Images of unemployed Greek youths throwing metal barricades through plate-glass windows; photos of Irish citizens lining up to withdraw their life savings from banks in Dublin; the fall of a government in Portugal; massive rallies of unemployed youth in Madrid… The Euro PIIGS[1] are on the run. There is a human reality behind the dry numbers of Europe’s debt crisis.
The warning signs of the Eurozone crisis started when yields on Greek bonds began to rise (i.e. the price of the bonds began to fall) in the fall of 2009, as the markets began to have doubts about the capacity of the Greek government to repay the country’s mounting public debt. And no wonder — Government debt in Greece stands at 127% of GDP. The new Socialist government elected in October 2009, revised the budget deficit up from the previous government’s estimates of “6 to 8%” to a more realistic 12.7% — later again revised up to 15.4%. The rise in bond yields led to increased borrowing costs for the government, which had to request a bailout from the EU and from the International Monetary Fund.
The government eventually proposed a series of
austerity measures as part of the bailout, which then led to a €110 billion EU/IMF package backed by Germany. After more than a decade of easy government money the party was over, and Greeks — who have much lower labor productivity than the Germans — could no longer afford to live like them. It’s an open secret that
tax avoidance in Greece has been rife and public procurement has involved kickbacks to decision-makers; but the Greek man and woman in the street has also benefited through excessively generous state-funded retirement and unemployment benefits. If Bunga-Bunga is frivolous partying on the public dime, then the Greeks have been at it since their entry into the Euro.
austerity measures as part of the bailout, which then led to a €110 billion EU/IMF package backed by Germany. After more than a decade of easy government money the party was over, and Greeks — who have much lower labor productivity than the Germans — could no longer afford to live like them. It’s an open secret that
tax avoidance in Greece has been rife and public procurement has involved kickbacks to decision-makers; but the Greek man and woman in the street has also benefited through excessively generous state-funded retirement and unemployment benefits. If Bunga-Bunga is frivolous partying on the public dime, then the Greeks have been at it since their entry into the Euro.
Ireland, being Ireland, was a different kettle of fish altogether. Macro-economic management had been quite responsible, with a reasonable level of public debt and manageable budget deficits. The Irish economy had expanded rapidly during the Celtic Tiger decade (1997–2007) due in part to a low corporate tax rate, and a well educated, relatively low-cost labor force. But low Eurozone interest rates and inadequate banking regulation led to an expansion of credit and an Irish property bubble. Irish banks, already over-exposed to the Irish property market, came under severe pressure in September 2008 due to the global financial crisis of 2007–2010. Ireland’s biggest commercial bank, Anglo Irish Bank Corporation, was heavily exposed to property lending and the downturn effectively led to its insolvency. The Irish government was forced to inject €1.5 billion for a 75% stake in December 2008, nationalizing the bank; an injection of a further €4 billion in capital was needed in September 2009; and €8.3 billion again in March 2010. The Minister of Finance has noted that a further €10 billion may be required to cover future losses.
This transfer of private debt to the public sector had a very deleterious effect on Ireland’s own sovereign creditworthiness, which led to rising bond yields and a bailout from the EU/IMF in November 2010. The profligate banking sector had blown the country’s economy despite the government’s responsible macro management; so it seems that banking regulation counts, after all. This time, unlike Greece, it wasn’t the public sector doing bunga-bunga but the banks, who thought the partying would never stop. The Irish government collapsed in early 2011 and was replaced by a coalition government composed of Fine Gael and Labor.
Portugal’s plight was more in line with the Greek situation than that of Ireland. Rising labor costs under the Eurozone regime and a correspondingly strong decline in labor productivity led to declining competitiveness, a unsustainable budget deficit, and a public debt burden equal to 90% of the country’s GDP. The markets recognized the unsustainable path the country was on by increasingly high cost of borrowing. In Late March 2011 the government tried to get things back on track with a new budget that included spending cuts and tax rises, but the government lost the vote and the Prime Minister said he would no longer be able to run the country.
The EU, with now an increasing body of experience on how to proceed and a newly approved European bailout fund (aka “European Stability Mechanism”) bolstered in late March to be able to guarantee up to €500 billion, is (along with the IMF) negotiating a bailout for the country at this very moment. It seemed so nice to be able to have Northern Europe (i.e. German) interest rates and Southern Europe lifestyle and labor productivity, but you can’t make something out of nothing. That’s bunga-bunga economics.
In the meantime, everyone is wondering who’s next. Who knows? Certainly Spain looks the most vulnerable of the remaining peripheral European countries. Official statements are that it’s in a much better position; that the loan portfolios of the Cajas (regional cooperative banks) are not in as bad a position as they seem; that macro management is doing just fine, thank you. But in the meantime the country has a huge stock of unsold housing from its own real estate bubble; the construction sector is stricken; and unemployment, which at end-2010 stood at over 20% (and in February 2011 at 43.5% for people 25 and under) is socially explosive. This sounds like a recipe to short Spain.
So, what does this mean for the emerging economies? Well, good news, mostly – markets have at last realized that an emerging Brazil or Malaysia are no less risky than the peripheral economies of Southern Europe, and in addition have far stronger growth prospects. Now investors have woken up to the fact that these economies have young populations, upward mobility and consumption patterns to match -- all the things that Europe has lost.
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Any lessons? Well yes, of course. Basic undergraduate macro-economics counts — economic laws can no more be wished away than the laws of physics. First of all, countries cannot sustain a standard of living for their populations (in the form of generous retirement benefits, a large public sector, and major tax-funded public works) that is not aligned with the country’s labor productivity and tax base. Europe has a declining population of active workers who must support an increasing number of retirees; it has (for the most part) rigid labor laws and other regulations that keep labor productivity lower than it needs to be[2] and output below its production frontier; and it has barriers to innovation[3] compared to the United States and the emerging BRICs[4]. The second lesson: yes, financial sectors do need to be regulated. Every generation seems to have to learn this lesson all over again, ever since the financial crises of the British South Sea Company of 1720 and the Dutch Tulip Mania of 1637; we have not learned to be wiser than our elders, alas. Poor macro-economic management (especially fiscal policy and public sector financial management) and lax financial sector regulation are perhaps the most important sources of sovereign risk in middle and high income countries, and no country is immune to this rule.
But perhaps most importantly, Europe has very significant potential for growth despite its demographic challenges. It has excellent education systems, decent infrastructure, and an increasingly unified market. What Europe needs is the courage to see immigration as a solution to its demographic situation rather than a threat; the courage to undertake an overhaul of the labor markets that discriminate so much against the young; and the courage to move, within the Eurozone, to better coordination of fiscal policy to reduce the incentive for governments with lower productivity labor forces to get a “free ride” on those with higher productivity labor and more responsible fiscal management. In sum, European leaders must learn to lead, and not to do bunga-bunga.
[1] Portugal, Ireland, Italy, Greece, Spain.
[2] In terms of annual value-added per employable worker. Of course, it is often said that European labor productivity is higher than that of the US (the “McJobs argument), but this is not true on a yearly basis, particularly once productivity is calculated based on the entire labor force. With high unemployment and low working hours, hourly productivity could well be high while GDP remains depressed.
[3] See http://ideas.repec.org/a/wsi/ijimxx/v11y2007i02p279-297.html. This is pehaps due to the fragmented European system of national patents and to fewer resources devoted to university research.
[4] Brazil, Russia, India, China — shorthand for the emerging middle income economies of the G20.
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