Getting at the Pulse of the EU Debt Crisis

The root of the crisis

Iceland and Greece are perhaps the most famous of the victims of the European debt crisis. What is most interesting about the cases of Iceland and Greece is that although the origins of the financial crises were very similar -- financial liberalization and hot money inflows – their responses have been very different.

Fraud was present in both cases and on the side of both the debtor countries and their international lenders. As the New York Times reported in February of 2010， Goldman Sachs helped the Greek government conceal the extent of its budget deficits in order to convince international lenders that Greek government bonds were a safe investment. In the case of Iceland， investigative work by the American filmmaker (and MIT Phd) Charles Ferguson， has revealed that Iceland’s private banks paid American academic economists to write reports that described Iceland’s financial system as extremely stable. The American credit ratings agencies gave Iceland high ratings up until a few months before the crisis.

International banks also behaved recklessly in lending to Iceland， Greece and other debtor countries. In the case of Iceland， most of the hot money inflows came through private banks in Ireland， England and the Netherlands. In the case of Greece， it was primarily banks in Germany， France and Italy that did the lending， as a recent report by Barclays shows. In all cases， these banks enjoyed an implicit hidden guarantee from their national governments that if something went wrong the government and taxpayers would bail them out.

Why can’t Iceland or Greece pay back their international lenders? For one， in both cases the debts are too high relative to the size of the Greek and Icelandic economies. In September of 2008 Iceland’s central bank estimated that Iceland’s three private banks had debts greater than 50billion euros， even though Iceland’s total GDP was only around 10 billion euros. Greece’s government and banks owe foreigners 550 billion euros， which is also larger than Greece’s economy， which amounts to only roughly 310 billion euros.

It is hard for Iceland and Greece to pay back their creditors for another important reason. Debt crises typically occur after periods of hot money inflows. The problem with hot money inflows is that they help to reduce the ability of debtor countries to pay off their debts.

Across Europe there is a strong correlation between countries that in 2008 had large trade deficits – a proxy for capital inflows – and the increase in government debt caused by the crisis (see figure).

Norway， which had a large trade surplus before the crisis， was the only European country to see its government debt decline between 2007 and 2009. In contrast， Iceland had a trade deficit equivalent to 26% of total GDP in 2008， and Icelandic government debt as a share of GDP increased by a whopping 60% in just two years from 2007 to 2009.

These trade deficits were partially the consequence of policies undertaken in Northern European economies， particularly Germany. German economists， Eckhard Hein， Achim Truger and Till van Treeck of the Macroeconomic Policy Institute have argued that the key origins of the peripheral EU debt crisis are trade and financial imbalances within the EU. Germany carried out policies to lower wages and reduce inflation that have made its unit labor costs significantly lower than its European trading partners on the periphery， many of which experienced large real estate and financial bubbles that drove up wages and the price level.

What are suitable prescriptions?

All financial bubbles eventually pop. When they do， a country can face a sovereign debt crisis. What are the possible solutions to this crisis? In broad terms， the prescription can be divided into unorthodox and neoliberal responses.

The main neoliberal response is to force the debtor government to reduce its budget deficit， primarily by reducing social spending， in order to pay international creditors. This is often accompanied by new lending from either creditor countries or international financial institutions such as the IMF. The neoliberal response has been endorsed widely by American economists such as Harvard’s Kenneth Rogoff， as well as many popular pundits including the New York Times’ Thomas Friedman.

The main unorthodox response is for the debtor country to suspend debt payments and maintain government budget deficits. Debtor countries may impose tariffs on imports， taxes on ag- ricultural exports， and encourage their currency to depreciate quickly. Capital controls are often used. One leading champion of unorthodox policies among US economists has been Nobel Prize winner Joseph Stiglitz.

These two approaches have strengths and weaknesses for both the debtor and creditor countries. There are unavoidable tradeoffs between these policy approaches， and history is the best guide for policymakers in weighing their choices.

Neoliberal response

The neoliberal response focuses on allowing repayment of debts. This approach has a major advantage forcreditor countries， at least in theory: they will get their money back. In practice， there have been many financial crises in which creditor countries did not get their money back. For debtor countries the neoliberal approach has a major benefit. It may help the country to maintain good relations with its creditors. The debtor country may also retain access to international financial markets and be able to borrow money in the future.

The problem for debtor countries is， however， that reducing government expenditure may end up worsening the recession. Their economy will contract further， which will make it even more difficult for it to pay back its creditors. With a shrinking economy， private lenders may actually be less likely to lend the country more money even if it is implementing an IMF approved austerity package. In addition， with a contracting economy， the debtor coun- try will demand fewer imports from overseas， and this will hurt the interests of its creditors.

The neo-liberal response is typically favored by banks and government financial officials because it allows the banks to pretend that the loans they made to foreign governments will not lose any value. Even for the creditor country， the costs to the neoliberal approach are paid by other domestic groups， namely taxpayers and manufacturers.

Unorthodox response

The unorthodox response is often bitterly opposed by the banking interests in Western countries. However， the interests of taxpayers and industry in creditor countries are often better served if the debtor country takes unorthodox measures.

Debtor countries often argue that the foreign banks bear some responsibility for bad lending decisions. Banks have an obligation to engage in due diligence and a responsibility to their depositors to be very careful in making decisions about how they lend. The current financial crisis shows that many private banks can be reckless with other people’s savings. If banks are forced to bear the cost of bad decisions， including firing bank executives or reducing their salaries they may be more careful in the future.

The priority of the unorthodox response is encouraging economic recovery in the debtor country. In the long run， this makes it easier for the debtor country to pay back its debts. In addition to government spending， another unorthodox way to increase aggregate demand is to encourage exports and discourage imports.

At the same time， the debtor country may encourage its currency to depreciate. The danger comes if the debtor country’s debts are denominated in a foreign currency. In that case， depreciation will raise debt costs. Even when debts are denominated in a foreign currency， depreciation can be very good for the domestic economy. In the case of Korea， Indonesia and Thailand， exports grew very rapidly after their currencies depreciated. This helped to encourage economic recovery.

A critical factor that must be considered is energy imports. Where a country is very dependent on oil imports， rapid depreciation can lead to inflation by causing the price of energy to rise rapidly. If the country can switch to domestically produced energy such as geothermal energy in Iceland， or coal in the case of China， depreciation is less likely to create inflation.

Greece and Iceland: Responses to the crisis

Since 2008， Greece has been taking a largely neoliberal path while Iceland has taken a more unorthodox path. This section will discuss these policies， their economic impacts， and the impacts of these policies on creditor countries， including China.

Greece: Orthodoxy

In a recent book on the Greek crisis， economist Jason Manopolousblames the real appreciation of the Greek exchange rate as the key factor in the Greek crisis， as well as a political culture in which Greek politicians subsidized favored interest groups， most prominently public sector employees.

The result of these imbalances was that by the end of 2009， Greece was faced with the biggest crisis in its recent history: chronic pathologies and fiscal instabilities， combined with an environment of unprecedented uncertainty in the international banking system， contributed to the gradual exclusion of Greece from international capital markets and made it impossible for Greece to continue borrowing as it had through the last two decades. This country`s policy responses are presented in Table (1).

The center piece of Greek policy since the crisis erupted has been to attempt to lower the government budget deficit by freezing and reducing wages for government employees， laying down of government employees， and reducing the generosity of the Greek welfare system. The consequence of fiscal tightening has been to deepen Greece’s recession， which has lowered government revenue and made it difficult for Greece to meet its deficit reduction targets. In 2008， GDP shrank a modest 0.2%， which was followed by a decline of 3.3% in 2009 and 3.5% in 2010

Fiscal austerity has been combined with rapid privatization of state assets. As a part of its second bailout package the Greek government agreed to privatize 50 billion euros worth of state assets， including the port of Piraeus (near Athens)， the largest electricity utility， and the country’s train operator.

Capital flight has already begun to occur in Greece as wealthy individuals move their money offshore， frequently to Cypriot branches of Greek banks. Poorer Greeks are withdrawing savings and putting it under their mattresses， which reportedly has led to an increase in home burglaries. There is a credit squeeze in Greece， where even exporters are having trouble gaining access to trade credit because of the perception that Greece’s banks are unstable.

The problem for Greece is that unlike many other countries that expe- rience financial crises， Greece does not have its own currency， so it is impossible for it to export its way out of the crisis so long as it remains in the Eurozone. Monthly data shows that the Greek trade deficit has not declined， even though imports are plummeting. As we shall discuss below， this is a sharp contrast with Iceland. After the debt crisis erupted in December of 2009， the Euro continued to appreciate， and the trade deficit has remained high at between 2 to 4 billion dollars per month.

Iceland: A heretical approach?

Iceland experienced a deep recession after its banking crisis erupted in October 2009， and experienced a sharp decline in both exports and imports. On November 19， 2008， Iceland and the International Monetary Fund(IMF) finalized an agreement on a $6 billion economic stabilization program supported by a $2.1 billion loan from the IMF. Following the IMF intervention， Denmark， Finland， Norway， and Sweden agreed to provide an additional$2.5 billion.

Iceland’s banking system had collapsed as a culmination of a series of decisions the banks had made. According to Economy of Iceland 2010， published by the Central Bank of Iceland， right before their collapse， the total assets of the Icelandic banks amounted to many times Iceland’s GDP. Increased doubts about the viability of the banking system， coupled with deteriorating access to global liquidity， led to a sudden stop of capital

inflows in early 2008， as the foreign exchange swap market， the primary channel of inflows and a major wholesale funding market for the Icelandic banks， broke down.

There was a deep and quick depreciation of Iceland’s currency after the first several months from Sep.2008 to Dec. 2011(see table The Monthly Trade Value Change). Then the exchange rate changed to stable from that time on. This helped Iceland to reduce the trade deficit at this time of crisis. The trade deficit peaked in July 2008， but then recovered quickly with the krona’s depreciation. The trade surplus peaked in December 2009 and has been at a stable level since then.

Iceland has maintained large government budget deficits， and even took the extraordinary step of refusing to fully compensate foreign investors for their lost investments and accounts with Iceland’s banks. And in the end， Iceland essentially defaulted on the loans Iceland’s private banks contracted with the Dutch and British.

Both Iceland and Greece passed through hard times after the crisis broke out. However， as this article has demonstrated， Iceland has performed much better than Greece， even though Iceland’s initial crisis was arguably much deeper. The trade surplus in Iceland has been kept stable; however the trade deficit in Greece has continued to deteriorate due to Greece’s inability to control its own currency. Iceland’s economy grew strongly in 2011 and unemployment has fallen to around six percent after peaking at 10 percent in 2009. Statistics Iceland forecasts GDP growth of 2.4% in 2012 after 2.6% GDP growth in 2011.

Iceland’s more rapid economic recovery has also benefited its trade partners. Although Iceland’s initial economic collapse and currency depreciation decreased imports， with Iceland’s more rapid recovery imports have also grown steadily. The contrast with Greece suggests flexibility is beneficial not only to debtor countries themselves but also their creditor trade partners.

Different trade policies have had different implications for Iceland and Greece， and the lesson for China may be that a more independent and elastic exchange rate policy is beneficial for a country when it emerges from a financial crisis.