There is a widespread sense that what is happening in the European economy today is unprecedented – the fallout of an attempt at economic union without political commitment to fiscal transfers. There is some truth in this, but European exceptionalism is a myth. In many ways, the countries of Europe’s periphery are reading from a script that has already been played out by many developing countries. There is much to learn from those experiences.
There is a typical scenario, which begins when a country is chosen by financial markets as an attractive destination. The reasons can vary, from perceptions about its growth potential to simply being the neighbor of a “dynamic” country. (In the Eurozone, periphery countries were chosen to benefit from low interest rates because of sharing the same currency as Germany or other core countries). This preference sets in motion processes that are eventually likely to culminate in the crisis, through the effects of a surge of capital inflows on real exchange rates.
With flexible exchange rates, capital inflows cause the currency to appreciate, but even with fixed exchange rates (or in the Eurozone’s case the same currency) real exchange rates appreciate as domestic prices rise faster than those of trading partners. This appreciating real exchange rate encourages investment in non-tradable sectors, the most obvious being real estate and construction, and in domestic financial assets like stocks and shares. But it also makes exports more expensive and imports cheaper, discouraging investment in these tradable sectors and often contributing to their relative decline despite rapid overall growth.
All emerging markets that received large capital inflows also had real estate and stock market booms. These in turn generated the income to prop up domestic demand and keep some sectors growing at high rates. This resulted in a macroeconomic imbalance, mostly not in the form of rising government deficits, but current account deficits reflecting debt-financed private profligacy. At some point, markets decide that this trend is unsustainable. We know that any factor, even the most minor or apparently irrelevant one, can trigger capital flight and financial crisis. Contagion is also a strong factor.
When that happens, countries are blamed for being “irresponsible” and “imprudent”, with fingers pointed at either public or private behaviour. But this misses the point, which is that when a country cannot control the amount of capital inflow or outflow, both movements can create consequences which are undesirable. Large capital inflow must necessarily be associated with current account deficits, unless the inflows of capital are simply (and wastefully) stored up in the form of accumulated foreign exchange reserves. This has indeed become the precautionary strategy of choice in the developing markets, but it is pointless (because money that comes in is not spent within the country) and expensive (because losses in holding reserves that are determined by differences in interest rates).
Therefore, with completely free capital flows and completely open access to external borrowing by private domestic agents, there can be no “prudent” macroeconomic policy; the overall domestic balances or imbalances will change according to behaviour of capital inflows, which will in turn respond to the economic dynamics that they themselves have set into motion.
This is really what has also occurred in Europe, particularly after the formation of the Eurozone. Private investors (banks and others) funnelled savings from the richer core countries to the poorer ones at the periphery, creating processes that led to what is now celebrated as the “productivity divergence” between north and south in Europe, but is more fundamentally a reflection of these same macroeconomic forces. If the run-up to the crisis is similar, what about the denouement? Here too, the global south can offer lessons. Adjustment through domestic contraction is hugely painful, socially devastating and often politically convulsive. Also, it does not always work; such a strategy eventually generates a recovery only if exports increase enough to make up for the collapse of domestic demands. This is much easier if countries can depreciate their currencies, but even that is not necessarily sufficient. Additionally if the world economy is not growing at that time, the chance of a recovery is generally slimmer.
The crisis can then involve not just short-term damage but longer-term loss of potential output and sometimes a different growth (or stagnation) trajectory altogether. Simply rescheduling the debt does not help; it delays the problem but then usually makes matters worse by adding to the eventual debt burden.
The countries that bounced successfully out of financial crisis in recent times to generate real recoveries in activity and employment – for example Malaysia or Argentina – are those that did not play by the rules laid down by the global establishment. They imposed capital controls, “restructured” their debts (effectively defaulted on some it), used expansionary fiscal policies to come out of slumps, and did other things that are frowned upon by the powers that be. But it is only the creative responses that work. So if the European periphery – and Europe in general – is to come out of the economic hole it has dug for itself, it may need to start “thinking out of the box” and look at these other experiences more seriously. The question however is, can this occur at all within the straitjacket imposed by the currency union and its present leadership?
Stuart Anthony Yeomans
Kuala Lumpur : Malaysia