The Eurozone Crisis – Policy Dilemmas

“The ideas of economists and political philosophers, both when they are right and when they are wrong, are more powerful than is commonly understood. Indeed the world is ruled by little else. Practical men, who believe themselves to be quite exempt from any intellectual influence, are usually the slave s of some defunct economist.” - John Maynard Keynes

By: Mariam Tabatadze Advisor: Purba Mukerji December 17, 2012

Abstract: The causes of the Eurozone crisis can be traced both long-term, in the types of institutions and economic targets that were created as bases for the monetary union and shortterm, starting with Greece’s admittance of an extremely high debt. There are various factors discussed in this paper, which are thought to have created the crisis and economists from different schools of thought assign relative importance to each factor according to their beliefs. Similarly, decision-makers attempting to implement best possible policies to combat the current social and economic issues, arrive at conclusions based on their ideological frameworks. Arguably, European leaders responded to the Eurozone crisis in a delayed, fragmented and inefficient manner due to their political, cultural and ideological differences. This paper attempts to examine various economic schools of thought and demonstrate how they inform the policy choices of modern European decision-makers in their considerations of implementing the best possible strategies to combat the economic crisis in the Eurozone area.


Introduction In order to understand the causes of the Eurozone crisis and the policy responses of the European leaders, one must look at European political and economic history, as well as, different economic schools of thought and their impact on modern decision-makers. The creation of the European Union and the Euro was a response to the region’s violent past (EU, 2012), where wars were common and often brutal – these hostile relationships culminated in World War I and World War II. Political and economic integration may be an effective tool to reduce and prevent conflict (UNECE, 2012) and the European Union is considered successful in this sense – since 1945, the region has experienced a period of reconciliation and peacefulness (Brumfield and Sterling, 2012). However, the creation of the Monetary Union and the Euro to increase economic integration has proven to be more problematic. The Eurozone crisis has exposed flaws in economic convergence, as well as, the effectiveness of existing economic institutions, such as, the European Central Bank and political institutions, for example the European Council. This paper examines the Eurozone crisis and how its current issues are a reflection of a longstanding economic debate on the degree and nature of the government involvement in the economy. There are various policy recommendations from different economic schools of thought on dealing with an economic crisis. Great economic thinkers (such as, Adam Smith and John Maynard Keynes to name a few), as well as, lessons from economic history, impact the decisions of modern leaders in their considerations of implementing a policy during a debt crisis. While the conservative, otherwise called “orthodox” or “neo-classical” economists generally recommend smaller government involvement in the economy to promote the private sector and market forces; the “heterodox” or “post-Keynesian” economists advocate for a greater government involvement in an attempt to stabilize the economy, when the private sector fails.


In section one, there is an overview of the history of the creation of the Monetary Union and consequently, the Eurozone. It discusses the various stages, treaties and economic tools, which were used in an attempt to create an integrated, coherent economic system. Section two is a brief overview of the causes of the Eurozone crisis, presented by economists from the two different camps identified above. Section three describes the fragmented and delayed response from European leaders, while also attempting to explain how ideological differences contributed to the disagreement between France and Germany. In section four, there is a historical overview of various perspectives surrounding public debt and the role of the government involvement in an economy. Section five and six focus on the topic of austerity, the former attempts to put it in a historical context and the latter examines its controversial implementation in Greece. The last two sections, seven and eight, discuss lessons from economic history in terms of successful applications of austerity measures and alternatives to austerity in the Eurozone crisis. The last section, attempts to summarize and bring the main arguments together, in order to provide conclusions of the research. 1. The Creation of the Monetary Union and the Eurozone On January 1, 1999, 11 member countries of the European Union adopted a common currency – the Euro. After an additional six countries joined, the EMU (economic and monetary union) united 300 million consumers. In order to create the Euro, exchange rates between European countries had to be fixed. However, in comparison to other fixed exchange rate examples, the countries involved had to give up more of their sovereignty, in terms of monetary policy, and hand it over to the European System of Central Banks (ESCB). There are mainly two reasons why the European Union decided to have a currency union:


1. To strengthen the role of Europe in the monetary system of the world; prior to the Euro, there was no other currency, which contested the influence and credibility of the dollar – one of the main functions of the Euro is to compete against the dollar. 2. To unify the European market; the model of the Euro was based on the United States. The customs union did not prove to be a sufficient measure to eliminate barriers to trade, hence, the EU decided to take a more drastic measure. Additionally, the assumption that more trade would lead to more economic dependency and less political tension was driving the decision, as well. The conversion to a new currency happened gradually; the process first began in the March of 1979, with the creation of the European Monetary System (EMS). The original participants included France, Germany, Italy, Belgium, Denmark, Iceland, Luxembourg and the Netherlands. The first currency crisis happened in 1992, when the EMS had expanded to include Spain and Portugal. It was a foreshadowing of the future, showing that the diverging inflation rates in Germany (2.7%) and Italy (12.1%) would be hard to tackle with a single monetary policy. In order to reduce the frequency of such crises, the EU created some “safety valves”: 1. Exchange rates could fluctuate up and down 2.25 % relative to their assigned value. Some countries succeeded in increasing the number to 6% and finally, the EMS decided to increase it to 15 %. 2. Additionally, in order to avoid attacks from speculators, capital controls were implemented. They were temporary and gradually removed, since the goal of the monetary union was to increase the ease of mobility and business transactions.


In 1989, Jacques Delors recommended a three-stage transition period to the economic and monetary union (EMU). Two years later, in 1991 the Treaty of Rome was agreed upon in the Dutch city of Maastricht; the Maastricht Treaty, which is a part of the Treaty of Rome, called for a single currency by the beginning of 1999. Another two years after the Treaty of Rome was drafted, in 1993, all of the twelve initial countries had ratified these treaties; the countries which joined later, had to agree to it, in order to become members. The three phases as taken from the ECB website were:  Stage 1 – 1 July 1990     Complete freedom for capital transactions Increased co-operation between central banks Free use of ECU (forerunner of the euro) Improvement of economic convergence

 Stage 2 - 1 January 1994      Establishment of European Monetary Institute (EMI) Ban on granting of central bank credit to the public sector Increased co-ordination of monetary policies Strengthening of economic convergence Process leading to the independence of the national central banks, to be completed at the latest by the date of the establishment of the European System of Central Banks  Stage 3 – 1 January 1999   Irrevocable fixing of conversion rates Introduction of the euro


Conduct of the single monetary policy by the European System of Central Banks

 

Entry into effect of the intra-EU exchange rate mechanism (ERM II) Entry into force of the Stability and Growth Pact

The main macroeconomic criteria in the Maastricht Treaty are: 1. The country’s inflation rate in the year before admission must be no more than 1.5 percent above the average rate of the three EU member states with the lowest inflation. 2. The country must have maintained a stable exchange rate within the ERM without devaluing on its own initiative. 3. The country must have a public sector deficit no higher than 3 percent of its GDP (except in exceptional and temporary circumstances). 4. The country must have a public debt, that is below or approaching a reference level of 60 percent of its GDP. Additionally, the Stability and Growth Pact negotiated in 1997 calls for further fiscal discipline; the goal of the SGP, is for countries to either balance or run on a surplus in the medium term. The economic benefit of a monetary union is the simplifying economic calculations and, providing a more predictable basis for decisions regarding international transactions. The tradeoff, however, is the loss of monetary sovereignty. This process can be illustrated by the optimum currency area theory, which describes the monetary efficiency gain and economic stability loss. Optimum currency areas are “groups of regions with economies closely linked by trade in goods and services and by factor mobility…a fixed exchange rate will best serve the economic interests


of each of its members if the degree of output and factor trade among the included economies is high” (Krugman, 2012). Despite the usefulness of the theory of Optimum Currency Area in illuminating the process of the creation of the Euro, there are several reasons why Europe may not be considered OCA. Firstly, labor mobility is limited due to certain restrictions and government regulations, cultural or linguistic barriers and the strength of the labor unions in certain countries. Labor mobility is an important indicator of economic integration of a region. Secondly, there is significant economic divergence among European countries – inflation rates are not similar, which has caused several problems, such as: 1. The real long-term interest rates in southern Europe (e.g. Portugal, Italy Spain and Greece), where the inflation is higher, fell in relation to the real interest rate in Germany throughout the mid-90s and late 2000s. 2. The real exchange rates of these countries appreciated in relation to German real exchange rates, despite the fact that the exchange rate was fixed at 1. These two processes caused: 1. A stimulation of demand, growth and more inflation, creating bubbles and excessive liquidity. 2. Expansion of current account deficits, in some cases extreme deficits, as observed in Greece. As demonstrated above in very simple explanations, there is too much heterogeneity in the European Monetary Union, for it to be considered an optimum currency area. While capital movement has been simplified through the adoption of the Euro, labor mobility has not been as

dynamic. The high unemployment rate currently seen in Europe may result in political and economic instability. Additionally, tackling divergent economies with a single monetary policy will affect countries asymmetrically and certainly disadvantage some on the expense of others. These issues are likely to cause more divergence not only economically, but also politically, as leaders of various countries quarrel over adopting policies favoring their position. 2. Overview of the Causes of the Debt Crisis from Various Perspectives It is evident, that the crisis started first with the realization of Greece’s troubles and then became an issue of the PIIGS altogether – Portugal, Ireland, Italy, Greece and Spain – also referred to, as “southern economies”. After they joined the economic union, “the bull-market convergence trades pushed bond yields in these countries toward the level of German bunds.” (Chang, 2010) The economically strong northern countries were running on surplus, which generated an influx of credit and capital flows to the southern countries. Some heterodox economists have pointed to these account surpluses as a major factor in the accumulation of debt in “peripheral” Eurozone countries. Foreign direct investment and bank lending from northern, “core” countries (mainly from Germany and France), was directed towards the eurozone, mostly the PIIGS countries. Especially, after the crisis of 2007-2009 broke out, in order to “play it safe” European banks decided to lend more within the Eurozone, which fueled the real estate bubbles in Spain and Greece. Additionally, one of the causes of the high fiscal deficit was decreasing public revenue. In the middle of the 2000s, taxes on higher incomes were lowered, causing the tax revenue to fall. In the latter half of the 2000s, Greece attempted to raise taxes, but failed to collect enough to alleviate the deficit issue. Similarly, Irish public revenue was decreasing in the same period,


while Spain and Portugal maintained their revenues. The global recessions of the 2007-2009 period caused aggregate demand to fall and tax revenues to fall, as well. In order to maintain the health of their economies, states started borrow from financial markets and increase their expenditure, causing the national debt to GDP ratio to rise dramatically after 2007 (Lapavitsas, 2010). The loss of competitiveness in the PIIGS countries is also one of the reasons for the economic crisis. Again, there are various perspectives provided by economists from different schools of thought, who explain the loss of competitiveness in their own frameworks. Heterodox economists claim, that the countries joined the Eurozone with a high exchange rate, in order to ensure low inflation – one of the main goals set by the ECB. Hence, the southern countries lost their ability to devalue and maintain competitiveness through monetary policy, which caused the “emergence of entrenched current account deficits for peripheral countries, matched by an equally entrenched current account surplus for Germany” (Lapavitsas 2010). However, a more conservative view, explains the loss of competitiveness by “a decade of wage growth exceeding productivity gains (which) led to real appreciation, loss of competitiveness, and large currentaccount deficits” (Roubini, 2010). It is true, that the initial compensation for workers in southern countries was much lower, than in northern countries, which prompted a high wage growth in the southern countries – in Greece, real wages grew 22% in the period between 2000-2008 and in Germany, real wages grew by 2% within the same period (Jones, 2010). Despite the efforts of the EU (e.g. the Lisbon Strategy) to create more convergence and help the southern economies in “catching up,” technological advancement has not translated in enough productivity growth (Lapavitsas, 2010).


3. The Response to the Crisis and Differences among Leadership Styles The lack of a central leadership and a fragmented, delayed response to the crisis has prompted a considerable amount of critique. While some point to the personal shortcomings of leaders, others point to cultural differences in leadership styles and understandings of the role of the government in economic processes. The two main countries managing the Greek crisis, arguably, have been Germany and France. Frank Bohn and Eelke de Jong (2010) argue that the severity of the Eurozone crisis has been caused by the lack of coordination among European leaders, due to their political, cultural and ideological differences. Some argue, that the German Chancellor Angela Merkel “dragged out the inevitable decisions,” (Bohn and Jong, 2010) while others claim, that the waiting period was necessary to show to the Greek public, the consequences of their economic choices. (Bohn and Jong, 2010) In any case, it is clear that there was a conflict between Angela Merkel and the French President at the time, Nicolas Sarkozy, on the topic of IMF involvement. While the German Chancellor favored involving the outside institution for political reasons, as an unbiased monitor, the French President preferred solving the crisis from within the EU. Greece, as shown in the timeline above, started showing signs of trouble in 2009, when the Prime Minister Papandreou admitted issues facing the Greek economy. Yet, it took until May of 2010 for Sarkozy and Merkel to resolve their differences at the EU summit. There are three main aspects, which were the causes of disagreement: 1. Perception of the role of the government in an economy 2. Leadership styles and their interaction with other leaders 3. Attitudes towards rules and power


The most important aspect for the purposes of this paper is the first one, as it relates to schools of economic thought and their differing views on the role of the government in a market economy. Hence, it is the aspect this paper will focus on. Various European countries come from very different traditions of economic thought (Bohn and Jong 2010). The UK is considered under the Anglo-Saxon view, where government intervention is only appropriate during severe market failures. In general, markets have a dominant role and the government provides appropriate regulation to ensure fair competition. France on the other hand, has a relatively more dirigistic economy, where it is more common for the government to own companies; in some cases, for example in the 80s, some French banks were nationalized. In Portugal, and other South European economies, it is common for a family or the government to own an enterprise – Greece would go under this description, as well. Germany, on the other hand is in the middle – though it is considered a social market economy, it is still reluctant towards hostile government takeovers. In essence, it is a “softer” version of a market-based economy (Anglo-Saxon). Considering these drastically different understandings of the role of the government in an economy, stemming from ideological influences of the different economic schools of thought, and the above-described divergent economies are not surprising to find. It is also not surprising that European political and economic leaders have had trouble in coming up with a “one size fits all” monetary policy to tackle the debt crisis. 4. Public Debt and the Role of the Government Public debt, in its current form, has existed for approximately three hundred years and has been mostly used to finance wars (Konzelmann, 2012). Starting in the early 18th century, various countries sought to increase their supply of raw materials through imperial expansion – these


ventures required significant funds and considering the unappealing nature of taxation, governments were forced to innovate on raising capital. For much of 18th and 19th centuries, frugality was greatly valued and an unbalanced budget was considered a destabilizing force in the economy. The debate on public spending at that time revolved around the question of how to balance a budget considering two options: taxation or borrowing. The former placed immediate burden on taxpayers and the latter postponed the burden until the interest was due, potentially to the next generation. British economists such as David Hume (1752), Adam Smith (1776) and David Ricardo were all concerned about the inevitable burden the future generations would face in an attempt to pay back loans due to excessive public borrowing. John Stuart Mill in his Principles of Political Economy (1848), justified a small amount of national debt in order to provide capital for investment to the poorer members of the society. However, he remained an advocate of free markets and agreed with the general consensus, that except for extraordinary circumstances, governments should aim for a balanced budget (Konzelmann, 2012). Before the First World War, the United States switched to the gold standard de facto in 1834 and de jure in 1900 when Congress passed the Gold Standard Act. In 1834, the United States fixed the price of gold at $20.67 per ounce and other countries joined the Gold Standard in 1870s. The Gold Standard was a way of regulating money supply in an economy – the amount of gold a country possessed was more or less stable, new production of gold would only add a fraction to the existing stock, hence, the gold standard ensured an absence of inflation and a stability of the price level. Additionally, since governments could not own negative gold, the issue of monetary and even, fiscal policy, as well as, the issue of debts and excessive government expenditures did not surface until the collapse of the Gold Standard in 1933 (Bordo, 2008).


During World War One and Industrialization, there were two major economic processes taking place: firstly, governments needed funds to finance their wars and secondly, industrialization was accompanied by massive urban poverty, which translated into social unrest and played a significant role in increasing public deficit. During the 20th century, the period of social reforms, most men gained the right to vote and advocate for their needs – these developments crystallized into origins of social programs and the strengthening of the role of the government, as a significant figure in the domestic economy. The post-war era is considered pre-Keynesian until the Great Depression. Though there were signs of what later became known as Keynesian ideas, emerging in economic thinking in 1920s, it was not until the Great Depression, that the role of the government was truly considered. American economists, such as William Foster and Waddil Catchings, were among leading preKeynesian scholars to point to counter-stabilizing mechanisms of government expenditure in relation to economic slumps by aiding the purchasing power of consumers and fueling the economy. The Great Depression was a turning point in global economic history – in addition to giving power to Keynes’ economic ideas, it signified a disappointment in laissez-faire economics and the power of monetary policy to ease crises. The period from 1933 to 1937 is an example of an effort to promote recovery through expansionary policies by the Roosevelt administration, which led to a crisis in 1937 and a short-lived reversal to austerity measures. The economy fully recovered as a result of the stimulus provided by the rearmament during the Second World War. The post-war period from the mid-forties to the sixties, was marked by effective interventionist welfare states; the “golden age” of post-war economic history.


However, as the ideological pendulum swung back once again during the time of economic distress and as a response to the first trade deficit since before the First World War, in 1971, signaled the emergence of Neo-liberal political and economic agenda with “Reaganomics” in the United States and “Thatcherism” in Europe. These tendencies were characterized by tight monetary policy to counter inflation, weakening of labor unions and labor standards, increased privatization and decreased taxation. Austerity is becoming the preferred policy in Europe, as a way of dealing with the debt crisis; the next section will discuss both the theoretical functions of austerity measures and their practical application, with the example of Greece. 5. Austerity in Economic Theory The main goals of austerity policies are to reduce the difference between the amounts of money that the government’s expenses and earnings; and restore trust in the ability of the government to pay its back its loans. There are three main economic schools of thought surrounding austerity, one can call them Ricardian, Keynesian and Neo-Classical. The Ricardian view, called the Ricardian equivalence principle is built on the notion that government spending is deferred taxation – people under this model will save in the present, in anticipation of rising taxes in the future. Thus, a stimulus during crisis would lead to a net effect of zero – consumers expect taxes to rise, as a result of the stimulus and they save more, leaving the goal of the stimulus (to boost demand) unfulfilled. Hence, the opposite is true for austerity - consumers expect a net increase in their future incomes and are more comfortable spending in the present. The assumption, that consumers live mainly in a stationary world, with forward-looking decisions, has been claimed false by left-leaning economists, who point to involuntary unemployment and the unavailability of credit in the present, as constraints to this model (Boyer 2012).


It is suitable to discuss the Neo-Classical school of thought following the Ricardian, as they share a similar set of assumptions regarding the rationality of consumers and their ability to have accurate long-term expectations. The Neo-Classical model also assumes that consumers within a market rationally plan their consumption over their lifetime. However, economists from this branch come to a different conclusion than the Ricardians – according to the Neo-Classical school of thought, while government expenditure might cause a short-term increase in consumption, it also causes lower savings in that period. Lower savings, increase interest rates and as a result, the large government spending is thought to “crowd out” private spending. On the other hand, austerity keeps the government expenditure small and leaves room for private spending, which is thought to have more expansionary effects, called either the “expansionary budget cuts” or “contractionary budget expansions” (Briotti, 2005). The Keynesian view is fundamentally different, because of its assumptions; instead of assuming rationality and far-sightedness of consumers, it assumes their tendency to consume based on their current disposable income, rather than their expectation of future income and future taxes. Therefore austerity under the Keynesian model produces a contraction of the economy with negative multiplier effects on aggregate demand. In his General Theory, Keynes proposed three hypotheses (Boyer 2012): 1. Microeconomic theory cannot be extrapolated and applied to Macroeconomic theory directly. 2. Uncertainty is an important factor within an economy. Most decisions about production and investment are combinations of individual expectations of various economic agents. 3. Effective demand, which is fueled by investment, creates more employment.


Hence if households decide to save, effective demand will decrease and the multiplier effect will cause unemployment, as well as, a drop in tax revenues, in turn causing an increase in fiscal deficit. Though this effect is thought to be short-term, expectations will adapt to the current state of the economy and suppliers will continue to produce based on their lowered expectations. Investment will also decrease due to low expectations and the growth in productivity will fall, which will cause problems in the long-run. Additionally, due to a fall in production, tax revenue will fall, causing a potential increase in the fiscal deficit (Boyer 2012). The debate on the effects of austerity has been an ongoing affair and even today, economists argue on the various outcomes tied to austerity. Some of the most prominent current economists arguing in favor of austerity policies are professors at the University of Chicago, Eugene Fama and John Cochrane. In 2009, Fama focused on the “crowding-out” effect and wrote, “bailouts and stimulus plans…absorb savings that would otherwise go to private investment…stimulus spending must be financed, which means it displaces other current uses of the same funds.” Cochrane has also argued in favor of austerity, in 2010, he wrote about the harmful effects expectations of future inflation during a crisis, trigger a “run” from the currency – a rapid selling of the currency to avoid its devaluation – causes an increase in interest rates and inflation. Hence, according to this view austerity is also a trust restoring mechanism to ease the pessimistic expectations of financial markets. However, there are also economists today, arguing against austerity. One of the most famous ones is Paul Krugman. In his opinion piece titled, “Europe’s Austerity Madness” in the New York Times (2012), Krugman describes the harsh nature of austerity in Europe, enraging workers across Greece and Spain, and causing a chaos in the streets, while reducing middle-class workers to searching for food in garbage bins. He explains that the already crippled economies, for


example, Spain after its housing crisis, were extremely vulnerable to the cuts in government spending. The unemployment rate skyrocketed as a result of austerity and left consumers without disposable income to stimulate demand through consumption (Krugman, 2012). 6. Austerity in Greece Greece has been unveiling a series of austerity measures since the crisis hit, which have been met with severe protests from the public. The first austerity measures were put in place in 2010. These measures became a necessity after Eurostat reported that the budget deficit of 2009 was 12.5% of the GDP instead of the reported 3.7% - the actual percent turned out to be more than four times the accepted rate of 3%. Greece also has a debt that amounts to 113% of the GDP, instead of the 60% accepted by the EU Guidelines. (BBC News, 2012) Later, the IMF found out that the size of the deficit was even worse than once thought – 13.6% of GDP. The austerity measures, as mentioned above have caused numerous strikes, whether from youth groups or worker’s unions and some protests have been violent, as well. Unfortunately the austerity measures have not been working the way they were envisioned to work, at least so far, and in December of 2011, Greece’s public deficit widened by 5.1%. (Irish Times, 2012) There are several reasons why austerity measures hit the Greek economy particularly harshly. Firstly, 40% of Greece’s revenue was generated by the public sector – this was one of the sources of the current problem. Austerity measures cut a significant amount of revenues, which in turn, harms the GDP. Secondly, as mentioned before, there have been massive protests – some violent ones, as well – which is negatively impacting two things: the political stability of Greece, which is important especially during a crisis and its tourism sector, which makes up 15% of its GDP (Vickery, 2012). To compensate for these shortages, Greece is attempting to generate


revenue through an increase in taxes, but the amount tax evasion and loopholes are making the tax increases ineffective. Below, is an overview of the austerity measures in Greece (Papachristou, 2012): Fiscal Adjustments Greece has to cut its budget by 1.5 percent of the GDP – 3.3 billion euros (March 2012) The breakdown of the budget cuts: o 1.1 billion euros from health o 400 million euros from public investment o 300 million euros of the defense budget o 300 million euros from the central government o 325 million euros will be miscellaneous cuts The Greek government also committed to 10 billion euros worth of austerity measures in the years of 2013-2015. Privatizations Over the medium term, the privatization target is 50 billion euros o 4.5 billion euros by the end of 2012 o 7.5 billion euros by the end of 2013 o 12.2 billion euros by the end of 2014 o 15 billion euros by the end of 2015


Labor Reform - Before any bailout funds are disbursed, Greece must pass legislation to reduce the monthly minimum wage, currently at about 750 euros gross, by 22 percent. For people below the age of 25, it will be cut by 32 percent; automatic wage increases based on seniority will be scrapped; collective wage agreements will be allowed to adapt "to changing economic conditions on a frequent and regular basis"; social security contributions are to be reduced by 5 percent. - About 15,000 state workers will be placed in a "labor reserve" in 2012, meaning they will receive 60 percent of their basic wage and dismissed after a year; one civil servant will be hired for every five retiring, with the aim of cutting the state sector workforce by about 150,000 people by 2015. Structural Adjustments Greece is required to alter its legislation to open a variety of professions for competitions such as: o Health care o Accountants o Tourist guides o Real-estate brokers Economic Targets There are specific targets relating to the deficit and budgets o 2012 – the annual growth of the general government primary deficit should be under 2.06%


o 2013 primary surplus should be 3.5 billion euros o 2014 primary surplus should be 9.5 billion euros The general government budget deficit must be reduced by 7 percentage points from 2011 in the coming three years. Recently, the Managing Director of the IMF, Christine Lagarde, spoke during a news conference at the Annual Meeting of the International Monetary Fund and the World Bank in Tokyo, and argued that Greece needed more time. She fears the political and social tensions in Greece have accumulated to a dangerous turning point and pressing harder on budget cuts may turn out to be counterproductive. However, extending the deadlines for Greece to “get its house in order” automatically expands the gap it will need to close in total. The German chancellor, Angela Merkel, who has been a central figure in the effort to pull the Eurozone out to of the crisis by austerity measures and reinstating fiscal responsibility, has not rejected the possibility of extending the timeline for further cuts. The German government has made it clear, that Greece must comply with the reform and austerity conditions agreed in its €130 billion rescue package (Peel, 2012). In addition to Merkel, there have been other European powers pressuring Greece to implement austerity policies. The “troika,” as the media refers to them, consists of representatives from the European Commission, the International Monetary Fund and the European Central Bank (Kanter and Jolly, 2012). As of October 31, 2012 the Troika wants Greece to hit a substantial structural budget surplus of 4.5% of GDP within three years. Additionally, to “unlock” a 31.5 billion euro loan, Greece has to agree to the new austerity package - raise the retirement age by two years, to 67; cut salaries and pensions, and increase taxes further. The left-wing parties in Greece, as well as labor unions, have already protested these propositions and gone on a 48-hour strike.


Meanwhile, Greece is running out of time – according to the Wall Street Journal, “Greek government coffers run dry on Nov. 16 unless the Troika releases a €31.5 billion ($41 billion) tranche of aid” (Mittich, 2012). The government deficit has gotten worse; it is now seen at 5.2% of GDP next year, against an earlier forecast of 4.2%. Additionally Greek debt is now expected to hit 190% of GDP in 2013, ten percentage points higher than previous projections. Even more worrisome, is that the goal of restoring trust through austerity programs will most likely not materialize, due to the fact that Greece has been making false promises – it was supposed to raise 50 billion euros from privatizations, but has only completed less than 2 billion asset sales in the past few years. Subject Descriptor Units National Gross domestic product, constant prices Gross domestic product, constant prices Inflation, average consumer prices in billions Percent change Percent change Percent Unemployment rate General government revenue General government total expenditure General government primary net Percent of GDP Percent of GDP Percent of GDP -4.687 144.550 -10.107 -2.194 165.412 -9.808 -1.662 170.731 -5.813 of total 12.452 39.701 50.197 17.326 40.867 49.980 23.827 43.479 50.998 currency 195,586 -3.517 4.713 182,078 -6.906 3.330 171,154 -6.000 0.938 2010 2011 2012

labor force Percent of GDP Percent of GDP

lending/borrowing General government net debt Current account balance


A brief table of data above, generated from the official website of the International Monetary Fund, shows the immediate results of the austerity programs on some key economic indicators in Greece. (IMF World Economic Outlook Database, 2012) The GDP has been shrinking, while unemployment has been increasing and the gross/net government debt as a percentage of the GDP is increasing, as well. Though inflation has been brought under control, the social cost is increasingly high – as demonstrated in the data above and in the streets of Athens. It is clear from these short-term results that austerity has not been the most effective policy choice; in fact, a negative Keynesian impact of cutting public spending is quite evident. Real incomes and living standards have been continually decreasing since 2008, decreasing tax revenues and increasing the debt/GDP ratio. The expectations of a Greek recovery are meek both domestically and internationally; this hinders Greece’s ability to attract investments and exacerbates its nee d for external funds. Since austerity measures have been worsening, the public expects an increase in the real income tax – deterring companies to hire new workers (exacerbating the issue of unemployment) and banks are not willing to lend to individuals; this is a typical pro-cyclical response of the finance sector (Boyer 2012). Though, it is possible, that neo-classical economists will turn out right in the long-term and contractionary expansion will materialize, it is highly likely that Greece will slip into a deeper depression, as a result of the harsh austerity measures it has been facing (Glover and Tomek, 2012). 7. Lessons from Economic History Economists have drawn several lessons from history; as Keynes described, an accounting-type approach to public finances is flawed. If there is an excess of saving in an economy, whether it is due to low demand or low expectations, another economic agent, the government, has to incur


debt in order to stabilize the economy (Koo, 2009). If the government fails to do so, the lack of demand will cause unemployment and a contraction of economic growth. Currency boards and fixed exchange rates often deteriorate, due to fluctuations in productivity, competitiveness, changes in trade balance and unemployment rates. There have been numerous cases in economic history, where it has become to costly to keep a fixed exchange rate – the collapse of the Argentinean currency board and the collapse of the Gold Standard are some of the examples. Though there are examples of successful austerity programs, most of them have one thing in common; austerity was pursued during a period of economic growth, as a part of a larger countercyclical policy. Germany is an illustration of this situation – from the years 2004 to 2007, Germany was experiencing an economic boom – in contrast to most European economies, it decided to increase the Value Added Tax, as a part of a larger, consistent countercyclical policy. As a result of this long-term strategy of increasing tax revenues, improving its public finances and practicing wage austerity (as mentioned earlier, real wages in Germany have risen by a very small percentage), Germany succeeded in improving its competitiveness (Boyer 2012). In the case of United States during the Bill Clinton administration, the President began with a fairly large deficit and ended his eight-year presidency “with basically none,” which was again a result of financing the deficit with an economic boom. Similarly in Sweden, the period between 1994 and 1998, marked a noteworthy reduction in its fiscal deficit, but the period was also marked by a rapid growth of the GDP (Sen, 2012).


8. Alternatives to Austerity Debt Restructuring and Haircuts Indecisive leadership in Europe, including German and French leadership, and delayed response to the crisis caused it to be more severe than it would have been. Initially, Germany opposed to debt restructuring (Reuters, 2011), while giving out loans at high interest rates (Wiesman, 2010); later, at the insistence of the IMF, Europe began to “trim” Greece’s sovereign debt. Though, it would have been a politically hard to “back a swifter and more generous restructuring of Greek debt, with private bondholders in northern Europe taking their share of the losses, and for the EU to provide more generous funding to pull distressed economies through the recession,” it would certainly have alleviated the results of the crisis (Moravcsik, 2012); perhaps, it could have prevented the Greek debt from snowballing to almost 190% of its GDP (WSJ, 2012). However, this action would have implied a series of negotiations with the creditors, while distressing the financial markets, as well as, having to answer to the German taxpayers. Improving the Fiscal Framework Though there have been attempts to improve fiscal responsibility among European countries, such as the Stability and Growth Pact, these guidelines have mainly been ignored and SGO has proved very hard to enforce (Hallet and Jensen 2011). There is still no coherent fiscal policy within the Eurozone area, which will correspond to the uniform monetary policy set by the European Central Bank. This institutional shortcoming must be fixed, in order to ensure a commitment to Europe’s goals of low inflation and fiscal discipline. The framework for setting specific debt targets can be obtained by empirical results of Reinhart and Rogoff (2009) on the link between debt and growth rates. However, these empirical results do not yet have a theory to


explain why the link exists. The problem with debt targets is not only the lack of theoretical explanations, but also enforcement. Eurozone Exit There are considerably large, emerging leftist parties, who consider the entire Eurozone to be a “neo-liberal project” and would very much like to break away from it. The Communist Party in Greece, is a growing party, which supports this option. Freedom from the Euro, would give peripheral countries the freedom to pursue their own monetary policies – devalue, allow for more inflation and increase competitiveness. Apart from political issues this would cause, the reversion to the Greek drachma would cause savings of many Greek citizens to dissolve. The section of the population hit by a “Grexit” would be the middle and the lower classes , whose savings are relatively modest and who have not evacuated their money from the country. According to some calculations, Greece would have to devalue some 500-600 percent, which would in turn cause a disaster in the financial sector and ultimately, a nationalization of the banks. The huge devaluation would cause an increase in the price of imports, such as oil, resulting in a general increase in prices and possibly hyperinflation (Robinson 2011). Economic chaos caused by the exit of Greece from the Eurozone would definitely not be an isolated event – German and French banks have the most exposure to Greek loans and would suffer greatly from a default. Attention to Financialization One of the main goals of Austerity, as mentioned above, is to restore consumer confidence and prove to investors that the governments in question can be responsible with its finances. The increased importance of the financial sector and their misbehavior has caused increased volatility


of the economy. There was an obvious failure on the part of international banks, hedge funds and rating agencies to evaluate the risks associated with the sovereign loans made to Greece, Spain and Portugal. (Ryan, 2011) The case of Ireland is another example of the flaws in the regulatory system in Europe – nationally, Ireland failed to regulate financial institutions and internationally, financial institutions lent to unsafe Irish banks with distorted portfolios and had concentrated in few markets (Ryan, 2011). Spain’s economic troubles were mainly caused by a housing bubble (arguably, generated by an influx of capital from the richer European countries), in fact, it was boasting budget surpluses before the bubble burst (Barber, 2012). Hence, it was not Spain’s public finances that were the cause of the crisis, rather the lack of financial regulation and increased liquidity, which fuelled a mortgage crisis. The imposition of austerity measures in Spain have only deepened its crisis and caused a high unemployment of 24.3%, highest since 1945 (Barber, 2012). Accepting the premise of increased and harmful financialization in advanced economies leads to a consideration of various policy measures and regulations beyond austerity (Callinicos, 2012). While the EU has recently passed new banking regulations, increasing the amount of capital banks must keep on hand, there must be more attention to the sector in order to ensure sustainable growth. (Moravcsik, 2012) In November 2012, Mervyn King, the governor of the Bank of England said, "global finance needs to return to its original mission of mobilizing private sector capital to finance real investment opportunities.” Already, there are signs that European leaders are recognizing the importance of redirecting the financial sector to serve the economy better (Dunkley, 2012).


The role of the European Central Bank ECB could issue European bonds, in exchange for sovereign debt – this would reduce interest rates in the peripheral countries and stimulate the European Investment Bank to invest more. Additionally, the ECB is currently not a “lender of last resort,” the way the Federal Bank is, in the United States. If it were to assume this role, the ECB could buy “troubled” bonds from countries in crisis to reassure the investors. The issue with this policy is, that Germany has a very strict agenda regarding inflation – if the ECB were to buy bonds, money supply would increase in the economy and inflation rates would go up, as well. Recently, Mario Draghi has demonstrated willingness to go beyond the traditional role of the ECB and launched an “unlimited” bond buying program, “the ECB would stand ready to buy any amounts of sovereign debt with a term of up to three years, thereby ensuring a government's access to funding, in return for a bailout deal with tight strings attached.” (Cooper, 2012) His plan has already been brought under attack by the head of the Bundesbank, Jens Weidmann, stating that it would impair ECB’s independence, while putting Europe at the risk of an increasing inflation (Farrell, 2012). Despite the fact, that the day Mario Draghi announced his plan, a poll showed “nearly one in two Germans had little or no confidence in him,” it has to be pursued in order to give European leaders more time to sort the crisis out and prevent a worsening of the debt in troubled countries, which are forced to borrow at high interest rates. When the crisis hit initially, there were unreasonably high borrowing costs resulting from investors’ panic. This should have been alleviated by the ECB earlier, but as of November 2012, Mario Draghi has mentioned he will do


“whatever it takes” to rescue the Euro (WSJ 2012), including buying bonds and tackling high interest rates (Dunkley, 2012). 9. Conclusions The Eurozone crisis was caused by a mixture of factors; some were entrenched issues, which arguably would pose inevitable problems after the introduction of the Euro, such as, the unfeasibility of bringing divergent economies under the same currency, the issue of incapacitating governments to use monetary policy and devalue, inflexibility in terms of inflation and the lack of a strong central bank to act as a “lender of last resort” in case of crises; other factors were more recent, such as, an influx of foreign capital from banks of the richer countries (such as Germany, which ran on a surplus) to the peripheral countries, especially after the 2008 crisis in the United States, creating bubbles (housing bubble in Spain), lack of financial regulation and corruption, as well as, inefficient management of public funds in Greece. Economists from different schools of thought place relative importance to specific factors according to their frameworks. Similarly, modern leaders and decision-makers such as, the German Chancellor Angela Merkel, the President of the European Central Bank Mario Draghi the managing director of the IMF Christine Lagarde and the ex-president of France Nicolas Sarkozy, operate in different political and economic frameworks and react to crises according to their values. The response to the Greek crisis, which grew into a Eurozone crisis, was fragmented and delayed due to the ideological and cultural differences of the various European leaders. An example of this was the standoff between France and Germany on the topic of IMF involvement in the Eurozone crisis.


Austerity, which has been the major policy propagated by European decision-makers, with the leadership of Germany, has proven to be counterproductive (at least in the short run). While “contractionary expansion” has not taken place as imagined by conservative economists, there is evidence of a negative Keynesian multiplier effect, resulting in the growth of the debt from 120% of the GDP to almost 190% in Greece, worsening unemployment and economic growth rates, in addition to political unrest and a great social cost. European leaders, in realization of the gravity of the Greek crisis, are finally agreeing to allow the country more time to fulfill its targets and restructure its debt, an initiative that has also been supported by the IMF. Additionally, the European Central Bank has been increasingly growing more active in the process of stabilizing indebted countries – showing willingness to acquire their bonds to avoid speculative attacks and unreasonably high interest rates. In fact, over the four-month process of writing this article, there has been a series of developments showing, that European leaders (both politicians and economists) realize the necessity of going beyond austerity. There has been an increased flexibility with the economic and fiscal targets, as well as, the deadlines that Greece has been given to achieve them; and a recognition of Greece’s inability to pay back the loans, hence a discussion of haircuts and debt restructuring. In conclusion, this paper attempted to view the roots of the Eurozone crisis through the frameworks of various economic schools of thought and analyze the policy measures taken by European leaders through them. The paper mainly focused on the policy of austerity - its ideological and historical roots, in addition to its practical application in Greece, as its implementation was a severely controversial topic. Though Greece’s public finances and the size of its debt were problematic, subjecting the country to harsh austerity measures only exacerbated


economic woes and political instability. Similarly, subjecting Spain and Ireland to austerity measures have caused high unemployment and low economic growth. It seems, that austerity is not a successful policy when used in a pro-cyclical manner, but it can be highly effective when used as a counter-cyclical tool to lower a government deficit during an economic boom. Ultimately, more economic convergence among European countries (with a coherent and better enforced fiscal policy), stronger regulation in the financial sector, internal devaluation, a more capable European Central Bank and flexibility with inflation targets are necessary for the eventual recovery of the European Union.



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