Posted by: Dirk | February 12, 2010

Emergency in Eurozone

I am really amazed how long it took for some to understand the woes of the Eurozone. And what is more, why did the troubles of Greece, which are relatively minor, start it all of? I think reflexes of the financial press are stronger with government debt crises than with bank (or other private sector)  debt crises.

Anyways, let me copy&paste. The following is taken from the post Will the euro act like the gold standard of the Great Depression? from November 14th 2009 and concerns Spain, not Greece (for those of you close to academics, yes, this is the old transfer problem revisited):

So, what is the right economic policy for Spain today? Before we answer this question, let’s see how economic policy will look like if the EU does follow the rules. At some point, the ECB’s interest rate will go up. That is pure pain for Spain, which will still be shaky at that time since it’s the laggard. The notorious EURIBOR, on which interest rates in mortgage contracts are indexed will rise, leading to higher debt payments. At the same time, a rise in the interest rate will make things more difficult for the financial sector as well. More costly capital might leave some firms underwater, and without a hope of ever coming up again. This will be about expectations also. Third, the real economy is harmed since firms will invest less. This might lead to more or longer periods of deflation, which makes debt repayment for Spanish households all the more difficult. Especially so, since at the same time nominal wages will be falling and nevertheless unemployment will continue to rise.

What Spain would need is more exports in order to repay debt. Domestic demand alone is too weak to bring about something close to full employment in Spain. However, with the euro there is no monetary policy option and fiscal policy is out as well. The stability and growth pact states that fiscal deficits cannot rise above 3% of GDP a year, and also it does not apply now it will in 2012. Even if the pact is scrapped, one wonders whether Spain can increase its government debt by much. The old solution of depreciating the currency is out, too, since Spain is part of the euro zone. A different price level from the rest of the EU is also difficult to achieve since there is the common market, which should lead to arbitrage whenever price differentials in tradables show up. The whole weight of adjustment therefore lies on wages. In order for Spain to export more, wages have to come down (or productivity go up, but this is not going to happen). With wages coming down, Spain will have prolonged deflation and also very big problems with repaying its debt.

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