjoying a boom fuelled by low interest rates. At the other end of the spectrum, mighty Germany was growing anaemically, but with very low inflation. To some extent the ECB’s one-size-fits-all interest rate exacerbated this polarisation: interest rates were too low for overheating countries, but too high for Germany (the situation is reversed today). The two oddities were Italy and Portugal, which seemed to be suffering the worst of both worlds with, simultaneously, slow growth and higher-than-average inflation.
There were, indeed, marked differences among both the hares and the tortoises. Among the fastgrowing countries, Greece had a government that was spending recklessly and fiddling statistics, whereas Spain and Ireland had public finances seemingly in good order, but private sectors that were running up high debt as a side-effect of housing booms. Too few questioned whether buoyant tax revenues might not just be a windfall from a property bubble. When it burst, they would collapse and spending would shoot up to pay for unemployed construction workers. Ireland’s net exports were booming even as it was overheating, but Spain’s were shrinking. Over two decades, Ireland had gone from being the poorest EU country to being one of the richest. But while the Celtic Tiger put on real muscle in the early years, boosting productivity by turning itself into an export base for multinationals, later it just gorged itself on cheap credit.
Among the laggards, Germany’s sickliness masked a process of protracted reform, especially Gerhard Schröder’s Agenda 2010 labour-market and welfare changes, pushed through after 2003. Germany was still digesting the cost of absorbing the former East Germany, and had entered the euro with an overvalued currency. But in a country accustomed to living with a hard currency and low inflation, and relatively consensual industrial relations, German bosses and workers set off on the long slog of wage restraint to regain competitiveness. Internal demand was so weak that almost all Germany’s growth came from increasing exports. But in Italy and Portugal slow growth was an unmistakable signal of reform paralysis. Both were losing export share. Higher inflation was pushing up wages, while productivity was stagnant. Italy had higher debt than Portugal, but Portugal was running higher budget deficits.
One cause of the problem was that southern European countries were hit harder than northern ones by China’s entry into the World Trade Organisation at the end of 2001. China’s exports of textiles, clothing and footwear grew sharply; those of Italy and Portugal declined markedly. Another issue was that foreign direct investment had shifted from the Mediterranean countries to the new countries from central and eastern Europe which joined the EU in 2004. There cheap skilled labour was plentiful.
Germany made full use of the opportunity by shifting factory production eastward. But France, among others, resisted. Rather it regarded low-cost, low-tax eastern Europe resentfully as a source of competition and “social dumping”. According to the World Bank, which in 2012 produced a detailed report on Europe’s economic model,1 another drawback in southern Europe was that many of its small family-run businesses were unsuited to competing in a big European market.
The striking north-south divide that has emerged in Europe may have even more profound historical and sociological roots. Many cite Max Weber’s Protestant work ethic. Others speak of Catholics’ greater readiness to absolve sins. When giving lectures, Vítor Constâncio, vice-president of the ECB and a former economics professor from Portugal, would sometimes hold up a colour-coded map of Europe and ask audiences what the darker colours in the north and lighter shades in the south might represent. The usual reply was GDP per head. In fact, they denoted literacy rates in the 19th century, with bible-reading northern Protestants more literate than the priest-dominated southern Catholics. Plainly debt and deficits are not the only or even the best measure of economic health. The trend in unit labour costs (flat in Germany but rising fast in the periphery) and current-account balances (surpluses in Germany and deficits in the periphery) is crucial.
Some of the euro zone’s problems might have been alleviated by reforms, both national and European, to make wages and prices more responsive. But along with reform fatigue in member countries, there was also integration fatigue across the EU. Deepening the single market might have provided a source of growth and competitive impulse. Much of the EU’s productivity lag, in comparison with the United States, is due to underperforming services. But the EU’s services directive, designed to break down some of the barriers, was watered down after the defeat of the constitutional treaty in referendums in France and the Netherlands in 2005. One reason was the panic in France over the supposed threat of the “Polish plumber”. Soon afterwards Roberto Maroni, an Italian minister from the Northern League, caused a stir by excoriating the euro for Italy’s poor performance and calling for a return to the lira.
Slow growth, economic divergence and political tension led some economists to start asking as early as 2006 whether the euro might break apart. Daniel Gros of the Centre for European Policy Studies, a think-tank in Brussels, thought that sluggish Germany and roaring Spain would soon swap places (he also worried about Italy).2 Simon Tilford of the Centre for European Reform in London painted a scenario in which markets might lose confidence in Italy, with its slow growth and reluctance to reform, pushing up its borrowing costs and debt, in turn prompting demands that Italy leave the euro.3
Banking on the euro
The launch of the euro greatly increased financial integration. Often banks grew large in comparison to their home countries’ GDP, and in comparison to banks in the United States, in part because European firms relied more heavily on bank loans than on the corporate-bond market. But it was a lopsided sort of integration. Cross-border lending to banks and sovereigns grew fast, but retail lending remained Balkanised in national markets. Cross-border ownership of banks grew only slowly. Mergers and acquisitions tended to happen within a country’s borders, a sign of strong economic nationalism in the banking sector.
Cross-border ownership was most apparent in the EU’s new members from central and eastern Europe. Among members of “old” Europe it remained for the most part tiny. But by late 2007, partly as a result of the Commission’s efforts to chip away at internal barriers, there was enough crossborder expansion to prompt at least one economist, Nicolas Véron, to publish a paper for the Bruegel think-tank in Brussels titled: Is Europe Ready for a Major Banking Crisis?4 He noted that banks had become too large and diversified for national supervisors, even if they met in the then Committee of European Banking Supervisors (CEBS), to oversee properly. He said:
The prudential framework for pan-European banks has become a maze of national authorities (51 are members of CEBS alone), EU-level committees (no fewer than nine) and bilateral arrangements (some 80 recently mentioned by European Commissioner Charlie McCreevy).
In an early hint at the future “banking union” that would emerge five years later, Véron argued that the largest cross-border banks (including British ones, given London’s large financial centre) should be supervised by an EU-level body, with a single set of rules to deal with failing banks and a harmonized deposit-insurance system.
Financial integration, it was widely hoped, would stimulate a more efficient allocation of capital across the EU. And in the euro zone, it was supposed to provide a means of absorbing country-specific shocks given the lack of adjustment tools. But when crisis struck, financial integration provided an open channel for financial contagion to spread. The fact that banks were large, and that their bond holdings were strongly biased in favour of their own sovereign’s debt, helped create a deadly feedback loop between weak sovereigns and weak banks. And because most of the banks’ cross-border assets were in the form of lending, rather than equity, the international flows that had financed euro-zone imbalances could more easily be cut off when credit became scarce.
Most or all of these problems were reasonably well understood and, indeed, predicted before the launch of the euro. In the Commission’s book on the euro, EMU@10,5 published in 2008 just ahead of the tenth anniversary of the start of the monetary union, there is mention of worries about imbalances, the divergence of economies and the dangers lurking in the banking system. But nowhere in its 320 turgid pages did it issue a clear warning, of the sort that some independent economists were voicing, about the risks of a self-fulfilling market panic, or of a destructive doom-loop between banks and sovereigns, or of large contingent liabilities in banks ending up on the books of already overindebted sovereigns. The clearest message was one of self-congratulation over the “resounding success” of the euro. It had boosted economic stability, cross-border trade, financial integration and investment, declared the authors. Traumatic exchange-rate crises were a thing of the past, and fiscal stability had been enhanced. Indeed, the euro had become “a pole of stability for Europe and the world economy”.
The euro having survived a decade, and regained its strength against the dollar, it was perhaps natural for European officials to boast of its achievements and dismiss the doomsayers, particularly those from the English-speaking world.
A much deeper mystery is the complacency of financial markets. They utterly failed to distinguish between the dodgy credit of Greece and the rock-solid dependability of Germany. The yield on government bonds (which moves inversely to price) fell in peripheral countries in the early years of the euro so that it became almost identical across the euro zone. Italy sometimes had to pay six percentage points more than Germany in interest to borrow money in the 1990s. By 2007, this “spread” had fallen to a fraction of a percentage point (about 20 basis points). Getting markets to impose discipline on governments had been one reason for enshrining the no-bail-out rule and forbidding the ECB from monetising government debt.
Perhaps investors were simply chasing anything that offered a marginally better yield. Markets often overshoot in both directions, after all. Some were still convinced the euro would lead to convergence among European economies. Others assumed that default within the euro zone was unthinkable: whatever the treaties said, solidarity among members would prevail, one way or another.
In his 1989 report on setting up a single currency, Jacques Delors himself had argued that, far from penalising imbalances, financial markets might for a while finance them because of the attraction of a large pool of euro-denominated debt:6
Rather than leading to gradual adaptation of borrowing costs, market views about the creditworthiness of official borrowers tend to change abruptly and result in the closure of access to market financing.
Before EMU yields were spread far apart, reflecting the market’s perception of each country’s risk of inflation, devaluation and default. They then narrowed as the launch of EMU approached before becoming closely entwined through the first decade of the euro. Then, with the onset of the euro crisis in late 2008, they spread out once more as markets suddenly started to worry about the risk of default. Greece and Ireland were to be the first strands to come loose.