Financial Crisis

What lurks beneath the Euro

Don't celebrate yet, Mr. Draghi. Source: Reuters

Earlier this year, the consensus among economists was that the United States would outstrip its advanced-economy rivals. The expected spurt in U.S. growth would be driven by the economic stimulus package described in President Donald Trump’s election campaign. But instead, the most notable positive economic news from the developed countries in 2017 has been coming from Europe.

Last week, the International Monetary Fund revised its growth projections upward for the euro zone. The more favorable outlook extends broadly across member countries, including the Big Four: Germany, France, Italy and Spain. IMF chief economist Maurice Obstfeld described recent developments in the global economy as a “firming recovery.” Growth is also expected to pick up in Asia’s advanced economies, including Japan.

Iceland, which suffered its financial crisis in 2007, has already been dealing with a fresh wave of capital inflows for some time now, leading to concerns about potential overheating. In July, Greece — the most battered of Europe’s crisis countries — was able to tap global financial markets for the first time in years. With a yield of more than 4.6 percent, Greece’s bonds were enthusiastically snapped up by institutional investors.

Greek and European officials hailed the bond sale as a milestone for a country that had lost access to global capital markets back in 2010. Greek Prime Minister Alexis Tsipras said the debt issue was a sign that his country is on the path to a definitive end to its prolonged crisis.

Despite the good news, declaring victory at this stage appears premature.

And in the United States, the Federal Reserve’s ongoing exit from its ultra-easy, postcrisis monetary policy adds to the sense among market participants and policymakers that normal times are returning.

But are they? Do recent positive developments in the advanced countries that were at the epicenter of the 2008 global financial crisis mean that the brutal aftermath of that crisis is finally over?

Despite the good news, declaring victory at this stage — even one decade later — appears premature. Recovery is not the same as resolution. It may be instructive to recall that in other protracted postcrisis episodes, including the Great Depression of the 1930s, economic recovery without resolution of the fundamental problems of excessive leverage and weak banks usually proved shallow and difficult to sustain.

It is also worth remembering the “lost decade” of the Latin American debt crisis in the 1980s. Brazil and Mexico had a significant and promising growth pickup in 1984–1985 — before serious problems in the banking sector, an unresolved external debt overhang and several ill-advised domestic policy initiatives cut those recoveries short. The postcrisis legacy was finally shaken off only several years later with the restoration of fiscal sustainability, debt write-offs under the so-called Brady Plan and a variety of domestic structural reforms.

Finally, Japan has also suffered several false starts since its 1992 banking crisis. There were recoveries in 1995–1996 and again in 2000 and 2010. But they tended to be cut short by the failure to write down bad debt (the so-called zombie loans), several premature policy reversals and an increasingly unsustainable accumulation of government debt.

The euro zone emerged from the financial crisis in 2008–2009 with some economic momentum. Unlike the Federal Reserve, however, the European Central Bank hiked interest rates in early 2011, which contributed to the region’s descent into a deeper crisis.

History, therefore, suggests caution before concluding that the current upturn has the makings of a more sustainable and broad-based recovery. Many of the economic problems created or exacerbated by the crisis remain unresolved.

To varying degrees, all of the advanced economies have significant legacy debts, both public and private, from the excesses that begat the financial crisis, as well as from the prolonged impact of the crisis on the real economy. Low interest rates have eased the burden of those debts (in effect, negative real interest rates are a tax on bondholders), but rates are on the rise.

Political polarization in the U.S. and Britain is at or near historic highs, depending on the measure used. As a result, many critical but politically sensitive policies to ensure future fiscal sustainability remain difficult to implement in both countries.

The U.K.’s withdrawal from the European Union — and Brexit’s medium-term impact on the British economy — is another source of risk that hasn’t been tackled. How Japan will resolve its public and private debt overhang is yet to be determined. Inflation will likely be part of that resolution, as it is improbable that an aging population will vote to raise its tax burden and reduce its benefits sufficiently to put Japan’s debt trajectory on a sustainable path.

In Europe, the high level of nonperforming loans continues to act as a drag on economic growth by inhibiting new credit creation. Furthermore, these bad assets pose a substantial contingent liability for some governments. Target 2, the euro’s real-time gross settlement system, has emerged as the euro zone’s mechanism for financing the emergence of widening structural balance-of-payments gaps, whereby capital flows out of Southern Europe into Germany. For Greece, Italy, Portugal and Spain, public-sector debt must now also include their national central banks’ sharply rising liabilities.

Perhaps the main lesson is that central banks must be even more cautious in deciding whether the time is ripe to normalize monetary policy. And even in the best of recovery scenarios, policymakers would be well advised to tackle the structural reforms and fiscal measures needed to mitigate risk.


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