Getting the Story Right: How You Should Choose between Different Interpretations of the European Crisis (And Why You Should Care)

Abstract

The European crisis has many causes. Worse, the different causes are mutually reinforcing. National economies lost competitiveness within the single currency, governments and households lived beyond their means, banks and other financial firms moved capital across borders and then called it back home again in a fit of panic. Europe is suffering as a consequence. European policy-making is suffering as well. With so many ‘causes’, politicians are dividing their attention across different and at times competing remedies. Europe appears to be ‘muddling through’ rather than acting decisively as a result. This paper argues that European policymakers should focus their attention on financial causal mechanisms. Although there is some truth to claims about lost competitiveness and excessive borrowing, a close focus on financial markets promises to offer the greatest leverage over the largest number of national economies. A close focus on finance also offers a clear choice between competing policy agendas: Europe's politicians must choose either to accept a renationalization of finance or they must embrace reforms necessary to stabilize international financial market integration. Only once that choice is made, and the necessary policy agendas are put in place, should politicians again turn their focus to issues of second-order (if still significant) importance related to market structural reform, fiscal consolidation, or asset market regulation.

Key Words:

• Household debt
• government borrowing
• euro crisis
• sudden stops
• financial markets

Acknowledgement

The author would like to thanks Francisco Torres, Kalypso Nicolaidis, Daniel Ottolenghi, Biswajit Banerjee, and Boštjan Jazbec for their very generous support and comments related to earlier drafts of this paper.

Disclosure statement

No potential conflict of interest was reported by the author.

Notes

1. The point I am making here connects to a large literature on the role of ideas in policy-making and during the current crisis in particular. In the interests of space, we pick up those connections in the introduction to this collection rather than developing them in this contribution.

2. My interpretation hews closest to De Grauwe and Ji in this collection; see Vines for a contrasting view.

3. Begg et al., in this volume focus on these longer-term considerations. They also make the important point that any reforms introduced during moments of crisis should take longer-term impacts into account.

4. Again, see Vines in this collection for a contrasting view.

5. Unless noted otherwise, references to comparative data are drawn from the Annnual Macroeconomic Database (AMECO) of the European Commission, which is available on-line at http://ec.europa.eu/economy_finance/db_indicators/ameco/index_en.htm. The data code for debt to GDP ratios is UDGGL. In 2007, Portugal’s debt to GDP ratio was 68.4 per cent, France’s was 64.2 per cent, and Germany’s was 63.5 per cent.

6. This data is taken from the OECD and is available on-line at http://www.oecd.org/std/fin-stats/. The trend analysis refers primarily to Italy; the data for Greece is a point level for 2007.

7. This point would be explored in greater detail below. The data for market pressure are the spread on long-term sovereign debt yields between Belgium and Germany. I have based my analysis on daily market data for bid-yields provided by IHS Global Insight. As that is a proprietary database, I do not include a URL.

8. The data for Target2 balances is available on-line at http://www.eurocrisismonitor.com/. The data for current account balances is from AMECO. The relevant code is UBCA.

9. The ratio of Italian household debt to gross disposable income was 83.3 per cent in 2010 and 82.9 per cent in 2011; the same ratio in Denmark was 300.2 in 2010 and 297.8 in 2011. Again, these data are from the OECD.

10. The AMECO code for world export market shares is AXGT and for manufacturing employment is NETM.

11. The AMECO code for relative real effective exchange rates is XUNRQ.

12. The argument here is based on an analysis of the decomposition of the relative real effective exchange rate (XUNRQ) into a relative nominal effective exchange rate (XUNNQ), a relative movement in GDP price deflators (PVGDQ), and a relative movement in real unit labor costs (QLCD). Those data lines are all reported separately in AMECO.

13. This analysis is based on analysis of Greek export composition with the rest of the EU-27 using two digit SITC codes as reported by Eurostat.

14. These data are from the AMECO database and can be made available upon request.