Drawing all the wrong lessons from the Euro crisis
Plenty has been written on this by smarter people than me – but since the troubles of Greece (and now increasingly Italy) are routinely invoked by those arguing that the U.S. needs to move to rapid deficit-reduction, it can’t hurt to emphasize the salient points again.
The cautionary tale one should take from the Eurozone crisis is not the dangers of large deficits. Yes, Greece and Italy do have large public debts – but nowhere near as large as Japan. Yet nobody is talking about a yen crisis. And Spain – often fingered as a likely candidate for a run by the bond-market vigilantes – has a public debt about half as large as that of the UK. And nobody is talking about a pound crisis.
Instead, the cautionary tale one should take from the Eurozone is that the tools of macroeconomic stabilization – fiscal, monetary, and exchange rate policies – need to be taken much more seriously than they have been for decades. Since 1980 a consensus (obviously wrong in retrospect – and not adhered to in real-time by plenty of admirable skeptics) developed among macroeconomic policymakers that fiscal policy should simply aim for balanced budgets (or even surpluses) and should not be used discretionarily to fight recessions; that monetary policy should simply target very low rates of inflation; and that capital markets (including international capital markets) should be left to govern themselves and capital should flow freely across international borders. The underpinning of this consensus was the belief that capitalist economies could and would generally heal themselves quite quickly following recessions, so macroeconomic stabilization policy (the tools used to fight recessions) were mostly unnecessary and would often just impede, not aid, speedy recoveries.
This flawed consensus informed the adoption of the Euro – countries surrendered independent monetary and exchange rate policies because they were sure they weren’t really all that important.
By adopting the Euro and entering a monetary union, member countries lost the ability to print their own currency and to regulate capital flows. So, when borrowing on international markets, they were now borrowing in a currency that they no longer had the capacity to print themselves. This inability to run the printing presses to pay off debt means that they can be forced into default if financial markets players ever decide to stop lending them money on reasonable terms.
Further, the common currency means that important stabilizing forces that kick in when financial markets stop demanding a country’s assets – increased exports and reduced debt obligations driven by the now-weaker national currency – are not operating for individual members of the Euro zone. This exchange rate channel is hugely important for countries trying to recover from financial crises – as the experience of Argentina and Iceland have shown. Further, this abandonment of monetary and exchange-rate policies was not accompanied by a beefing-up of a continent-wide fiscal policy that could be used to buffer downturns. Michigan or Nevada, for example, do not have their own monetary or exchange-rate policies, but they do get lots of federal transfers (like unemployment insurance) when their economies do more poorly than the national average.
To put this simply – the Eurozone was essentially a ship constructed for the fairest weather possible – a world without recessions. Now that the weather has turned foul, the consequences of not taking macroeconomics seriously is coming clear.
Worse, the too-limited scope that Eurozone countries have for macroeconomic policy stabilization resides solely in the actions of the European Central Bank (ECB) – which is barely even trying to mute the broader economic crisis. As John Quiggin notes, the ECB has actually raised rates within the past year – raising interest rates in the midst of the worst economic downturn in a generation! Recently, the new ECB head has cut these rates – but they remain a full percentage point higher than those in the United States or Japan.
So, what do we really have to learn from the Euro crisis? That the tools of macroeconomic management matter a lot – and they should not be given up casually. Failing to heed this lesson is already hurting the U.S. economy.