Sunday, January 22, 2012

The Eurozone Crisis - Things are not always what they seem

The popular story that has circulated in the richest countries is that this is a morality tale. The extravagant behavior of the Irish and Mediterranean Countries led to the crisis. Rather than working,they danced, rather than saving and investing, they spent. (known here as the Zorba the Greek Syndrome).

After the fall of communism, Germany, France, and other more developed countries sought to integrate Eastern Europe as well as countries on the periphery like Greece, Italy, Greece and Spain into the European economy. The Euro was created to avoid currency fluctuations and improve stability in trade.

The problem was that there was a European monetary system but separate fiscal systems in each country. This worked out fine until the stress of the great recessions exposed the weakness of the alliance. The nations on the periphery failed to manage their economies, spent more then they could afford and failed to invest. This led to a huge debt that would be difficult or possible to pay back. Follow this link to a comic version of the story

Consequently, the banks who had purchased government bonds from those countries were facing potential defaults from the peripheral countries. The potential of huge losses spread fear of a contagion that would lead to widespread bank failures throughout Europe and a double dip recession. Only through the generosity of the richer countries could Europe be saved from the proliferous periphery.

Here's the problem, with the exception of Greece, the debt problems of the peripheral countries was not much worse and in some cases better than the wealthier European countries. Furthermore, the moral faults of those nations was clearly misplaced. Investment and capital formation was as great or greater and the work ethic actually appears stronger (see the above graphs).

Then what was the cause of the crisis? The answer appears to be quite the opposite. The alternative explanation is that the adoption of the Euro resulted in a flow of capital to the periphery to take advantage of the cheaper labor and new markets. When the recession hit, the capital reversed it's direction leaving a massive current accounts deficit. Since all of the counties had one currency, they were unable to devalue their currency to balance the outflow. I'll cover more this in my next blog.