Seminar 11: The Eurozone Crisis (b)


To treat the crisis in European sovereign debt markets as an outcome of fiscal irresponsibility and profligate state spending is to confuse correlation with causation.

Last week we analysed data that suggests the crisis in Europe has very little to do with a profligate public sector, and everything to do with private finance markets.

It was a private sector banking crisis, amplified by the institutional design of the EMU, that became a sovereign debt crisis.

The proximate cause of the Euro crisis is a banking collapse. The ultimate cause are structural imbalances that emerged form jointing together qualitatively distinct national models of capitalism into a single currency, without a fiscal state.

The banking crisis in Europe has cost almost $4 trillion.

By the end of 2009, German banks, alone, had lent $720 billion to Greece, Ireland, Italy, Portugal and Spain . French banks had lent $493 billion.

Collectively, Eurozone banks were exposed to $727 billion in Spain, $402 billion in Ireland, and $206 billion in Greece.

Bank exposure Euro

Why then has the policy response to the Euro financial crisis almost entirely focused on fiscal consolidation (austerity) and labour market reform (structural reform)?

Explaining austerity as a policy response 

To answer this question we need to examine how the institutional matrix of the EMU interacts with the domestic ideational and material interests of its member-states.

In political economy, comparative responses to international crises are usually attributed to variation in domestic producer group coalitions.

We can also think about how to explain the comparative politics of economic policy choices in terms of ideas (epistemic elites) and interests (political coalitions).

Economic ideas are not just instruction sheets for what governments should do. They are a power resource that enshrine very different conceptions of how the burden of adjustment should be distributed. They are never purely technical decisions.

Initially, when the financial crisis hit, the governing economic idea of free efficient self-correcting financial markets was discredited. Policymakers in most countries pursued an immediate Keynesian response.

Even the IMF were arguing that monetary tools were not enough to solve the crisis.

Change in revenue

Change in Euro expenditure

Brazil, China, USA, and even Spain lined up to stimulate their economies. But this Keynesian reprieve barely lasted 12 months. Why?

From the Keynesian reprieve to ordoliberalism 

In the Euro area, and at international summits, Germany led the charge against stimulus and called for a return to fiscal consolidation and structural reform as a policy solution to the crisis.

This shift away from Keynesian oriented policy ideas do not imply a shift back to ‘neoliberal ideas’. Rather it was led by the German “ordoliberal” tradition.

The ordoliberal idea is built around an instruction sheet that suggests the job of government is not to correct market failures but to set and enforce rules.

The role of government is to provide safety nets, ensure that cartels do not develop, limit unproductive speculation, impose strong budgetary discipline, and ensure a politics of order and stability.

In this conservative tradition, policy failures by government not markets make crises.

The German economy has been successful with this instruction sheet.

This now being imposed across the euro area. It assumes that if all countries follow a the EU economic instruction sheet (government stability, fiscal austerity and structural reform), they will solve their crises.

The problem is that peripheral and southern Europe states do not have the domestic institutions to make this export-led instruction sheet work.

The US may to be to the right ideologically, but in a crisis, more often than not, economic policy takes a sharp left turn. The opposite is the case in Europe: Policymakers championed stability, inflation control, and budget cutting.

The Americans were arguing for global Keynesianism at international summits, whilst the Europeans were calling for regional austerity and improved competitiveness.

At the G20 summit in 2010 the general ideational climate radically changed. Jean Claude Trichet, the then President of the ECB wrote in the Financial Times:

Stimulate no more – it is now time for all to tighten

Soon afterwards, the German finance minister Wolfgang Schäuble published an opinion piece where he outlined what would become the Euro strategic discourse until today:

Europe needs expansionary fiscal consolidation

The ECB followed with their June 2010 monthly bulletin, and called for:

Growth friendly fiscal consolidation

Change in expenditure 

Change in expenditure

Change in fiscal deficits 

Change in Fiscal deficit

Ordoliberalism was back with a German bang, without banking responsibility.

The core idea, or instruction sheet governing the Euro policy response suggested that not only would fiscal consolidation reduce budget deficits, it would send a positive signal to market actors, create stability, improve confidence and kick-start economic growth.

However, it was not just German ordoliberal ideas that created this shift in the policy response at European level, it was also determined by what was happening in banking sector of the Euro periphery.

Remember, the cost of borrowing in Greece fell from 20 percent on a ten year bond in the mid-90’s to 4 percent in 2005. Eurozone banks were stuffed full of peripheral bonds.

Some economists argue that the best thing to do in 2009 was for the ECB to buy up secondary market Greek debt (at a cost of 50 billion) and bury it in their balance sheet.

But the ECB has no legal mandate to do this, and Germany was morally opposed to it.

In Ireland, the combined asset liabilities of the three main banks equaled 400 percent of GDP, most of which was lent into real estate. The collapse in Irish property prices threatened to take the whole banking sector down with it.

The government stepped in and sovereign debt increased to 120 percent.

Spain is Ireland magnified. Its domestic regional savings banks (cajas de ahorros) were stuffed full of bad assets, undercapitalized and massively exposed to a collapse mortgage market. The housing boom meant private sector debt increased to 200 percent of GDP.

As Mark Blyth argues, it was a banking crisis cum sovereign debt crisis. To blame the public sector is to mistake correlation with causation.

Southern Europe picks up the bill

In 1979, Spain was the seventh largest industrial economy in the world. It is now seventeenth. Construction, and various private sector services filled the gap during the Euro years. One quarter of the population are now unemployed.

Italy, on the other hand, is Portugal magnified. They are low growth, low productivity economies. Portugal traditionally exported textiles and footwear.

Most of this collapsed with competition from Asia and East Europe.

Most workers went into private services in the non-tradeable sectors. According to some research, the number of lawyers in Portugal increased by 48 percent between 2000-2008. Growth per capita barely increased by 0.2 percent during these years.

Italy is the polar opposite of Spain, but very similar to Portugal. It has huge public not private debt, and accounts for the third largest bond market in the world. 20 percent of the population is over 65. In 2035, one third of the population will be over 65.

These countries have a growth not a fiscal crisis.

To deal with the growth crisis the European policy response is built around “growth enhancing fiscal consolidation and structural reform aimed at kick-starting export competitiveness”.

In 2010 – Greece received European financial assistance (110 billion) in return for a 20 percent cut in public sector pay, pension cuts and structural reform.  In 2011, an additional 110 billion was provided with a 20 percent cut in spending required in return.

In 2010- Ireland received European financial assistance (60 billion) in return for a 24 percent cut in public spending.

In 2011 – Portugal received financial assistance (78 billion) in return for a 25 percent cut in public spending + structural reforms.



By 2011, the entire Euro crisis was framed against a policy narrative of lazy debt-ridden PIIGs rather than an over-leveraged private financial sector crisis.

The policy response converged around higher fiscal rules, banking recapitalisation and structural reform of labour markets.

Despite some comparative differences, what is most striking about the EU is that countries responded to the international crisis in much the same way.

To understand this economic policy response requires an appreciation of the real ideological and political factors underpinning the monetary union.

Saving a too big to fail banking sector in a stateless currency 

It is about saving a euro wide banking sector that is too big to fail in a single currency where costs are nationalised not federalised.

With no EU-wide fiscal authority, there are no shock absorbers in the system, other than national balance sheets (the budget, and the national accounts).

European policymakers know this. But the response has not been to build common fiscal institutions but to impose stricter and more ridged fiscal rules on the nation-state.

Fiscal democracy has been traded in favour of the single currency.

This is the new Euro trilemma, and it is highly questionable whether it is politically sustainable, without a banking union.

See Eurobarometer on the core concerns facing European citizens (economic situation, unemployment, public finances and immigration) and note the comparative difference between the north and south of Europe.

Northern European countries are concerned about the public finances of other member-states and immigration, whilst southern European countries are concerned about their economic situation and unemployment.

To think that a one-size fits all economic adjustment across diverse varieties of capitalism, based around an ideational instruction sheet borrowed from German ordoliberalism, assumes an unrealistic level of planning capability by nation-states that should concern even the most moderate Hayekians in Europe.

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