The Eurozone Crisis still Threatens Global Growth Paolo Guerrieri Professor of Economics, University of Rome Sapienza; Professor, College of Europe, Bruges he outlook for the global economy in 2012 term austerity. The recessionary effect caused by is clear, but doesn’t look very reassuring: re- fiscal austerity may itself fuel market doubts about Tcession and stagnation in Europe, anemic government solvency and thus worsen the fiscal po- growth at best in the United States, and a sharp sition of the euro area’s highly indebted countries, slowdown in China and in most of the emerging defeating the very purpose of the initial austerity market economies. Under the present conditions measures. In light of these considerations, a com- and policies, there are very serious downside risks mon European commitment to growth is strongly for the global recovery; the most serious of these needed. Furthermore, a push for balancing trade being a new deterioration of the eurozone crisis. within the eurozone should also be made compati- ble to the new overall global equilibrium. In the past, In the eurozone, fiscal austerity measures ap- the eurozone has largely balanced trade with the rest plied on a large scale are determining recession- of the world, although countries like Germany ran ary effects on output in many Southern European large trade surpluses against the rest of the eurozone. economies and stagnation in the core euro area. The risk is that future adjustment could transform Interest-rate spreads for Italy and Spain are widen- the eurozone as a whole from a region with balanced ing again, while borrowing costs for Portugal and trade with the rest of the world to another trade sur- Greece remain high. plus and export-led growth area like East Asia. That would make it even more difficult to stabilize and The European Central Bank’s longer-term refinanc- promote growth in the global economy as a whole. ing operation to provide nearly $1 trillion in cheap three-year funding to European banks has tempo- The Conventional Narrative of the rarily stabilized the eurozone and the global finan- Eurozone Crisis cial system, but has not addressed the underlying problems of the crisis in the peripheral countries: Since the start of the crisis, European leaders have large and rising private and public debt as a share of misdiagnosed the problems and set the wrong GDP on the one hand, and a deepening recession policy course based on fiscal austerity. On the con- and large macroeconomic imbalances on the other. ventional (German) reading of the crisis is that it is not the product of the eurozone system itself, but The major risk is that the eurozone is going to re- of misbehavior of individual countries within the peat the fundamental mistakes of the Great De- region in terms of fiscal laxity and irresponsibility. pression. Under present conditions, more turmoil There is a banking crisis as well, but it is not seen as is likely and Europe will suffer along with the rest a central part of the problem in Europe. Therefore, of the world. under this reading of the crisis, the adjustment should be entirely one-sided and centered on the Looking ahead, the primary goal of the G-20 and the highly indebted countries. The resulting prescrip- international community should be to call for a re- tion was austerity and economic reforms. Accord- balancing of some aspects of the current strategy in ing to the current approach if the periphery can Europe to ensure that there is not an excess of near- THINK TANK 20: New Challenges for the Global Economy, New Uncertainties for the G-20 49 achieve this then the eurozone debt crisis will be particularly those across Southern Europe, would resolved without new great institutional changes. be well-advised to take supply-side reforms more seriously than they have in the past. But there are Fiscal austerity measures have been introduced obvious contractionary effects for the eurozone as a and diffused everywhere in the eurozone from whole deriving from such an asymmetric approach. Greece’s unique fiscal problems to countries such As previously noted, increases in saving and ex- as Spain and Ireland which have banking and porting in eurozone deficit countries have to be not fiscal crises. The belief is that these countries offset by equal increases in spending and importing should restrain from excessive spending enough in surplus ones. Peripheral Europe cannot possibly to restore credibility, bring down interest rates and succeed in reducing its borrowing substantially un- restart economic growth. However, what is hap- less surplus countries like Germany pursue policies pening is that growth has suffered and recession that allow their surpluses to contract. has hit all peripheral countries. If most eurozone country governments are cutting spending at the For the past two years, policymakers across Eu- same time, the contractionary effect on GDP is rope seem to contest this point and argue that fis- further magnified. The deficit countries must im- cal consolidation by itself will boost growth. The prove competitiveness and save more to pay down main hypothesis is that confidence-inspiring mea- their debts, without offsetting a decline in saving sures will foster and not hamper recovery. Howev- and expansionary policy in the surplus countries er, these assertions have little empirical evidence to like Germany. Slowdowns in one country will re- support them. As a careful study conducted by the duce demand for exports in others. International Monetary Fund concluded in 2010, “fiscal consolidations typically lower growth in the Fiscal austerity in individual European countries short term”. In other words, their net effect on de- has resulted in excessively tight macroeconomic mand is contractionary, rather than expansionary. policy for the euro region as a whole. Together with Furthermore if a eurozone deficit country were Europe’s inability to handle the problems in Greece, to reduce its trade and current account deficits it contributed to weakening market confidence and without Germany playing any offsetting role, this creditworthiness in many countries, notably Spain would implicitly assume that the rest of the world and Italy. The decline in sovereign bond prices of would have to absorb a huge shift in the eurozone’s highly indebted countries has exposed the banks’ external position, from broad balance to large sur- undercapitalization. The prospect that European plus. Currently, there seems to be very little room governments will have to finance recapitalization to shift the euro area’s imbalances to the rest of has driven up risk premiums on government bonds. the world by transforming the region as a whole The sovereign debt crisis in the periphery is thus into another export-led growth area like East Asia. bound up with a banking crisis across the euro area Such an action would also make it even more dif- as a whole. As a consequence, the banking crisis and ficult to stabilize and promote growth in the world sovereign debt crisis has been so far interacting with economy as a whole. each other in a perverse direction. An Alternative Diagnosis and Therapy Fiscal Austerity Alone Will Not solve the Crisis In the light of what has been said, it is no wonder that Europe’s economic prospects are so poor. Twelve It is very clear that the fragility of the financial European countries are in recession—meaning system, together with the sovereign debt crisis, they have suffered at least two consecutive quarters represents the biggest threat to the long-term sta- of negative growth—including big countries like bility of the eurozone. It’s also clear that fiscal aus- Spain and Italy. Eurozone unemployment has risen terity alone will not solve the crisis. EU countries, THINK TANK 20: New Challenges for the Global Economy, New Uncertainties for the G-20 50 for a 10th consecutive month to reach a new record many years large current account deficits were eas- high of 17.1 million in February, with the pace of in- ily financed by net private capital flows of surplus crease showing little sign of slowing due to austerity countries in the euro area. In other words, the banks programs across the continent. of the core countries (Germany and France) heavily financed the excess demand in the peripheral coun- To avoid further recessionary trends in the euro- tries, thus promoting the accumulation of large zone and the potential for another major global macroeconomic imbalances within the eurozone. crisis, it is crucial that European policymakers modify their policy strategy. First, they should The global financial crisis in 2008-09, however, has recognize that fiscal austerity has become part of put an end to this easy financing and has revealed the crisis. We need an alternative therapy based on many weaknesses in the euro architecture. Private a better understanding of the causes of the crisis funding of imbalances dried up and the system since the diagnosis and the corresponding therapy of euro area central banks has had to replace the are strictly related. banking sector as a key source of funding of cur- rent account imbalances and private capital move- Contrary to the official narrative of the underly- ments. This massive intervention was to a certain ing cause of the eurozone crisis, with the exception extent successful, but the cost was the dramatic of Greece, the real cause of the crisis is not the fis- increase of budget deficits and sovereign debts in cal irresponsibility of some EU member countries deficit countries. In the years after the crisis, highly but rather the unsustainable accumulation of debt indebted European countries with large external among private actors (households and banks) linked deficits experienced the highest sovereign bond to the large and persistent imbalances in the euro yield spreads.