The European face of the economic crisis

I've written frequently (most recently last Thursday) about the state of the US economy. It's too easy for those of us on this side of the Atlantic to lose sight of the fact that in Europe, the crisis is as bad as, if not worse than, it is here.

I normally distrust Paul Krugman's economic theories, based on and informed by his radical liberal politics as they are; but his analysis of the situation in Europe is pretty accurate, IMHO.

You still hear people talking about the global economic crisis of 2008 as if it were something made in America. But Europe deserves equal billing. This was, if you like, a North Atlantic crisis, with not much to choose between the messes of the Old World and the New. We had our subprime borrowers, who either chose to take on or were misled into taking on mortgages too big for their incomes; they had their peripheral economies, which similarly borrowed much more than they could really afford to pay back. In both cases, real estate bubbles temporarily masked the underlying unsustainability of the borrowing: as long as housing prices kept rising, borrowers could always pay back previous loans with more money borrowed against their properties. Sooner or later, however, the music would stop. Both sides of the Atlantic were accidents waiting to happen.

In Europe, the first round of damage came from the collapse of those real estate bubbles, which devastated employment in the peripheral economies. In 2007, construction accounted for 13 percent of total employment in both Spain and Ireland, more than twice as much as in the United States. So when the building booms came to a screeching halt, employment crashed. Overall employment fell 10 percent in Spain and 14 percent in Ireland; the Irish situation would be the equivalent of losing almost 20 million jobs here.

But that was only the beginning. In late 2009, as much of the world was emerging from financial crisis, the European crisis entered a new phase. First Greece, then Ireland, then Spain and Portugal suffered drastic losses in investor confidence and hence a significant rise in borrowing costs. Why?

In Greece the story is straightforward: the government behaved irresponsibly, lied about it and got caught. During the years of easy borrowing, Greece’s conservative government ran up a lot of debt — more than it admitted. When the government changed hands in 2009, the accounting fictions came to light; suddenly it was revealed that Greece had both a much bigger deficit and substantially more debt than anyone had realized. Investors, understandably, took flight.

But Greece is actually an unrepresentative case. Just a few years ago Spain, by far the largest of the crisis economies, was a model European citizen, with a balanced budget and public debt only about half as large, as a percentage of G.D.P., as that of Germany. The same was true for Ireland. So what went wrong?

First, there was a large direct fiscal hit from the slump. Revenue plunged in both Spain and Ireland, in part because tax receipts depended heavily on real estate transactions. Meanwhile, as unemployment soared, so did the cost of unemployment benefits — remember, these are European welfare states, which have much more extensive programs to shield their citizens from misfortune than we do. As a result, both Spain and Ireland went from budget surpluses on the eve of the crisis to huge budget deficits by 2009.

Then there were the costs of financial clean-up. These have been especially crippling in Ireland, where banks ran wild in the boom years (and were allowed to do so thanks to close personal and financial ties with government officials). When the bubble burst, the solvency of Irish banks was immediately suspect. In an attempt to avert a massive run on the financial system, Ireland’s government guaranteed all bank debts — saddling the government itself with those debts, bringing its own solvency into question. Big Spanish banks were well regulated by comparison, but there was and is a great deal of nervousness about the status of smaller savings banks and concern about how much the Spanish government will have to spend to keep these banks from collapsing.

All of this helps explain why lenders have lost faith in peripheral European economies. Still, there are other nations — in particular, both the United States and Britain — that have been running deficits that, as a percentage of G.D.P., are comparable to the deficits in Spain and Ireland. Yet they haven’t suffered a comparable loss of lender confidence. What is different about the euro countries?

One possible answer is “nothing”: maybe one of these days we’ll wake up and find that the markets are shunning America, just as they’re shunning Greece. But the real answer is probably more systemic: it’s the euro itself that makes Spain and Ireland so vulnerable. For membership in the euro means that these countries have to deflate their way back to competitiveness, with all the pain that implies.

The trouble with deflation isn’t just the coordination problem Milton Friedman highlighted, in which it’s hard to get wages and prices down when everyone wants someone else to move first. Even when countries successfully drive down wages, which is now happening in all the euro-crisis countries, they run into another problem: incomes are falling, but debt is not.

As the American economist Irving Fisher pointed out almost 80 years ago, the collision between deflating incomes and unchanged debt can greatly worsen economic downturns. Suppose the economy slumps, for whatever reason: spending falls and so do prices and wages. But debts do not, so debtors have to meet the same obligations with a smaller income; to do this, they have to cut spending even more, further depressing the economy. The way to avoid this vicious circle, Fisher said, was monetary expansion that heads off deflation. And in America and Britain, the Federal Reserve and the Bank of England, respectively, are trying to do just that. But Greece, Spain and Ireland don’t have that option — they don’t even have their own monies, and in any case they need deflation to get their costs in line.

And so there’s a crisis.

There's much more at the link. Interesting, informative and recommended reading.

I'm no fan of the (sometimes appalling) liberal bias of the New York Times, but I must say I'm grateful to them for publishing this level of economic history and analysis. Even if I don't always agree with the perspectives of their authors, they make a valuable contribution to the ongoing debate, and provide information that many other outlets simply don't bother to publish. That sort of in-depth coverage is indispensable if we're to make informed decisions about our own economic prospects.

Peter