Thursday, November 10, 2011

What's Happening in the Eurozone?!

This blog is currently in something of limbo land; it's my hope that via whatever RSS feed or other means you have (bookmarks) once you started reading this blog associated with taking econ101b in Birmingham that you keep reading it; the aim is to keep pointing out relevant real world events. Of course though, the current term in Birmingham is econ101a, and hence I'm yet to lecture econ101b for the current year.

Nonetheless, the world doesn't stop between March of one year and January of the next, and one vast, gaping example is the eurozone crisis.

What, exactly, is going on here? One thing that is hugely true is that anything surrounding Europe in any form attracts huge amounts of emotive and vitriolic argument, and not a little bit of deception too by those able to keep their emotions hidden. Europe may divide the Tory party, but it also divides most British folk too.

So we must try to abstract from this. What is currently happening is a number of countries within (and without - e.g. Iceland) the eurozone is that they are struggling to borrow to cover their spending plans. In all cases, governments have particular spending plans they would like to enact, and in order to fulfil them they are currently borrowing because tax receipts do not cover their desired expenditures. The problem is that such borrowing requires paying interest to the willing lender, and currently a lot of lenders appear to be less willing to lend to these countries.

In some cases, this has got to the stage where a default (the country effectively goes bankrupt, telling those that lent to it that they won't be repaid ever) seems inevitable. Naturally, the problem here then is for those creditors who lose a source of income, and also for the governments that default since it will lead to dramatically higher interest rates in the future to borrow (would you lend to someone who just told people they couldn't repay?).

There then appears to be a problem because some of these countries that may default are within the eurozone. Were these countries like the UK and outside the UK, then a default may be less likely because they could simply print more money to pay off debts and inflate away the debt in time, but of course this recourse isn't available to eurozone countries since they do not have the power to print their own currency. Also, outside the eurozone they could default, making them more competitive as a nation hence hopefully able to start exporting more and importing less which would help the process of escaping from debt. However, if their debt was denominated in a foreign country (e.g. US dollar or euro), then this devaluation would only make the situation worse, as their debts would increase.

It will probably be fairly obvious, but a large number of people are suggesting that the euro is entirely to blame for the problems countries like Spain, Italy, Ireland and Greece are suffering, because they can't devalue. But it's a little more complicated than that, since as said that assumes their debts are in their own currency. Many countries borrow from abroad, and were Greece outside the eurozone, it's not obvious they wouldn't still have borrowed from eurozone banks. When debt is denominated in foreign currencies, then if an economy runs into trouble as Greece has, and its currency depreciates as would be expected, then its debt increase because they are foreign currency debts.

Generally, those blaming the euro for all the troubles were predisposed against the euro, because as you are likely learning, things are never quite as simple as that in economics, and often a bit of economic theory spoils a good rant.

Now, what are the consequences of a eurozone country defaulting? Does it need to leave the eurozone as a result? It doesn't appear obvious that they do - although again, those that don't like the euro appear dead set on presenting this as the only outcome. Given the trans-national nature of the monetary system they are engaged in, Greece defaulting is little different to any economic entity (e.g. a firm, a person) going bankrupt within a country. They will suffer the consequences as they rebuild afterwards, and perhaps some functions of government activity in Greece will be disrupted for a while around the default. But they will recover.

Why, then, are eurozone countries (and the IMF and the EU) ploughing millions and billions and trillions into Greece? Probably the best explanation (that doesn't recourse to euroscepticism) is, like the bail out of the banks in 2008, governments see this as the course of action that minimises disruption. A full scale default by Greece would create some problems for banks that are exposed to Greek debt, which would then translate into the domestic activity of these banks, already criticised for their lack of domestic lending in many countries. The consequence would be, of course, more depressed economic activity.

However, it seems the result of such actions of ploughing in the trillions is only to prolong the agony as opposed to actually providing Greece with any lasting solution. Some kind of adjustment (it is an economy that doesn't produce productively enough, effectively) is required in Greece but the problem is that in the course of that adjustment things will only get worse - budget deficits worse, economic growth worse, etc. The bottom line though appears to be that the necessary adjustments don't appear to be being made because they are not being forced to be made because of all the talk of European bail outs, repeated ones, that just prolong the market uncertainty.

Greece simply defaulting of its own right, starting from scratch again, is likely the best solution. It won't be pretty, but most likely a lot prettier than the current situation of bail out after bail out being announced, none of which are ever sufficient to stem market uncertainty (nor should they be since Greece as an entity does not appear to have changed). The Greece starting from scratch could decide from the outset what its desired level of public spending and government intervention is, and could decide this based on what it can borrow and at what rates (potentially not even borrowing at all). Currently its previous obligations tie it (and the rest of Europe) up in knots; at least if it defaulted and started again, that uncertainty would be over.