The Euro
crisis has turned into one of the most serious challenges that the European
Union (EU) has had to face so far. At its root the crisis is a
balance-of-payments crisis; caused by divergent economic developments among
member states in the pre-crisis years and the deep financial integration that
accompanied this process.
Balance-of-payments
crises share the same core problem: a country invests more than it saves, consumes
more than it produces, and imports more than it exports, all of which is
reflected in a current account deficit. When the foreign capital that finances
these imbalances dries up, crisis looms. For example, Greece’s current account
deficit of 11.2 percent of GDP in 2009 implies that the country was consuming
about one tenth more than it was producing at the eve of the crisis. From this
perspective, it is not surprising that the adjustment process has proven
painful.
The
purpose of this essay is to situate the Greek experience in a wider perspective
by comparing the Greek crisis and its politics to similar crises in other
countries. It first discusses why we see variation in policy responses and crisis
politics across crisis countries. The second section discusses how the euro
crisis differs from other balance-of-payments crises. Finally, the third
section discusses the implications that arise from this for Greece.
Explaining variation in policy responses and crisis
politics across crisis countries
What
are the policy options for countries faced with balance-of-payments crises? These
countries need to cut consumption and boost production, and there are several
strategies how this can be achieved. The first option, and the one most
frequently exercised in the past is exchange-rate devaluation, a strategy also
known as external adjustment. This
strategy makes exports cheaper and imports more expensive, and hence helps the
economy to rebalance. A second possible adjustment strategy is internal adjustment, in which relative
prices are reduced through austerity and structural reforms (this is the
strategy pursued by the crisis countries in the Eurozone). Because cutting back
consumption is never popular, both of these adjustment strategies tend to be
economically and politically costly. Policymakers therefore frequently resort
to a third option: financing the current
account deficit. Possible sources for such funds include capital officially
provided by international organizations such as the International Monetary Fund
(IMF) or other governments, but also less visible transfers such as those
recorded in the European Monetary Union’s (EMU) Target2 balances. The problem
with this strategy is that financing does not resolve the underlying causes of
imbalances, unless it is conditional on substantial reforms.
Balance-of-payments
problems thus confront policymakers with a list of unattractive options. Which
of these are they likely to choose, and how easy is it to implement this choice?
Assuming that policymakers care about the state of the national economy, they
consider how the different options for policy adjustment will affect the
country as a whole and choose the option under which the country’s economy will
suffer least. This suggests that policymakers decide on their preferred
adjustment strategy by considering the country’s “vulnerability profile” –
i.e., the potential costs of external adjustment for the country relative to
the potential costs of internal adjustment (for a more detailed discussion see Walter 2013, 2016).
The
choice of adjustment strategy is clear-cut if one adjustment path clearly
imposes more costs than the alternative, because this setting creates strong
incentives to implement the less costly strategy in a swift and decisive
manner. For example, countries for which austerity and structural reforms are
very costly, whereas the potential costs of external adjustment are
comparatively low (such as a country characterized by high unemployment,
inflexible labor markets and a large export-oriented sector) typically respond
to balance-of-payments pressures with a swift devaluation of the exchange rate
and without much financing. Taiwan in the Asian Financial Crisis or Poland in
the 2008-10 Global Financial Crisis are good examples for this type of country.
In the latter case, internal adjustment was potentially costly because of high unemployment
rates and a strained fiscal situation, while the country was barely vulnerable
to a depreciation of the currency. When BOP pressure emerged, Poland therefore
immediately allowed its exchange rate to depreciate, a strategy that was
uncontroversial and even welcomed by the export industry. Throughout the
crisis, the centrist coalition government under Prime Minister Donald Tusk remained
popular and did well in all elections. In fact, Poland was one of the few
countries in the region where more conservative challengers did not replace the
incumbent government during the crisis.
Likewise,
when the potential costs of devaluation are significantly higher than those of internal
adjustment, governments are likely to opt for internal adjustment, while
maintaining exchange-rate stability. For a long period of time, this
vulnerability profile was thought to be unlikely to materialize; in fact,
several studies suggested that democracies would ultimately always devalue
rather than implement painful domestic reforms (Eichengreen 1992; Simmons 1994). However, in
some countries, financial globalization has vastly increased the vulnerability
to external adjustment (Walter 2013). For example,
when labor markets are flexible, but the private sector is highly indebted with
foreign-currency denominated debt, internal adjustment can become the preferred
adjustment strategy. Because domestic prices decrease more slowly with this
strategy, some temporary financing to bridge the time until the reforms start
to bite is likely, but such financing will be regarded as a way to smoothen,
rather than avoid, adjustment. The experience of four Eastern European
countries - Bulgaria, Estonia, Latvia, and Lithuania during the global
financial crisis is instructive. When hit by the crisis, these countries
quickly implemented harsh internal adjustment strategies involving large fiscal
adjustment, huge cuts in public sector employment and wages, as well as health,
education, and labor reforms, all in an effort to maintain their exchange rate
pegs with the euro. High levels of foreign currency borrowing and the strong
wish (both for economic and geopolitical reasons) to join the Eurozone in the
near future made these countries very vulnerable to external adjustment,
whereas rather flexible labor markets and a sound fiscal situation reduced the
potential costs of internal adjustment. Thus, although the internal adjustment
strategy plunged these countries into deep recessions and tripled unemployment
rates, the policy decision to maintain exchange rate stability enjoyed strong
popular and political support. All crisis countries in the Eurozone have
embarked on this adjustment path as well, largely because an exit from the Eurozone
would be associated with huge costs.
Policymakers
face a much more difficult situation when both internal and external adjustment
are very costly – for example because a country exhibits high levels of
unemployment, rigid economic structures, and widespread foreign-currency denominated
debt.[1]
For countries with this vulnerability profile, distributive conflict is a
defining feature of the resolution of balance-of-payments crises. This
vulnerability profile therefore creates strong incentives to instead avoid (or
at least delay) adjustment and finance the current account deficit instead. Crisis
politics in countries with this vulnerability profile will be fraught with
political conflict, delay and attempts to involve other countries in the crisis
resolution process through financing. Examples for countries facing crisis with
this vulnerability profile abound and include Mexico in 1994, Thailand and
South Korea in 1997, and Hungary in 2010. In Hungary, for example, high levels
of foreign-currency denominated borrowing coupled with a strained fiscal
position rendered both adjustment policies costly. As a result, Hungarian crisis
management was characterized by delay, IMF involvement, and a deteriorating
economic and political situation, including electoral challenges, public
protests and strikes, and government breakdowns.
Overall,
this brief discussion shows that differences in national vulnerability profiles
are associated with variation in adjustment strategies and crisis politics. Crisis
management can be relatively uncontroversial in some countries, but can cause
large political difficulties in those countries where the costs of both
internal and external adjustment are high.
How the Eurozone crisis is different
What
does the vulnerability analysis imply for the Euro crisis, and how is the euro
crisis different? The fact that the Eurozone is a monetary union makes the
politics of responding to the euro crisis unique in two key respects.
First,
the costs of external adjustment are exceptionally high for Eurozone members.
Because external adjustment would imply Eurozone exit and possibly the loss of
EU membership, such a step is likely to cause financial havoc and a huge
economic and political fallout for both the exiting country and the European
Union as a whole. Whereas this is less problematic for countries such as
Ireland, for which internal adjustment is feasible, it places countries such as
Greece, Portugal and Spain into the unfortunate vulnerability profile where any
adjustment will be associated with high costs. Although these countries have
traditionally addressed BOP problems through exchange-rate adjustment, these
countries have tried to overcome the euro crisis through a combination of macroeconomic
austerity, structural reforms and financing support. Yet, the political fallout
of the crisis has been considerable.
However,
adjustment can also be achieved through policy reforms in countries with
current account surpluses. In these cases, external adjustment conversely implies
an appreciation of the exchange rate (and, in the euro zone, euro exit),
whereas internal adjustment requires stimulating domestic demand and allowing
higher inflation rates. In the euro crisis, many surplus countries are equally
vulnerable to both of these adjustment strategies. For example, Germany is
highly vulnerable to internal adjustment due to its high inflation aversion,
but is equally vulnerable to a breakup of the Eurozone.
The
upshot of this analysis – that most countries are reluctant to reform – paints
a rather depressing picture, because it suggests that EMU policymakers should
have a difficult time in implementing a decisive crisis resolution strategy.
The painful and drawn-out reform process, the convoluted and controversial
politics of the euro crisis, and the strong reliance on external financing in
the form of bailouts, the European Stability Mechanism (ESM) and growing
Target2 balances all attest to these difficulties. Domestically, incumbents in
deficit countries have been punished electorally, support for radical parties
has increased and protest politics has become more prevalent in the wake of the
crisis.
A
second unique feature of the euro crisis concerns the bargaining power of
deficit and surplus countries. It is usually difficult for deficit countries to
shift the burden of adjustment onto surplus countries, and the euro crisis has
been no exception in this regard. EMU surplus countries such as Germany have
proven to be rather reluctant to accept higher rates of inflation or to
actively stimulate domestic demand, although the European Central Bank’s recent
loose monetary policy can be interpreted as a small step in this direction. However,
significant financial inter-linkages within the monetary union mean that the
costs of a further escalation of the crisis or even a break-up of the Eurozone would
be huge for deficit and surplus countries alike. This substantially increases
the willingness of surplus countries to cooperate with deficit countries.
Surplus
countries that wish to avoid internal adjustment at home may therefore be more
willing to contribute to a financing of current account deficits in peripheral
countries through intra-EMU or intra-EU transfers, possibly even permanently.
The discussions about a fiscal union, an EU-wide unemployment benefits scheme,
or “intra-EU solidarity” more generally attest to this possibility and it is
likely that these discussions will intensify if the crisis persists. Given that
this is quite unpopular among many Europeans, however, such financing carries
the risk of fueling already growing Eurosceptic sentiments within member states.
Taken together then, this suggests that the resolution of the Eurozone’s
problems will continue to be a drawn-out, painful and politically costly
process.
Implications for Greece
What
does this discussion imply for Greek crisis politics? A comparison with the
Eastern European experience shows that Greece’s balance-of-payments problems,
and as such the size of the needed adjustment, were very large when the crisis
erupted. Nevertheless, Greece exhibited by no means the biggest problems.
Rather, a comparison of the average current account deficits for the period
2005 to 2007 shows that Greece’s current account deficit – and hence the size
of the adjustment burden – was significantly smaller than the deficits in
Latvia, Bulgaria, and Estonia. Nonetheless, these countries managed to address
their crisis swiftly with huge cuts in public spending, tax increases and
reductions in public sector employment.
In
contrast, crisis resolution has been highly contentious and protracted in the
Greek case. Greek crisis politics has been characterized by much delay, a
strong reliance on external funding, difficult relations with lenders and
political conflict, public protests and the electoral success of extreme
parties. This is typical for countries with a vulnerability profile in which both
internal and external adjustment are very painful and politically costly. Greece
clearly exhibits such a difficult vulnerability profile, because the structure
of the domestic economy and political system complicate austerity and
structural reforms, whereas euro exit is even more unattractive.
Still,
the events of the past months have raised the question whether the costs of
internal adjustment will at some point surpass the costs of external
adjustment. In other words, the question is whether Greece will at some point
exit from EMU. Judging from the experience of other countries with a similar
vulnerability profile, euro exit appears to be a distinct possibility. However,
given that the Greek crisis is occurring in the context of a monetary union,
the picture is rosier if three crucial aspects are considered.
First,
within Greece, popular and political support for the euro remains extraordinarily
strong. In two public opinion surveys fielded in July and September 2015, more
than two thirds of respondents supported staying in the Eurozone and the EU,
and this support remained very high even when respondents were explicitly told
that this would require more spending cuts and tax increases (Dinas et al. 2015). Even among
those hit most harshly by the crisis, more than 60% supported Greece’s
continued membership in the Eurozone.
Second,
there is also strong European support for keeping Greece in the Eurozone and
especially in the EU. This is mostly driven by worries in other Eurozone
countries that a “Grexit” would irrevocably damage the Eurozone and the
European project more generally. As discussed above, the high vulnerability of other
Eurozone countries to a Greek exit from the monetary union gives Greece
considerable bargaining power. Even though the third bailout package has been
associated with very tough conditions, the fact that a third program was
granted is quite unusual in international comparison.
Finally,
and mostly as a consequence of the second point, Greece has been receiving more
financial support than most countries facing BOP crises. Copelovitch and
Enderlein (2014) show that in terms
of loan size relative to the country’s economy, the 2010 and 2012 programs for
Greece were among the largest the IMF has ever granted. At the same time,
considering the size of the loans, Greece received comparatively few
conditions. For example, conditionality in the 2010 Greek program was the
second lowest among the euro crisis borrower countries. This contradicts the
general notion that Greece has been subject to unusually harsh conditions, but
attests to Greece’s ability to bargain with creditors.
In
sum, it is clear that were Greece not a member of EMU, external adjustment
would probably have long been part of its adjustment strategy. But the
membership in the monetary union changes the situation because the large cost
of and uncertainty associated with euro exit have led to strong support,
especially within Greece but also within Europe, for a continued Greek
membership in the Eurozone. In the long run, the answer to the question whether
Greece will exit from EMU will depend on whether the (perceived) opportunity
costs of exit will change over time.
References
Copelovitch, Mark, and
Henrik Enderlein. 2014. "Kicking the Can Down the Road: The Euro Crisis
and the Political Economy of Troika Bailouts." University of Wisconsin.
Dinas, Elias, Ignacio
Jurado, Nikitas Konstantinidis, and Stefanie Walter. 2015. "Survey
evidence from the July 2015 Greek referendum and the September 2015 Greek
elections.".
Eichengreen, Barry.
1992. Golden Fetters: The Gold Standard
and the Great Depression. New York: Oxford University Press.
Simmons, Beth. 1994. Who Adjusts? Domestic Sources of Foreign Economic
Policy During the Interwar Years. Princeton, NJ: Princeton University
Press.
Walter, Stefanie. 2013. Financial Crises and the Politics of
Macroeconomic Adjustment. Cambridge: Cambridge University Press.
———. 2016. "Crisis
politics in Europe: Why austerity is easier to implement in some countries than
in others." Comparative Political
Studies.
[1] Crisis management is easiest when the potential costs of both external
and internal adjustment are low. Unfortunately, countries with severe balance of payments problems are
unlikely to find themselves in this category.
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