The Eurozone Crisis: The Much Praised “Convergence” as a Cause

Eurozone crisis, Eurozone and UK Government borrowing rates, 10 year yields, January 1993 to October 2011

The Eurozone crisis is complicated, and a mess.  Europe as a whole is probably already in an economic recession.  But one of the seeds for this crisis (there are several) can be found in what was seen then as the remarkable, and at the time much praised, “convergence” in government borrowing rates among the Eurozone members from the introduction of the Euro on January 1, 1999 (and Greece from its entry on January 1, 2001), until the Lehman Brothers collapse in September, 2008.

The graph shows how markets drove interest rates on government bonds to equality for Eurozone members, until the Lehman collapse in 2008.  It is really quite remarkable that the markets acted this way.  They treated the Government of Greece as if the probability it would default or otherwise reduce the value of the loans made to it (e.g. by an involuntary restructuring), were the same for it as for Germany (or any other Eurozone member).  Even if the markets thought that Germany would in the end always bail out any member otherwise unable to repay its debt, one would have thought that the markets would have at least viewed this as not 100% certain, and that they would in any case ultimately face some degree of loss even with a German bailout.  That the markets did not act this way shows how unbridled faith in markets acting rationally and fully informed is dogma, and is not supported by history.

The graph also shows the 10 year borrowing rate by the Government of the UK.  The UK has its own currency, and it must have been painful for it to see that the markets treated Eurozone members such as Greece and Ireland as better risks than the UK in the middle of the last decade.  I have included the UK in the above graph in part to show how tightly bound the borrowing rates were for the Eurozone members during this period. And despite a UK fiscal deficit which is now higher than all Eurozone members other than Greece (and in fact close to that of Greece, where the Greek fiscal deficit is projected to be 9.1% of GDP in 2011, vs. 8.8% projected for the UK), and public debt ratios similar to the EU average (and a third higher than that of Spain, for example), the UK 10-year borrowing rate is now almost the same as Germany’s (as of this writing on December 12, the 10 year UK rate was 2.10%, vs. 2.02% for Germany).  An independent currency helps.

The Eurozone crisis has reached the point that it has, threatening a renewed world-wide downturn and a possible break-up of the euro itself, because the traditional tools to manage a crisis are not there, due to the euro and the rules under which it was established.  The European Central Bank says it is not permitted to be a lender of last resort to Euro member governments, thus forgoing an important mechanism normally available to countries with a sovereign currency.  And as a member of the Eurozone, individual countries cannot devalue, where a devaluation could improve competitiveness and spur growth.  Many conservative economists have argued that putting nations is such straightjackets is the way to prosperity.  The Eurozone crisis shows that is simply not correct.

There are no good alternatives in what to do now.  The time for corrective actions should have come much earlier, including from the launch of the euro when the convergence in government borrowing rates was observed, despite the clear differences in capacity to service public debt among the Eurozone members.  But in coming up with a resolution to this crisis, one element will need to be that losses are taken by the lenders who had earlier treated all Eurozone governments as the same.  It was this failure of the market to differentiate across the Eurozone members that supported both profligate governments (such as Greece) and profligate private borrowers (such as banks in Spain and Ireland that  drove real estate bubbles), and more broadly financed at too low a price the trade imbalances that developed among the member countries.

Ensuring the lenders suffer such losses is not only morally justifiable (that is, all the costs should not be imposed Greece, Italy, Spain, and others, even if this would suffice, and it won’t), but also important to ensure another such crisis does not develop again in a few years.  Angela Merkel and Germany are trying instead to impose strict fiscal rules on public sector deficits and the accumulation of public debts, but it is unlikely that such blunt rules will suffice to cover the complexities of any real world situation the countries find themselves in.  Furthermore, such fiscal rules, if seriously applied, will limit the ability of governments to respond as they should to economic downturns, even recognizing that the rules in principle allow for some flexibility in such circumstances.

And by Germany insisting that banks and other lenders not take losses on the loans they made to the riskier countries (other than Greece), where such loans were made at rates that reflected an assumption of no risk, lenders might well feel that in other than extreme cases (like Greece) they will in the future again be bailed out.  While one should hesitate in relying solely on the markets, given their poor track record, the markets would function better if lenders were forced to take losses on their bad lending decisions.  That would then act as a check on excessive government borrowing in circumstances when such borrowing truly was excessive rather than a reasonable response to the real world situation the countries might find themselves in at some point in the future.  And such market discipline would function better than crude, one size fits all, fiscal rules that limit a government’s ability to respond appropriately to downturns.