September marked the 10-year anniversary of the Lehman Brothers collapse, the prelude to the worst global financial crisis since 1929. As we pass that mark, we are also approaching the 20-year anniversary of the launch of the Euro. And when the retrospective assessments of the Euro’s first two decades are written, they will all be set in the context of the economic disaster that followed the Lehman collapse.
Back in January 2009 European officials assumed that the crisis was purely a U.S. phenomenon, unlikely to affect European economies. This assumption could not have been farther from the truth; a recession started in Europe in the first quarter of 2009, just a couple of months after it hit the U.S.
But the real tragedy happened later: a timid recovery during 2010-11 was followed by a second recession starting in the third quarter of 2011, from which Europe did not start recovering until 2015. Yet the place where the crisis had originated, the U.S., avoided the second recession and continued its recovery. What went wrong? How could a crisis that started in the U.S. have caused so much damage in Europe?
The answer to those questions is threefold:
- Central Bank choices
Both the U.S. Federal Reserve and the European Central Bank followed broadly similar policies in reaction to the crisis, lowering interest rates and injecting liquidity. But they differed greatly in how far and when they applied these policies.
By December 16, 2008, interest rates were close to 0% in the U.S. The Federal Reserve had already engaged in quantitative easing (QE) by committing to buy about $1 trillion of securities, an amount than later grew through two additional rounds of QE. That same month, interest rates in the Eurozone were as high as 2.5% and took five months to go all the way down to 1%. And there is no doubt that the ECB felt uncomfortable with these historically low rates; at the first opportunity, in the summer of 2011, they pushed interest rates up again to 1.5%. There was, moreover, no attempt to introduce QE in Europe at this time.
It took a second recession in Europe, along with a change in leadership before the ECB undertook to do “whatever it takes” to save the Euro. Mario Draghi (who replaced Claude Trichet as ECB president) took interest rates down to zero and after difficult political negotiations, put a QE plan in place by 2015. Although policymakers agreed that the measures were necessary to prevent the Euro from breaking up under the pressure of the crisis, they came too late to save the Eurozone from its second recession in 2012.
- Fiscal policy
As the ECB’s bazooka began to run out of ammunition, all eyes were on fiscal policy. After an initial fiscal policy stimulus, Eurozone governments – especially those in struggling Southern European countries (Spain, Greece, or Portugal) – switched dramatically towards austerity in the years 2010-2014. Most experts now agree that these policies had such damaging and persistent negative effects on growth that they were self-defeating. Governments were reducing spending in order to bring their debt levels under control. But GDP fell so much that the actual effect was to push up the ratio of debt to GDP. As a result, debt became even less sustainable than before the austerity measures were implemented.
Why did the Euro area get its macroeconomic policies so wrong? Undoubtedly some of the mistaken decisions reflect poor judgment on the part of policy makers at the time. The ECB unanimously voted in favor of an increase in interest rates on July 7, 2011, because of concerns about inflation, which turned out to be, ex-post, a clear mistake.
But one cannot forget that policy in the Euro area is complex and subject to political constraints. QE was postponed because it was deemed to be inconsistent with the stated “no bailout” rule of the Euro treaties. Austerity was seen as the only correct policy because of the German view that the crisis was the outcome of a lack of discipline on the part of other governments. In the words of Jurgen Start, former ECB member: “The truth is that, in contrast to many Eurozone countries, Germany has reliably pursued a prudent economic policy. While others were living beyond their means, Germany avoided excess.”
While this might be a reasonable advice for an indebted individual, it is the wrong advice for countries and a disastrous policy when applied to all countries at once. In his 1936 book The General Theory of Employment, Interest and Money, John Maynard Keynes described what we can call the paradox of thrift: “the reactions of the amount of his consumption on the incomes of others makes it impossible for all individuals simultaneously to save any given sums. Every such attempt to save more by reducing consumption will so affect incomes that the attempt necessarily defeats itself.” In other words, if we all try to save at once, no one saves, and we are just poorer.
Where does the Euro go from here?
Ten years after the crisis, observers of the U.S. economy are asking whether we learned enough from the 2008 crisis about how to manage risk in the financial system. The Euro area is asking a very different question: whether we have learned enough about monetary and fiscal policy to better manage the next crisis. I am afraid the answer is no.
Interest rates today remain low (negative), monetary policy is far from normal with no room for decreases to stimulate the economy if a crisis happened. The ECB could do more QE, but it will likely face opposition by some countries – and ECB President Mario Draghi will not be around, as he will step down by October 2019. Fiscal policy is in no better place. Euro governments continue to struggle with high debt levels, leaving little room for a fiscal policy stimulus if a recession happens.
What’s more, to be effective, Eurozone governments would also have to coordinate their fiscal policies for them to have any effect. That will require a political consensus across the Euro countries, yet another challenge, for the fallout from the financial crisis of 10 years ago has not only left the region economically enfeebled but has also marked deep political scars. In the next crisis, it will not be easy for the ECB and Eurozone governments to put into effect the measures needed to prevent a repeat of the past 10 years.
So as we approach the Euro’s 20th birthday in January, let’s try to accentuate the positive in that achievement and find ways to strengthen the political ties underpinning this project. If our politicians cannot achieve some sense of common purpose, there is little likelihood that the Euro will celebrate a 30thbirthday in 2029.
Author: Antonio Fatás
Article first appeared in the Harvard Business Review