Austerity and the Eurozone

There has been much discussion recently about the austerity measures being imposed on Greece, Italy and others in the Eurozone in the interests of returning their budgets to balance and implementing much needed structural reforms. The question is not whether these measures are necessary, but whether in the current economic situation they are achievable.

Firstly, some basic economics.

If a country runs a trade surplus it is a net exporter of goods & services and an equivalent net importer of capital. Conversely, if a country runs a trade deficit it is a net importer of goods & services and an equivalent net exporter of capital.

If a country runs a fiscal surplus it means that the government's income is greater than its spending. Conversely, if a country runs a fiscal deficit it means that government spending is greater than its income.

There is of course a relationship between trade surplus(deficit) and fiscal surplus(deficit). If the domestic private sector is balanced (neither spending overall nor saving overall), then a country with a trade surplus will also have a fiscal surplus, and a country with a trade deficit will also have a fiscal deficit. If the private sector is spending overall, then a country with a trade deficit may still have a fiscal surplus due to indirect taxation increases. Conversely, if the private sector is saving overall (or paying off debt), a country with a trade surplus may still have a fiscal deficit because of reduced tax income. The most poisonous mixture is a country with trade and fiscal deficits where the private sector is net saving, which makes for an economy dangerously close to recession. British readers will recognise this as the UK's problem....which I shall return to in another post.

The trade flows between countries net to zero. So within an economic area, such as the Eurozone, a trade surplus in one country must be balanced by trade deficits in one or more other countries. Everyone wants net exports, but not everyone can have them. Which is why the "exports are good, imports are bad" view that is so prevalent at the moment is economically nonsense.

Countries usually issue debt to cover their deficits, so the longer a country runs a fiscal deficit the deeper in debt it will be. If attempts are made to cut a fiscal deficit without also reducing the trade deficit, either by increasing exports or cutting imports, the deficit is in effect transferred to the private sector who are forced either to use existing savings or borrow to pay for goods and services previously paid for by government. If the private sector has no savings (or is unwilling to use them) and is unwilling or unable to borrow, then cutting a fiscal deficit without export growth causes recession. I hope this is clear.

How does all this stuff about trade and fiscal surpluses and deficits apply to the Eurozone?

Germany  has a large trade surplus with its Eurozone partners. As Gavyn Davies points out, the excess of its exports to Eurozone countries over its imports from them just about balances the trade deficits of Greece, Italy, Portugal and Spain combined. These countries all have excessive public debt, and all except Italy have fiscal deficits - and Italy has only achieved primary balance this year. Basically, the four of them have imported from Germany more than they have exported to it, and they have funded those purchases by borrowing from, among others, German banks. Germany has therefore benefited from the debts taken on by those countries, not only because of the income generated by the exports themselves, but also because of the interest paid by those countries to German banks. It is fair to say therefore that Germany's trade surplus with the Eurozone is funded by the excessive debts taken on by those four countries, and that its fiscal surplus arises from taxes paid on income from exports and lending to those countries.

In the Eurozone, like everywhere else in the Western world, the private sector is already highly indebted and unwilling or unable to take on more debt. For deficit countries to reduce their fiscal deficits, therefore, their trade deficits must also reduce. One of the major issues that these countries face is that the locked exchange rate within the Eurozone makes their exports uncompetitive compared to Germany's. Making their exports competitive requires massive reduction in the cost of production, particularly labour costs, which is politically immensely difficult to do. It is highly unlikely therefore that their trade deficits will reduce due to increased exports. But if Germany's Eurozone trading partners reduce their trade deficits by cutting imports - which is already happening - then its trade surplus can’t possibly be sustained. Germany’s economy is heavily reliant on exports to the Eurozone. Balanced budget measures in other Eurocountries will therefore force the German economy to shrink unless it increases its exports outside the Eurozone. It is in fact doing this, but whether it can increase external exports enough to compensate for declining Eurozone exports is questionable.  And this does of course undermine the whole purpose of the European Union, which was to promote trade between European countries.

Currently the issue of trade imbalances is being ignored by the Eurozone leadership, especially Germany's Merkel, and the insistance on fiscal austerity in deficit countries is not balanced by a requirement for fiscal loosening in surplus countries. They don’t seem to understand that since within a currency union the usual monetary tools such as interest rates and exchange rates can't be used to control trade flows, fiscal policy must substitute for these ON BOTH SIDES.

So why is the Eurozone leadership, against all sound economic advice, so wedded to the idea that austerity measures alone will achieve balanced budgets and growth in deficit countries without compensatory fiscal loosening in the surplus countries and redistribution of surpluses to the deficit countries?

Value judgements about government financing - deficit = "bad", surplus = "good" - skew government decision-making in favour of spending restriction that may not be the most appropriate course of action in the economic circumstances. So in the Eurozone, deficit countries ("bad", profligate) must reduce their spending and make structural reforms, but surplus countries ("good", prudent) are models of fiscal rectitude so need make no changes.

These value judgements are completely unhelpful. "Good" and "bad" depend on your point of view. Someone who is a thrifty net saver is likely to regard saving as "prudent" and spending as "profligate".  Someone who has a less frugal lifestyle and spends instead of saving may well regard saving as "selfish", if it means others go without, and spending as "generous". Neither has any right to regard their viewpoint as better than the other, or to attempt to impose their values on others. But that is what is happening in the Eurozone. People in the countries that have net saved regard their way of doing things as  "right" and don't see why they should pay to support countries who have spent instead of saving. They can't see that their saving has only been possible because of the debt-financed spending of the deficit countries. And conversely, people in the countries that have net spent don't see why they should pay to bail out the irresponsible lenders who have financed their spending, and why Germany shouldn't give back some of the money it has earned from its exports and lending.  The result is that the dominant country, Germany, tries to impose austerity on countries who won't accept it and who adopt all manner of underhand ways of avoiding having to implement it. It's a standoff.

Now, some people believe that austerity-induced recessions are good because they "clear out" malinvestment and force structural reform. To some extent that is true. But the Eurozone is a special case. Austerity-induced recession only works as a reform strategy if the country concerned has control of interest and exchange rates, so that it can manipulate these to encourage business growth and exports. The Eurozone countries have no such control, and no politician who valued his job would seriously try to impose the wage cuts really required to restore competitiveness.  Austerity-induced recession therefore cannot possibly be the brief painful clearout it is meant to be, because growth will be strangled at birth by counterproductive monetary policy and insufficient demand for exports. Without fiscal support from the surplus countries, the recession facing the deficit countries in the Eurozone will last for decades - if the people of those countries allow it to go on so long.

Which brings me to my final point. Structural reforms are indeed desperately needed in the deficit countries, but for the Euro to survive, structural reforms are needed in the surplus countries too. Germany and other countries in fiscal surplus need to relax their fiscal discipline to encourage domestic spending so that smaller Eurozone countries such as Greece have a fighting chance of exporting to them. And surplus countries must commit to reinvesting their trade surpluses within the Eurozone instead of outside it. To be fair, Sarkozy did comment that countries in fiscal surplus need to consume more, and the G20 communique contains a commitment to do something to increase demand in surplus countries. So maybe light is beginning to dawn. But it may be too late to save the Eurozone.

Unless the imbalances between Eurozone countries are addressed, the deep recession in Greece will spread to other countries too, eventually including Germany. It is already beginning to. And once recession takes hold in the entire Eurozone, people will start to see that their lives and their futures are being sacrificed on the altar of a political dream that is rapidly becoming a nightmare - and they will take action. We are already seeing political unrest in Greece, Spain and Portugal. As recession deepens, this unrest will worsen and may be violently repressed - a fertile ground for actual revolt and even war.

Is preserving the Euro in its current form really worth wrecking the lives of an entire generation of Europeans, and risking the end of over 60 years of peace in Western Europe? I think not.


  1. Is there an alternative to breaking up the eurozone? And can the politicians do it?

  2. Ian,

    Yes, there is an alternative. It isn't too late for countries to agree to support each other through the necessary reforms and to work together to sort out the imbalances that are tearing the Euro apart. But I don't think the political will is there.

    1. Has more to do with the peoples of Europe than with the politicians who are elected by them.
      It are fundamentally the peoples of Europe that disagree. One has to persuade them first.

  3. A very clear post. Structural reforms to the German Economy is an important point. One that is actually made by a couple of German economists at

    The story goes back to the 1990s. Structural labour reforms in Germany prevented the wages of workers from rising after monetary union. Two immediate effects of this:

    1) As firms kept the gains in productivity, it meant that direct investment was higher in Germany than what it should be in the periphery. 'Investment' in the periphery basically encouraged the consumption and the means to buy exports. This did not encourage the Eurozone to grow together.

    2) As workers were not rewarded for any gains in productivity, German firms became more competitive than those in the periphery. German exports exceed their imports from the periphery whilst periphery's imports exceed their exports.

    This asymmetric shock (or imbalance) destabilized Europe. This is very thing that Monetary unions are suppose to protect against.

    The financial effects follow. German trade surpluses in the Eurozone could only be supported as long as the deficits in the periphery are financed. To do so meant stepping deeper and deeper into new exotic, if not toxic, financing arrangements.

    This was not sustainable, but it was (1) profitable for the banking industry to supply them and (2) the Governments were increasingly desperate to buy them.

    The impossible rules of the old and new Stability and Growth Pact (an arbitrary line on the percentage of debt/deficit to GDP allowed) encouraged governments (some more than most) to apply creative accounting or fiddle the books. The Global Crisis of 2008 shatter the illusion.

    This financial instability was caused by a Euro trading imbalance. Sovereign debt crisis countries all share one common characteristic: a trading deficit with their Eurozone partners.

    This is caused by a fixed unfair trading advantage. This is the structural reform that needs to be addressed. Dare I suggest an 'internal revaluation' so that German workers can spending their money on a sinful holiday in Greece?

    It was unfair to the German worker, as they didn't get their gains in productivity. It was unfair to the periphery, as they had to compete against an unfair German export advantage.

  4. A related point is the problem arises from allowing unregulated private capital flows on the one hand combined with rigid rules about public deficits. A well designed federal tax and spending system would redistribute consumption spending and alter savings rates automatically without the need for any big meetings by politicians. Critics of the Euro pointed out the weakness of having no central fiscal mechanism. All these arguments replay the discussions at Bretton woods and Keynes' proposals for a world currency. Surplus countries must run down their surplus eventually and should be encouraged to do so by appropriate rules.

  5. Currently the issue of trade imbalances is being ignored by the Eurozone leadership, especially Germany's Merkel, and the insistance on fiscal austerity in deficit countries is not balanced by a requirement for fiscal loosening in surplus countries.

    Not just the European leadership, leadership around the world for the past sixty years.

    It's a damn shame that the world didn't commit to an international clearing union and a Bancor in the 1940s. Germany is hanging Europe and itself on a cross of "surplus good, deficit bad". Maybe the Martians will come and buy our goods and let us all have surpluses?

  6. Do not underestimate the growth that Greece, Portugal and Spain have experienced in terms of real disposable household income since they joined the euro:
    These graphs do not tell you anything about unemployment, but they do tell you a lot about increased standards of living.

    1. I'm not underestimating anything. In May 2012 I wrote about the debt-financed unsustainable growth in living standards that Greece had experienced, and the inevitable consequences of the withdrawal of that financing:

      (the charts take a while to load). And I'm very aware of the continual wage repression in Germany, Finland, the Netherlands and Austria. It's not just that peripheral economies have lived beyond their means. It is also that those four "surplus" countries have adopted beggar-my-neighbour economic policies. Germans should be as angry as Greeks about the mess that the Eurozone is in.

    2. But think of the euro history: 1999 Introduction of euro. Everybody happy.
      Then 10 years of increasing living standards and soaring wages in peripheral countries. Peripheral countries even happier.
      Then crisis and unemployment: peripheral countries very unhappy.
      My question is: why is it impossible to return to the situation of lower unemployment and lower wages in the peripheral countries as we had in the first few years after the introduction of the euro? Apparently people in the peripheral counties seemed happier 10 years ago then they are now. Would they be willing to accept lower wages in return for more jobs?

    3. Would you be happy about returning to the standard of living that you had 10 years ago, if you came from a poor agrarian economy?

      But in fact these economies have lost competitiveness relative to where they were 10 years ago. To regain it they would have to have LOWER wages and a poorer standard of living than they did when they joined the Euro. That is the direct consequence of the beggar-my-neighbour policies adopted by Germany and its satellites during the boom years. Solidarity, it ain't.

    4. Well no, not so much a consequence of German policies but rather a consequence of low interest rates since the euro was introduced, resulting in soaring private sector loans. A debt-fuelled boom.
      Governments in peripheral countries could have seen this coming and could have taken measures after the introduction of the euro, but they didn't. These governments just spent money, while they should have followed a programme of fiscal austerity in those days, to temper the economic growth and lower their national debts.
      They just waited too long, Now it's very late.


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