Myths and facts of the Euro crisis part 4 – how to save the Euro – an analysis by João Madeira

As shown in the previous text the run on bank deposits and sovereign debt of periphery countries justified the need for an intervention to change the negative expectations in debt markets and to help interest rates converge to the good equilibrium (governments pay lower interest rates and repay their debts). The creation of the EFSF and EFSM was appropriate. This policy act has been viewed negatively by citizens of the Euro centre and the periphery alike. The view of the centre citizens is that their governments accepted paying the debts of the periphery countries. The view of the periphery citizens is that the centre countries are imposing on their countries too severe austerity measures. Both views are wrong.

Centre governments agreed to temporarily lend money to the periphery at below market interest rates (since, as argued previously, the periphery seems currently a victim of a self-fulfilling prophecy). It is in the own interest of centre governments to avoid a needless default of the periphery’s sovereign debt (since centre countries banks own a large part of that debt) and there are good prospects of an adequate return to such loans. With the help of the centre, Euro periphery governments on the other hand avoid having to adopt even more severe austerity measures. Everyone gains from these interventions. Unfortunately the creation of such funds proved insufficiently to deal with the problem.


Figure 1: Bank deposits growth rate
Figure 1

Currently it is not just the Euro periphery governments which face severe financing difficulties. Figure 1 shows the bank loan growth rate of several Euro countries. As one can see there is a bank run in Euro periphery countries like Greece and Ireland (and also to less extent Portugal) with clients removing their savings from banks.

It is known that no bank would be able to fully return the deposit money of all their clients if they were all to do so at the same time (because the deposit money is being used in long term investments). All would be hurt. It is therefore necessary to prevent bank runs. Therefore the ECB interventions in December 2011 and February 2012 of providing three year loans to banks at low interest rates were also necessary. Unfortunately these interventions were also insufficient. A plausible explanation is that banks owe a lot of the sovereign debt of periphery governments and therefore to solve the bank run problem also involves solving the periphery sovereign debt problem. Another reason is the concerns with a potential Euro exit of some of the periphery countries. In this aspect I think that European leaders did not act in the best way. A Euro Greek exit has been mentioned as the inevitable consequence of a default on its debt (I think as a way to persuade Greek citizens to not vote for populist leaders that oppose austerity measures and also as a way to create political pressure in favour of a fiscal union supported by many politicians).

There is however no motive to link the use of a currency with the repayment of debts (when an American citizen defaults on its mortgage this does not prevent him/her continuing to use the dollar and when the state of Arkansas defaulted on its debt in 1933 it was not forced to abandon the dollar). I think a default on sovereign debt may become a necessary measure for the Greek government (or others in the periphery) but this should not imply a Euro exit. By establishing a connection between the repayment of debt and Euro membership European politicians contributed in a needless way to the worsening of the run on banks. The fear of a Greek exit from the Euro is in my view aggravating the economic situation in Greece (why would a company pay its suppliers today in Euros if there is a chance it can pay them tomorrow in Drachmas instead? Suppliers are aware of this and therefore reduce credit to clients).

Since prior interventions failed to address the problems of sovereign debt and run on banks, further stronger measures were needed (especially because financial markets are highly interlinked and therefore very vulnerable to contagion; one should recall that the Great Recession started in a small section of the USA mortgage market and from there spread to the US and European financial sectors – that is, there is the risk the current periphery problems will spread to the Euro centre and even beyond the eurozone). It is in this context that one should look at the recent ECB intervention on September 6, 2012. The ECB is proposing to buy debt in unlimited quantity, from the countries in difficulties, as long as such countries commit to adopting structural changes in order to increase long run growth perspectives (a problem which, except for Ireland, has plagued most European countries for a long time).

This seems to me to be the best solution to the eurozone problems. An alternative solution could be to allow the default of sovereign debt of periphery countries. If this leads certain banks into bankruptcy as a result then new investors would be invited to buy their assets maintaining their responsibilities to depositors (the old shareholders and other creditors would suffer the losses). However, this would be a risky solution; one needs only recall what happened after the Lehman Brothers bankruptcy.

Another possible solution, desired by many, would be a fiscal union. This would however be very complex to implement (it would take years to negotiate) and the fears of centre countries to adopt it seem understandable. One other solution would be for the ECB to simply buy the sovereign debt of those countries facing difficulties unconditionally. However, if those governments did not repay their debts the eurozone would go through a period of high inflation (the outcome would be a real loss of value of the savings of Euro citizens and it would certainly be costly to return to an environment of low inflation – in the USA, the necessary credibility needed to conquer inflation in the early 80s was achieved with large interest rate increases by the FED leading to a severe recession with unemployment reaching levels not seen in decades).

The solution chosen by the ECB can be quickly implemented and with the scale that is deemed necessary (it has therefore a good chance of solving the bank run and sovereign debt problems) and by requiring long term structural changes to the beneficiary countries it attempts to ensure these will be able to repay the debt (avoiding not just a future inflation problem but also achieving finally a way out of the European growth stagnation problem – there was a significant differential between the eurozone periphery and the centre in the 90s and unless structural reforms are made, periphery countries will not likely be able to borrow again at rates as favourable as those of the centre, as occurred during the first decade of the Euro).

Another important measure under discussion is that of the creation of a eurozone banking union. If there had been greater shared responsibility for deposits, supervision and regulation the current problems would not be as large (particularly in the cases of Ireland and Spain). It is also relevant to improve the regulation of the financial sector (which was at the core of the Great Recession).

To remove the implicit government subsidy to large financial firms is very hard (particularly after the bailouts of recent years, certainly everyone expects governments to rescue systemically important institutions) but it is important to reduce it (possibly through living wills which would give regulators a plan for shutting down complex financial firms).

Due to such difficulty, it seems necessary to me to also have regulation which separates commercial banking from more risky financial activities (as proposed by the Vickers commission and the Volcker rule) and/or higher capital requirements (as required in Basel III). This is also not an easy proposal, since one does not wish excessive regulation to prevent financing of good investment projects and also because the complexity of financial activity makes it hard to detect infractors.


Figure 2: Current account balance in percentage of GDP
Figure 2

Could a Euro exit also be a good solution for some of the Euro periphery countries? I’m of the firm opinion the answer is no. Figure 2 (above) shows the current account balance in percentage of GDP for several countries after 2008. The graph is a good illustration of some of the evidence mentioned previously. Despite having lost competitiveness similarly to periphery countries, the Netherlands has a trade surplus (an indication that periphery deficits are indeed, for the most part, not the result of an exchange rate misalignment). Iceland, whose currency fell sharply in value in 2008, is also an interesting case. One can see how significantly its current account improved subsequently as a result. However, this did not solve the core problem (its current account stopped improving since mid 2009). If one looks at recent data it is possible to see that Iceland is the country with worse current account balance of those considered. On the other hand, Portugal has obtained consistent and sizable improvements in its current account.

It doesn’t seem to me therefore desirable for periphery countries to exit the Euro. The benefits of currency devaluation would disappear after a relative short time period (two to three years, possibly less…). In the long run it is improbable that there are benefits of devaluation (Kalyoncu, Artan, Tezekici e Ozturk, 2008, looked at devaluation episodes in 23 countries and found long run output growth to be affected in only nine countries, in six countries there were negative long run effects and in three there were positive long run growth effects).

If a periphery country decides to leave the Euro the costs will certainly be high. Banks will enter bankruptcy although their foreign debts will stay denominated in Euros whereas their domestic assets would be redenominated in a new currency of lesser value (this would certainly negatively impact credit availability to citizens and businesses alike). There would be a massive bank run on deposits. There would be litigations for years to decide which contracts should remain in Euros and which should see conversion to the new currency. A Euro exit would certainly be a traumatic event. Would it be worth it for benefits that would perhaps last only two years (Rose and Yellen, 1989, results even question whether there are significant effects in the short and medium run)?

That is, the creation of the Euro may not have been a good idea, but currently exiting the Euro looks to me to be certainly a bad one. There are many that compare the Euro to the gold standard in place at the start of the Great Depression. There are certainly similarities but many differences as well. The gold standard was more than a fixed exchange rate system. The gold standard prevented countries in recession from adopting expansionary monetary policy. This does not happen with the Euro (since the start of the Great Recession the ECB has reduced its target rate significantly and expanded its balance sheet substantially).I also do not think the Euro is condemned to failure due to the absence of a fiscal union (Ireland maintained a fixed exchange rate with the UK between 1922 and 1979 without major problems).

Are there other alternatives to Euro periphery countries to austerity and structural reform? The ECB reference rate is still higher than those of the BoE and FED, so there is still room for further expansionary monetary policy on its part. However when interest rates hit close to zero, monetary policy becomes increasingly difficult (see for example John Cochrane’s blog post of September 4, 2012).

Another much debated idea is that of fiscal stimulus. Keynesian theory predicts substantial multipliers when interest rates are at the zero lower bound. This can certainly be an option for countries like the UK, USA and Germany but certainly not for the Euro periphery since these governments cannot obtain financing at low interest rates (but it should caution against the dangers of too much austerity). Even for the USA and UK I have serious doubts whether fiscal stimulus is a good choice. The empirical evidence of large fiscal multipliers is quite a controversial issue in economic research (Barro, 1991, did not find substantial multipliers; for a recent survey of favourable evidence to fiscal stimulus I recommend Romer’s 2011 Hamilton College’s lecture). The success of such policy would also depend on increasing government spending during the recession and then reduce spending (to avoid future increases in distortionary taxes) once the private sector returns to a robust growth path.

But would it be easy for future governments to cut public spending? Would it be easy for future governments to cut civil servant wages or pensions? It seems to me the answer is no; politically it would be much harder to make unions and pensioners accept cuts when the economy returns to robust growth (in practice the increase in government spending would likely become permanent). Another problem is that financial crises can lead to prolonged recessions (one needs only recall Japan’s lost decade). Certainly it could prove problematic for even countries like the US, UK or Germany to sustain large systematic deficits for a long period of time.

I don’t believe therefore there is a magical cure that would enable Euro periphery countries to avoid adopting austerity measures and structural reforms. The return path to prosperity isn’t easy but I certainly believe in the ability of Euro periphery countries to achieve it (the Irish example in the 90s shows well how adopting good institutions can quickly change a country’s wealth creation dynamics)


João Madeira

University of Exeter



Data for figure 1 can be obtained from the ECB website:

Data for figure 2 can be obtained from the OECD website:

John Cochrane’s blog can be found here:

Barro, Robert J. (1981). “Output Effects of Government Purchases,” Journal of Political Economy, vol. 89(6), pages 1086-1121, December.

Kalyoncu, H., Artan, S. ,Tezeciki, S. & Ozturk, I. (2008). “Currency Devaluation and Output Growth: Empirical Evidence from OECD Countries.” International Research Journal of Finance and Economics, 14: 232-238.

Romer, C. (2011). “What Do We Know about the Effects of Fiscal Policy? Separating Evidence from Ideology”, invited lecture at Hamilton College, November 7.

Rose, Andrew K. & Yellen, Janet L. (1989). “Is there a J-curve?,” Journal of Monetary Economics, vol. 24(1), pages 53-68, July.

Myths and facts of the Euro crisis part 3 – capital flight and financial instability in the Eurozone – an analysis by João Madeira

My previous texts seem to suggest that the Euro is likely not the main cause for the problems several European countries currently face. If not the Euro, then what is the origin? The cause must be common not just to the periphery countries of the Euro but also to those other countries which have been significantly affected by the Great Recession. The factors that lead to the Great Recession are several and complex (I must confess I don’t really understand well a lot of what happened – if it was obvious then governments, regulators, economists or investors, among others, would have taken measures that would have prevented the recession). In my view the explanation seems to be behind the deregulation of the financial sector and the liberalisation of capital movements; the work of Reinhart and Rogoff (2008) shows empirical evidence that such factors are typically associated with financial crises.

The liberalisation of capital movements after the Maastricht treaty, which became effective in 1993, led to large capital movements from the countries which today constitute the center of the eurozone to the countries which make up the periphery of the current eurozone (and other countries, like Iceland which is also part of the European Economic Area), where it was possible to obtain better returns due to their less developed financial systems. This explains the large current account surplus in the Euro centre countries (like Germany and Netherlands) and the deficits in the Euro periphery countries and Iceland (where the deregulation of the financial sector in 2001 further worsened the situation).

Many attribute to the Euro the main role behind the periphery deficits since these countries lost competitiveness relative to Germany, lacking their own currency to correct the imbalance. This seems unlikely, as the Netherlands also lost competitiveness to Germany and had a trade surplus whilst Iceland (which did not join the Euro) was by far the country with largest current account deficit in this period (Poland also had large deficits in this period without being a member of the Euro and the same can be said of Slovakia, that only joined in 2009, or Estonia that joined only in 2011). Past research in economics has simply not found a strong and robust empirical relation between exchange rate misalignments and current account deficits (see for example Auboin and Ruta, 2012; Huchet-Bourdon and Korinek, 2011 or Chinn and Wei, 2012).

The great financial centres, like the UK but mostly the USA also experienced large current account deficits at the end of the 90s and in the early 21st century. In this case, the capital originated mostly from East Asia (particularly China) and also the Middle East (where high oil prices allowed for high savings as well). The high saving rates in these countries (the study of Wei and Zhang, 2011, suggests an imbalance in the sex ratio of young adults as one of the main factors which explains the high saving rates in China) did not encounter adequate investment opportunities in the undeveloped home financial markets and therefore flowed to countries with sophisticated financial markets like the USA (another likely contributing factor was China’s exchange rate policy of maintaining a devalued currency to favor its exports).

The study of Ito and Chinn (2007) confirms empirically this strange phenomenon – while among industrialised economies (like those in Europe) the growth of the financial sector leads to large current account deficits, the opposite happens in developing economies.

In theory, liberalisation of capital movements is something positive as it allows for a more efficient capital allocation. My speculation for the association of capital liberalisation and financial crises is as follows. Initially capital flows to those countries where it can obtain the best returns; however, when the best investment opportunities end, the flow of capital persists. The reason for this may be because the capital owners do not mind that the financial sector directs the capital to projects of dubious value because they trust the government to rescue those financial institutions from bankruptcy in case of need (that is, the financial sector benefits from an implicit government subsidy).

The bank managers have an incentive to make loans even to dubious projects since bad loans will likely only be recognised as such in the medium and long run (in the meantime managers have already received bonus from the making of such deals). The clients who receive the loans also have an incentive to go ahead with a dubious investment since if it proves disappointing they will not have to fully repay the loan. This explains why so much capital was diverted to the housing market. While supply does not keep up with demand (it takes time to build new houses and obtain the necessary permits) prices increase and the investments see a positive return. Once supply adjusts to demand housing prices fall and investors suffer losses. After this, capital flows reverse, credit tightens and a recession follows (without credit, it is hard for companies to develop new projects or expand their current business).

Public finances also suffer greatly not just because of the bail-out of the financial sector but mostly (see Reinhart and Rogoff, 2008) due to the loss of revenue (businesses in trouble do not pay much tax) and increase in social transfers (such as unemployment subsidies). Countries with a current account surplus are also affected in a negative way (but in a less extreme way) since their banks see their assets abroad lose value (French and German banks suffered large losses due to exposure to American subprime mortgages and Greek sovereign debt) and see a fall in exports.

Figure 1 below shows the growth rate of bank loans in several Euro countries. One can see that the credit crunch was particularly severe in Ireland (which explains why Ireland despite having good economic institutions has been so greatly affected by the Great Recession) and Greece.


Figure 1: Bank loans growth rate
Figure 1

It was not just the private sector that saw its credit access worsened. Initially governments were not affected but in 2010 Greece saw its interest rate rise significantly. In 2011 Portugal and Ireland also saw its interest rates increase sharply. One can see this in Figure 2 below which shows the long term interest rates for several countries. One can see that during the period of credit abundance the Euro periphery countries saw their interest rates decrease substantially (the differential that existed relative to the Euro centre countries practically disappeared). With the Great Recession and the reversion in capital movements the interest rate differential between the periphery and the centre resurged. In this aspect I’m convinced the Euro played an important role in the worsening of the crisis. The only countries which saw their interest rates rise dramatically were those of the Euro periphery (one can see for example that the UK, USA and Iceland were not affected to the same extent). De Grauwe (2011) explains that one of the reasons for this is that countries that belong to a monetary union are more vulnerable to self-fulfilling prophecies (for fearing a default on the debt, lenders demand higher interest and this leads to the fulfilling of their fears) due to having no control of the currency in which their debt is issued. De Grauwe (2012) shows evidence that a self-fulfilling prophecy explains a significant part of the rise in interest rates of the Euro periphery countries.


Figure 2: Long term interest rates
Figure 2


João Madeira

University of Exeter



Data for figure 1 can be obtained from the ECB website:

Data for figure 2 can be obtained from the OECD website:

Auboin, Marc & Ruta, Michele (2012). “The Relationship between Exchange Rates and International Trade: A Literature Review,” CESifo Working Paper Series 3868.

Chinn, Menzie & Wei, S.J. (2012). “A faith-based initiative meets the evidence: Does a more flexible exchange rate facilitate current account adjustment?” Review of Economics and Statistics.

De Grauwe, Paul (2011). “The Governance of a Fragile Eurozone.”

De Grauwe, Paul & Ji, Yuemei (2012). “Mispricing of Sovereign Risk and Multiple Equilibria in the Eurozone,” mimeo, Jan 2012

Huchet-Bourdon, Marilyne & Korinek, Jane (2011). “To What Extent Do Exchange Rates and their Volatility Affect Trade?,” OECD Trade Policy Working Papers 119.

Ito, Hiro & Chinn, Menzie (2007). “East Asia and Global Imbalances: Saving, Investment, and Financial Development,” NBER Working Papers 13364.

Reinhart, Carmen M. & Rogoff, Kenneth S. (2008). “Banking Crises: An Equal Opportunity Menace,” NBER Working Papers 14587.

Wei, Shang-Jin & Zhang, Xiaobo (2011). “The Competitive Saving Motive: Evidence from Rising Sex Ratios and Savings Rates in China,” Journal of Political Economy, vol. 119(3), pages 511 – 564.


Myths and facts of the Euro crisis part 2 – labour regulation and unemployment – an analysis by João Madeira

In Anglo-Saxon countries the Euro seems to be seen in a very negative way. Many look at the Euro as an institution which reduced the vibrancy of the economies that adopted it. Table 1 below dispels this idea. Yes, it is true that until the Great Recession the UK, Iceland and USA grew more than most Euro members, but this was also true before the creation of the Euro.


Table 1: Average GDP growth rates in percentage
Table 1

Also, the country which grew most during this period was Ireland, one of the Euro members. The Netherlands, another Euro member also had a good performance. What then explains the lack of dynamism of Euro economies? I think the answer is in excessive regulation which becomes an obstacle to economic growth. A paradigmatic case is the labor market. Table 2 displays the OECD’s Employment Protection Index and appears to confirm the hypothesis of a negative impact on economic growth of excessive labour regulation. The only economies which managed to sustain robust growth rates for a significant period (Greece and Spain were only able to do so for a brief time) were exactly those with less labour regulation (Iceland, Ireland, UK, USA and Netherlands).


Table 2: OECD Employment Protection Index
Table 2

Is it coincidence? I think not. Excessive labour regulation limits the growth of productivity (for example, by preventing the relocation of workers to more useful activities) and discourages investment (a private business always has significant risk, a potential investor might decide not to go through with it if he/she knows that later it will be very costly to reduce the workforce).

Besides being a serious obstacle to the long run economic potential of many Euro economies, I believe that excessive labour regulation (and not the Euro) has played a determinant role in the truly tragic situation which many periphery Euro countries face today. Figure 1 shows us how unemployment rates in the periphery countries have increased dramatically after the Great Recession. As we saw in Table 1, Iceland and Ireland suffered as much as Greece in terms of GDP loss. The UK suffered similar output loss to that of Spain, Italy and Portugal. But Figure 1 shows that in terms of unemployment increase the economies of these countries responded in very different ways. In 2011 the unemployment rate of Iceland was 7%, Ireland’s 14% and Greece’s 18%. In the same year, the UK, Spain, Italy and Portugal had unemployment rates of 8%, 22%, 8% and 13% respectively. Is it a coincidence that the two countries (Spain and Greece) which have the more rigid labour markets are precisely those which suffer higher unemployment? On the other hand, of the countries with less regulated labour markets, only Ireland experiences one of the highest unemployment rates (and of the more regulated countries only Italy did not see a dramatic increase). Despite unemployment rates in Iceland and UK having increased, these did not reach the levels seen in the other countries that suffered similar output losses.


Figure 1: Unemployment rate
Figure 1

What can explain this? A recent study by Shimer (2012) indicates that increases in unemployment rates are explained mostly by a reduction in hiring and not by increases in firings. That is, excessive labour regulation can contribute to a rise in unemployment in a recession because the negative effects in terms of a reduction in hiring outweigh the positive effects of reduced firings.

Excessive regulation also contributed in another way to the amplification of the effects of the recession in periphery countries (for those interested in anecdotical evidence I suggest the reading of John Cochrane’s blogs here and here which describe some of the difficult situations which businesses face in periphery countries). Let’s look at Table 3 which shows the proportion of enterprises per number of workers in several European countries.


Table 3: Enterprises share (in percentage) per number of workers (year of 2005)
Table 3

One can see that except Ireland (and to some extent Portugal), the periphery economies of the Euro have a much smaller share of medium-sized and large-scaled enterprises in comparison to other European countries (this likely indicates, that excessive regulations make it difficult for companies to grow beyond a certain point and/or regulation shields the current large enterprises from new competitors). How can this explain that the Euro periphery has been more intensively affected by the Great Recession? Well, it is precisely small enterprises which are more credit constrained and exhibit higher business cycle volatility (Gertler and Gilchrist, 1994). Economies which have a higher proportion of small firms are therefore more vulnerable to credit contractions. Smaller firms also typically export much less (in the EU only 8% of small and medium-sized enterprises export while 28% of large-scale enterprises do) and therefore reducing the obstacle to the growth of these firms would also help these countries to increase their exports.


João Madeira

University of Exeter



Data for tables 1, 2 and figure 1 can be obtained from the OECD website:

Data for Table 3 can be found at the EC website:

John Cochrane’s blog can be found here:

Gertler, Mark & Gilchrist, Simon (1994). “Monetary Policy, Business Cycles, and the Behavior of Small Manufacturing Firms,” The Quarterly Journal of Economics, vol. 109(2), pages 309-40, May.

Shimer, Robert (2012). “Reassessing the Ins and Outs of Unemployment,” Review of Economic Dynamics, vol. 15(2), pages 127-148, April.

Myths and facts of the Euro crisis part 1 – an analysis by João Madeira

The Euro crisis is maybe the most important economic question of the moment. Despite being a highly debated matter, I think that the discussion hasn’t always been the best for it has been too coloured by political sympathies and national pride. In my view, the facts should be the basis of the debate. After all, it is customary to say that one can’t argue with facts. So let’s start by seeing if the opinions frequently made regarding this issue are corroborated by the facts or if they’re instead just myths with scarce support.

The generalised opinion regarding the Euro crisis is that the periphery countries (Spain, Greece, Ireland, Italy and Portugal), that are going through severe difficulties in financing their public debt, are in this situation because they have abused their status as Euro members to finance large increases in public spending at the expense of the virtuous centre countries (Germany, France and Netherlands, among others). But is this true? Let’s look at the evolution of debt for several countries in the table below:

Table 1

One can see, that in the period between joining the Euro in 1999 (2001 in the case of Greece) and 2007 (before the Great Recession), only three eurozone members increased the size of the public debt: Germany, France and Portugal (to this group of “infractors” maybe we should add Greece who resorted to financial trickery to hide the true amount of its debt). Among the virtuous countries, that significantly reduced public debt, one finds Spain, Netherlands, Ireland and Italy.  The great increase in debt of Spain, Greece, Ireland, Italy and Portugal only occurs after 2008. That is, the large increase in public debt of these countries occurs as a consequence of the Great Recession (government spending increased due to the need to pay unemployment insurance, among other social expenses, while revenue fell since firms generate fewer profits) and not as a result of immoral behavior of the periphery countries. The generalised image of immorality of periphery countries (it is symptomatic that the media often refers to these countries as PIIGS) and virtue of the centre countries does not correspond to what actually occurred.

For those that believe that the public debt problem in the periphery countries was worsened by Euro membership let’s compare what happened in Euro countries to what occurred in Iceland and UK (which are not members of the Euro) after the Great Recession. Between 2007 and 2010 Greece’s debt increased from 106% of GDP to 148%. In the same period, Iceland’s debt increased from 23% of GDP to 81%. In Portugal debt increased from 67% to 88% and in the UK from 43% to 86%. Such facts make it hard to argue, that public debt in periphery countries would be better, if they were outside of the Euro.

Another commonly held opinion is that the creation of the Euro led to a too large increase in credit in the periphery countries of the Euro resulting in speculative bubbles in their housing markets (and therefore magnifying the effects of the Great Recession). The graph below (Figure 1) allows us to examine if such opinion is true (unfortunately the index does not include data for Greece, Iceland or Portugal):


Figure 1: Housing Price Index
Figure 1

The graph clearly shows that at the end of the 20th century and start of the 21st century there was a significant increase of house prices in all of the countries considered (apart from Germany) followed by a fall after the Great Recession. The pattern however is the same for periphery countries like Spain and Ireland and for centre countries like France and the Netherlands. The pattern is also the same for countries that were not Euro members (USA, UK and New Zealand). Does it make sense to blame the Euro for the price rises in housing in Spain and Ireland? If so, why not blame the dollar or the pound for the same having happened in the USA and UK?


Figure 2: Unit Labour Costs
Figure 2

Another common explanation for the current plight of the Euro periphery countries is that these have lost competitiveness relative to the centre. Figure 2 (above) shows the evolution of unit labor costs for several countries. One can see that the periphery countries have clearly lost competitiveness relative to Germany that maintained its labour costs nearly constant. However, one can also see that the evolution of labour costs in these countries was similar to what happened in Euro centre countries such as France and Netherlands and to countries which aren’t members of the Euro like the USA, UK and Iceland. Curiously Iceland was the country that lost more competitiveness relative to Germany since 1999. These facts make it hard for me to see the Euro as the cause of loss of competitiveness relative to Germany or for the current problems the periphery faces.

We have seen how untrue the image of immoral behavior on the part of periphery governments is (which unfortunately has contributed to make the inhabitants of centre countries think that the periphery citizens aren’t worthy of solidarity from centre governments) but what about the image that the Euro is an institution that benefited mostly the centre? To answer this let’s look at table 2 which shows the average growth rates before and after the creation of the Euro (the numbers for Greece would be similar if we were to consider instead the periods 1992-2000 and 2001-2007):


Table 2: Average GDP growth rates in percentage
Table 2

One can see that prior to the Great Recession only three Euro members grew less than before adopting the Euro (Netherlands, Ireland and Portugal) but most (Germany, Spain, France, Greece and Italy) grew more. Could this have been merely the result that those years were better for the world economy in general? Apparently no, for in the same period the UK grew at a slightly lower rate and the US at a substantially lower rate. The good performance of the centre relative to the periphery only occurs after the Great Recession. Could the Euro be responsible for this? I think the facts also contradict this idea. Among the countries which suffered the most since the beginning of the Great Recession one finds Euro members, such as Greece and Ireland but also Iceland, which does not belong to the eurozone. Among other countries which have also suffered significantly with the Great Recession one finds Euro members such as Spain, Italy and Portugal but also the UK which has its own currency. Therefore it seems to me also a myth the belief that the Euro has benefited the centre more than the periphery or that it has been one of the main factors behind the severe economic crisis which the periphery countries have experienced in recent years (unfortunately this myth has contributed to a feeling of antagonism of periphery citizens towards centre countries).


João Madeira

University of Exeter



Data for tables 1, 2 and figures 2 can be obtained from the OECD website:

Data for figure 1 can be found at the FRB Dallas website:

Understanding Sovereign Debt: Economics Meets Politics – Dr Giancarlo Ianulardo

1) The Problem of Sovereign Debt

Just as economic agents such as individuals, households and firms may take out a loan, sovereign states need to borrow when they run deficits. When the revenues are not sufficient to cover spending, the only solution is to borrow and make a promise to repay the debt in the future. Borrowing money is the same on an individual and collective level but with one crucial difference, a difference arising from the word “promise”. In a well functioning legal system, firms and individuals do not need to be trustworthy; they only need pledgeable assets which can be seized by national courts if the agent does not abide by the terms of the contract. No such thing as a “court” is available at the international level, but still individuals and countries are lending to other sovereign states. It is perfectly possible that a state could renege on its obligation, yet thanks to sovereign immunity it would suffer no consequences. Thus for almost thirty years economists have questioned the very existence of sovereign debt in the absence of enforcement by third parties.

Why does sovereign debt exist at all if there is no enforcement mechanism?

Two main answers were proposed by economists in the 1980s. According to the first “carrot” approach, lenders are able to obtain repayment because they are able to promise renewed lending, or more “carrots”, in the future if the debt is repaid. This is a reputational based approach. Indeed, according to this theory borrowers want to enjoy a stable level of consumption which is not possible when the income varies because of adverse economic conditions. Thus when sovereign states are forced to borrow during hard times, they need to repay their debt in order to avoid being cut off from future credit.

The second approach is a “stick” based one. According to the proponents, reputation is insufficient in sustaining loans owing to the possibility that countries could get money from lenders, save it in “Swiss banks”, declare default and use the proceeds of the “Swiss accounts” in the future. Only direct punishments (trade sanctions or even gunboat diplomacy) can sustain lending.

However, subsequent empirical research has shown that there is very little evidence of direct punishments, if any, and certainly not in recent times. Thus a different mechanism needs to be put in place.

Notice that the availability of a credible enforcement mechanism is in the interest of both creditors and debtors. Creditors can be assured of repayment, whilst as a consequence of this debtors will receive the loans in the first place. In the ‘90s economic theory explained the existence of sovereign debt using more sophisticated game theoretical models. These have revitalised reputational models and have explained the very existence of debt with the “cheating the cheater” mechanism. In practice, this theory demolishes the “Swiss bank” approach; it argues that if a Swiss bank honours the deposit of a defaulting government all the other lenders will not honour their debts towards the Swiss bank. Thus the criticism raised against reputational models no longer works. Though formally correct, this solution to the “Swiss bank” problem implies that a highly coordinated mechanism among creditors is in place.

In order to explain sovereign debt a more direct mechanism has to be found and recent literature has started to pay increasing attention to the political element. Indeed the missing element in the previous discussions has been the political one.

The decision to repay or default by a government differs radically from a similar decision by an individual agent because in the case of the government it is a political decision taken by political actors who are the agent of the voters-citizens who elected them.

Since political leaders try to maximise the possibility of remaining in power they will need to take decisions which do not hurt the median voter’s mood (and interests). This political economy element is present also in non democratic countries. Even here, political leaders make decisions that will not hurt political or economic elites and are unwilling to make decisions that could spark revolution. We will focus here only on democratic countries, with particular concern on the Eurozone crisis.

2) Sovereign Debt Crisis in the Eurozone

 The first key to understanding the present Eurozone debt crisis is to clarify that these are different crises. Countries involved in the crisis at the moment are Greece, Ireland, Portugal, Spain and Italy. Ireland and Spain have suffered a private sector crisis hitting the banking sector (Ireland) and the housing sector (Spain). The governments in these two countries have run large deficits to support the private sector bankruptcy, transforming the private debt into public debt. Though public finances were in order before the 2008 crisis with low debt to GDP ratio, the latter started to increase dramatically because of large deficits and this has led to a confidence crisis. In Greece, public finances were out of control; large public spending and low tax revenues led to an accumulation of debt, decreasing the confidence of foreign investors. Portugal may be considered as a half way case between the two preceding ones, with not so sound public finances (though not so dramatic as in Greece) but also private debt problems. Finally, Italy represents still another situation. The government had already accumulated a massive debt to GDP ratio at the beginning of the ’90s, when a debt restructuring process began. Since then, the Italian government has run almost always primary surplus (taxes were above public spending), and the deficit that has occurred at the end of each year has only been due to interest payments on the stock of the outstanding debt. Deficit to GDP ratio is the second best in the Eurozone after Germany and the government is committed to running a balanced budget (zero deficit) by the end of 2013. The main problem in Italy is the low growth rate.  This has dramatically affected the Italian economy in the last 20 years, (since the fiscal consolidation began), with an average structural gap of 1% GDP below the Eurozone each year. In other words, with good deficit to GDP ratio Italy can commit to repaying its creditors each year, but is struggling to reduce the stock of debt (which has been stabilised but is still at a high level). Thus if a shock hits the economy the debt may become explosive (though at the moment it is under control).

If one uses the debt to GDP ratio as an indicator, it is clear that a low denominator GDP negatively affects the ratio, but notice that this is not the only way to consider a country’s fiscal stance. Indeed it is not clear why one should compare a flow variable (GDP) with a stock variable (debt). Another option would be to compare two stock variables; liabilities (debts) and assets (private and public wealth of a nation). If this option was used, Italian sustainability would be seen very differently given the high savings (excluding government bonds) accumulated by Italians.

 3) Political Economy of Debt

 How can politics help us to understand the way ahead?

So far, we have seen that incentives do matter. However in the case of sovereign debt there may exist not only external incentives in the form of direct or indirect punishments by foreign lenders, but also domestic punishment in the form of firing the political leaders if their decisions are not aligned with the median voter’s interests. In this respect, the first thing to say is that we need to focus not on the aggregate stock of debt but mainly on external debt, i.e. debt not owned by domestic citizens. This means that the composition of debt is crucial. High external and low domestic debt make debt repayment far more unsustainable because domestic taxpayers realise they will have to pay a huge amount of taxes to repay debt, which is mainly held by foreigners. In some cases, defaulting on foreign debt may become extremely popular. The case of Greece is symptomatic of this unsustainability. Indeed ¾ of Greek debt is owned by foreigners, whilst only ¼ is owned by domestic agents. In the latter category, ½ are domestic banks and ½ are private citizens. This means that no more than 13% of private domestic citizens are owners of public debts. In these conditions it is easy to understand that domestic citizens do not want to repay the debt if this involves high sacrifices in terms of wage and pension cuts. A referendum in Greece which is now being discussed would only ratify this refusal. If the government calls a referendum it will lead to default and loss of European support, if the government does not, it may lead to further riots and protests. Something similar happened in 2001 in Argentina when the government cut wages in order to repay debt, leading to massive protests and a new president who immediately defaulted. On the other hand, German and French banks are the main debtholders of Greek debt and this explains their activism. Banks such as BNP would be at risk if Greece was to default and the French government would then have to intervene to recapitalise it. Iceland is another case where citizens were called to express their willingness to repay the debt of the bankrupt Landsbanki bank; they refused to pay for it. The situation would be quite different in countries like Italy where domestic citizens and institutions hold a large share of debt (50% – 60%).

 In conclusion, the aim of this discussion has not been to venture into the roots and consequences of the Eurozone debt crisis, but simply to shed some light on the difficult situation in which the countries hit by the crisis now find themselves. One important thing to understand is that sovereign debt is not risk-free. If lenders incautiously lend money to countries with large foreign debts at relatively high interest rates, they must be prepared to bear the consequences of their decisions, just as they were readily prepared to take advantage of the high interest rates. 

 Preliminary Bibliography to know more

 Congleton, R. D. (2002), The Median Voter Theorem, Center for the Study of Public Choice, George Mason University.

 Gros, D. (2011), External versus Domestic Debt in the Euro Crisis, CEPS Policy Brief, No. 243, 25 May 2011,

and Voxeu,

 Kolb, R. W., editor, (2011), Sovereign Debt, Wiley, Hoboken, New Jersey.

 Mauldin, J. and J. Tepper (2011), Endgame, Wiley, Hoboken,  New Jersey.

 Reinhart, C. M. and K. S. Rogoff  (2009), This Time is Different, Princeton University Press, Princeton and Oxford.

 Stein, J. L. (2011), The Diversity of Debt in Europe, Cato Journal, vol. 33 (2). 

This article first appeared in the November 2011 edition of The Witness

Does money make you happy?

The money-happiness link

The money-happiness link

Much has been said about whether money can buy you happiness; in advance of his book on the subject, colleague and fellow economist Dr Carlos Cortinhas examines some new research on the subject:

Common wisdom has always maintained that money can’t buy you happiness. But science, as it turns out, says otherwise. According to the widely cited work of Richard Easterlin, money does make you happy but only up to a point. Wealth beyond a certain amount does not make us happier: once we’ve achieved a reasonable degree of financial security (internationally, an annual income of roughly $15,000 per year) our basic needs are met and our sense of wellbeing does not improve as income rises. Or so studies by Easterlin and his followers have suggested.

A recent paper by Daniel Sacks, Betsey Stevenson and Justin Wolfers suggests that Easterlin and his followers got it wrong. After poring over data from 140 countries, they concluded that rich people are happier than poor people, people in rich countries are happier than people in poor countries and when countries get richer their people tend to get happier. Therefore, it appears that the happiness effect isn’t relative; it is based on a person’s absolute income.

These results stand in opposition to a number of previous studies on money and happiness that suggested that people were concerned only with the wealth of their next door neighbours. So, if you were keeping up with – or better yet, surpassing – the Jones’s you were fine. By that logic, people in impoverished countries could be happy if they were just a little bit better off than those around them. That conclusion was very appealing to people from prosperous nations.

The data for these studies invariably comes from large scale surveys such as the World Values Survey or the Gallup World Poll that include questions like “All things considered, how satisfied are you with your life these days?” or “Taking all things together, how would you say things are these days—would you say you’re very happy, quite happy, not very happy or not at all happy?”. These answers can then be transformed in a scale that allows for international comparisons and for the study of changing trends over time. An example of this is the findings in the World Values Survey, which has compiled data from over 350,000 people in 97 countries since 1981. This survey found that Denmark is home to the planet’s most contented citizens with Zimbabwe being home to the most miserable.

Adapted from “Subjective Well-Being, Income, Economic Development and Growth”, NBER Working Paper no. 16441 (October 2010), “The Data Is In, More Money = More Happiness: Justin Wolfers”, (January 2011) at:
Survey Says: People Are Happier” (August 2008), Bloomberg BusinessWeek at:

The economics (and mysteries) of poverty and hunger

Apologies for my absence of late: things have been rather busy. Still busy, in fact, which explains why I’m just going o post a link to another blog, rather than writing one myself.

More Than 1 Billion People Are Hungry in the World

There’s another reason for linking rather than writing: quality. The link takes you to a post written by Abhijit Banerjee and Esther Duflo, both from MIT and both as good as it gets in terms of economists studying poverty and hunger.

If their article (and all the papers underneath it) is right, then there are huge implications for policy and aid for under-developed countries and people. But not everyone agrees with how economists view poverty. Let me know what you think.

The Alternative Vote explained

With the Alternative Vote referendum fast approaching, here’s an attempt to demystify the process from my guest blogger, Professor John Maloney, an economics colleague and election expert.

Have you had the official leaflet describing the alternative vote system? In one way it’s doing a good job for first-past-the post, by making the counting procedure under AV sound endless. The bottom candidate drops out, their second preferences are allocated, there’s another count, the new bottom candidate drops out, and so on until one candidate has more then half the votes. Well, in Exeter, there were seven candidates last year. That sounds like anything up to five counts (when you get down to two, one of them must have more than half the vote – unless it’s a tie!). Goodbye to election night and welcome to counting week?  In fact it wouldn’t have been as cumbersome as that. Look at the actual Exeter result:

Ben Bradshaw (Labour) 19,942

Hannah Foster (Conservative) 17,221

Graham Oakes (LD) 10,581

Keith Crawford (UKIP) 1,930

Chris Gale (Liberal) 1,108

Paula Black (Green) 792

Robert Farmer (BNP) 673

What’s the first thing that strikes you about these figures, if you put your mind into AV mode? It should be the fact that, even had Mr Oakes received all the second-preference votes of all the bottom four candidates, he would have remained inexorably in third place and the next candidate to be eliminated. In fact, only two counts would have been needed; the original one and then a recount with the second preferences of all five bottom candidates given to either Labour or Conservative.

Who would have won? Ben Bradshaw beyond a doubt. The UKIP vote would have broken heavily for the Tories, but the Green vote would have been largely Labour.  As for the Liberal vote it’s hard to say; perhaps even harder to judge is the redistribution of the BNP vote, which might have split quite evenly between the allegedly right-wing Conservative party and the allegedly working-class Labour Party (and also the alleged protest voters’ party, the Lib Dems, had they still been in the frame.)  But, unless every opinion poll in the year before the election was wrong, a majority of the Lib Dems themselves preferred Labour to the Conservatives.  Quite possibly Mr Bradshaw would have ended up with a bigger majority than he actually got.

But the big imponderable is how far people will use their second, third and fourth choices. Obviously, if no one at all bothered with second preferences, AV would cease to be AV and first-past-the-post would stay in place. But how many people will put down a second choice? And how many people in Exeter would have ranked candidates all the way from one to seven?  An opinion poll last summer found that a large minority of voters would not bother to endorse more than one candidate.  But an opinion poll taken before the argument had even started may not be a good guide to how people behave if AV becomes the reality. Will candidates woo the voters along the lines of ‘if you can’t put me first please put me second, or failing that third – or even fourth, please?’  What they will probably stop doing is to say ‘please put me first, even if I’m your second choice, because only I can beat party X.’  Indeed supporters of AV have claimed that tactical voting  — backing the strongest challenger to the candidate you want to keep out – will disappear, and all first preference votes will now have the additional virtue of sincerity.

There will certainly be less tactical voting. But it’s not obvious there will be no tactical voting. Suppose your order of preference is Tory, Lib Dem, Labour, but you think that the Tory can’t win and that Labour will get the most first-preference votes.  Assuming the Lib Dem second preferences are more pro-Labour than the Tory second preferences, you will want the Tory second-preferences to count. How do you achieve that? By making sure that the Tory candidate, your actual favourite, drops out in the first round. Your (tactical) first-preference vote will be for the Lib Dems.

Is this a likely scenario or a university lecturer being tortuous? Nearer the second than the first, no doubt. But some voters might think like that, and it’s another factor which makes the consequences of AV as unpredictable as the result of the referendum itself.

The banking mess

Three-and-a-half years have passed since the banking run on Northern Rock in the UK, two-and-a-half since the collapse of Lehman Brothers in the US. And we’re still waiting for the government’s decision about what to do with the banks.

There’s been some tinkering. The Financial Services Authority, which bore more than its fair share of criticism for the banking crisis, has been broken up. Responsibility for financial stability has been given to the Bank of England: it has a new committee to look after it. The Chancellor has agreed Project Merlin with the banks: a deal that combines bonuses, transparency and lending. The Independent Commission on Banking has made some menacing noises about a possible restructuring of the banking sector; we’ll find out what that might mean in April, when it publishes its interim report. But given the scale of the banking disaster, and the general consensus that Something Must Be Done, it is remarkable that so little has been done so far.

Let me remind you how bad things have been. The 4 days in September 2007 saw the first run on the retail deposits of a United Kingdom bank since Victorian times. Since then, the UK government has committed at least £1.2 trillion to support the banking sector: equivalent to 85% of GDP, over 20 times the annual spend on education, over 10 times annual expenditure on health. Despite all this support, banking is still broken. The latest Bank of England figures are shown in the figure below: the annual change in the amount lent to small businesses (the blue line) and all small-and-medium enterprises (the orange line). With access to credit choked off, it’s not hard to understand why UK growth is so weak.


It gets worse. The Bank of England estimates that UK banks will need to raise up to £500 billion over the next two years just to replace existing funding. That is, none of this funding would be used for new lending: the banks have to run this hard just to stand still.

The underlying problem is that the banks’ capital is still at risk. About half of all loans issued since 2004 are in breach of their covenants. Commercial real estate accounts for about half of the loans outstanding in the UK; and commercial property values are currently around 35% below their peak.

So, something really does need to be done. (But we knew that anyway, even without all of the figures that I’ve just thrown at you.) There seems to be general agreement that banks cannot be allowed to be “too big to fail”. That leaves 2 broad options. The first is that banks gain enough capital that they are never again in any serious risk of failing. One of the causes of the crisis is the extent to which UK banks “levered” themselves: that is, lent more money than they actually had at any given moment. Banks have always done this, but the practice really took off over the last 10 years. The figure below (taken from the Bank of England’s financial stability report in December 2010) shows UK bank leverage over the last 50 years.


The second option is that banks are simply allowed to fail. In practice, that means that holders of senior debt in banks will lose some or all of their money, rather than having their investment protected by taxpayers. Unsurprisingly, they dislike this option. And being, on the whole, wealthy and influential individuals, they have done a pretty good job in convincing policy-makers that this option would simply cause investors to withdraw their money and invest elsewhere. But Denmark has chosen to go this route: when Amagerbanken failed on 7 February, bondholders lost 41% of their investment.

We shall see which option we go for in the UK. We are in the hands of John Vickers, who is heading the Independent Commission on Banking. The bad news is that’s he’s firmly part of the establishment (currently warden of All Souls College in Oxford, former head of the Office of Fair Trading and member of the Bank of England’s monetary policy committee). This may not bode well for taking on the might of the bankers. The good news is that he has some experience of taking on the establishment: he was, after all, behind the move to eliminate the notorious All Souls’ three-hour exam on a single word. The hope is that sorting the banks will be easy in comparison.

The outlook for 2011

It seems a shame to start off my new blog on a gloomy note. But it makes sense to open with the outlook for 2011. And there’s no way round it, I’m afraid. This year is not going to be much fun for most of us.

The problem that we face is an unpleasant combination of high price inflation and low growth. The current headline inflation rate (measured by the Consumer Prices Index, or CPI) was 3.7% in December. National income (measured by the Gross Domestic Product, GDP) fell by 0.5% in the last three months of 2010. It’s not as bad as the mid-1970s, where inflation hit 24% and GDP fell two years running. But that’s hardly a great comfort.

The surge in prices is mainly the result of 3 factors. There is strong demand elsewhere in the world, especially China roaring along at 10% growth, for rubber, cotton and fuel (and food, a bit). Bad weather in advanced countries has reduced the supply of cereals. With demand up and supply down, the simplest of economic models predicts higher prices, which is exactly what we’re seeing. It’s a reminder that the UK is small economy in a global market for commodities. In the UK, this is compounded by rises in taxes (VAT went up to 20% in January) which will add to the prices paid by consumers. By the latest forecasts, the average household in the UK is likely to pay around £950 more in 2011 for the things that it bought in 2010.

This wouldn’t be so bad if everything, including wages, went up at this rate of inflation. But wage inflation is muted: the average wage went up just 1.1% in the last 3 months of 2010. At that rate, the average household income will go up in 2011 by about £350, leaving quite a gap between income and expenditure rises. Worse still, lots of households face benefits cuts. Those reliant on the public sector for their jobs may face unemployment as the reductions in government spending really start to
bite. All in all, real wages (that is, wages after inflation is taken into account) are likely to be no higher in 2011 than they were in 2005.

How will policy-makers respond to all this? The Bank of England can hardly cut interest rates further; and will probably not raise interest rates soon, despite strong inflation. What would be the point? The causes of inflation lie mostly outside the UK. This is good news if you hold debt, like a mortgage; bad news if you’re a net saver. The Government has nailed its colours to the mast of reducing spending and increasing taxes, in order to reduce the deficit that ballooned to save the banks. (That’ll be the subject of a future post, by the way.) In short, not much to cheer anyone up much.

So, if you’ve yet to feel the effects of everything that has hit the UK over the last 2 years, 2011 may come as a shock.

I hope to be a bit less gloomy in my next posts. But with the banking situation to cover, I’m giving no guarantees.