Macroeconomic policies in the

Eurozone since the sovereign debt

crisis

Paul De Grauwe
 Stagnation in Eurozone
Figure 1: Real GDP in Eurozone, EU10 and US
(prices of 2010)

135

130

125

120

115

index 2000=100
110

Eurozone
105

EU10
100

95 US

90
2000.02001.02002.02003.02004.02005.02006.02007.02008.02009.02010.02011.02012.02013.02014.0
Deflationary bias since 2011

Growth GDP in Eurozone (EU18) and EU10 (percent)

-2

Eurozone
-4 EU10

-6
Increasing unemployment

Figure 5: Unemployment rate in Eurozone, EU10 and US

Eurozone

EU10

US
Increasing savings
as a result of austerity
Figure 6: Current account Euro area
Deflation threat

Figure 7: Inflation in US and Eurozone

US

Eurozone
 What happened since the start of the
sovereign debt crisis that has led to a
systematic divergence of economic
growth in the Eurozone as compared
to the non-Euro EU-members?
The answer lies in the nature of
macroeconomic policies pursued in
the Eurozone.
 Two factors played a role
Asymmetric adjustment to the
external imbalances accumulated
during boom years
Misdiagnosis about nature of crisis
Supply side versus demand side
Private and public deleveraging
 Asymmetric adjustment:
internal devaluation in debtor countries
Relative unit labour costs Eurozone: debtor nations
135

130

125

120
Italy
Ireland
115
Spain
Axis Title Portugal
110 Greece

105

100

95

90
2000.0 2001.0 2002.0 2003.0 2004.0 2005.0 2006.0 2007.0 2008.0 2009.0 2010.0 2011.0 2012.0 2013.0
 Without internal revaluation in creditor
countries
Relative unit labour costs Eurozone: creditor nations
125

120

115

110 Finland
Belgium
105 Netherlands
France
Axis Title Austria
100
Germany

95

90

85

80
2000.0 2001.0 2002.0 2003.0 2004.0 2005.0 2006.0 2007.0 2008.0 2009.0 2010.0 2011.0 2012.0 2013.0
 Misdiagnosis I:
Its a supply side problem
Something strange happened: policymakers
(especially in the North of Eurozone)
identified the problem to be on the supply
side
and pushed for structural reforms
to make supply side more flexible
They applied Says Law: supply creates its
own demand (even President Hollande was
converted)
Supply did not create its own demand
 Conditions for Says law to hold: closed
system
Output
markets

Consumers Firms

Factor
markets
 System is not closed
Consumers save
Decisions of consumers to save and
producers to invest do not coincide
Interest rate should do the job; but it may
fail to do so (lower zero bound; liquidity trap)
Consumers import:
not necessarily equality import and export
No easy mechanism to equilibrate the two
 Misdiagnosis II:
it is a public finance problem
The explosion of government debt
since the financial crisis was seen as
evidence of government profligacy
Thus debtor countries were pushed
into extreme austerity
And creditor nations were told to
balance the budget as soon as
possible
 Private and public debt prior to crisis.

Source: CEPS and European Commission

A little blowup of previous figure
 Summary
problem was not on the supply side but on the
demand side
problem was mainly one of excessive debt
accumulation of private sector
This was a balance sheet recession
Leading private agents into desperate attempts
at deleveraging
Thats when
the European policymakers pushed national
governments to also deleverage producing the well-
known Fisher debt deflation problem
and the same policymakers told national
governments to fix their supply side
Lets look at the demand side:
Two deflationary spirals.
Keynesian savings paradox
Debt deflation paradox (Irving Fisher;
Minsky, Koo)

These two spirals have same structure

They arise because of coordination failure
when negative collective movements
(animal spirits) occur.
Keynesian savings paradox
1. Individual problem
When one individual desires to save more, and he
is alone to do so, his decision to save more
(consume less) will not affect aggregate output.
He will succeed to save more,
Once he has achieved his desired level of savings
he stops trying to save more.
2. Collective problem
When the desire to save more is the result of a
collective lack of confidence (animal spirits) the
individual tries to build up savings when all the
others do the same.
Output and income decline and the individual
fails in his attempt to increase savings.
 He will try again, thereby intensifying the
decline in output, and failing again to build-up
savings.
There is thus a coordination failure: if the
individuals could be convinced that their
attempts to build up savings will not work
when they all try to do it at the same time,
they would stop trying, thereby stopping the
downward spiral.
3. Role of government
Somebody must organize the collective action.
An individual agent will not do this because the
cost of collective action exceeds his private
 Fishers debt deflation
1. Individual problem
When one individual tries to reduce his debt,
and he is alone to do so, this attempt will
generally succeed.
The reason is that his sales of assets to
reduce his debt will not be felt by the others,
and therefore will not affect the solvency of
others.
The individual will succeed in reducing his
debt
2. Collective problem
When the desire to reduce debt is
driven by a collective movement of
distrust, the simultaneous action of
 They all sell assets at the same time, thereby
reducing the value of these assets.
This leads to a deterioration of the solvency of
everybody else,
forcing everybody to increase their attempts at
reducing their debt by selling assets.
There is coordination failure: If individuals
could be convinced that their attempts to reduce
their debt will not work when they all try to do
this at the same time, they would stop trying
and the deflationary cycle would also stop.
3. Role of government
Somebody must organize the collective action.
An individual, however, will have no incentive to
organize such a collective action
 Failure of macroeconomic policies
in Eurozone
There coordination failure
Each country being pushed into austerity
(i.e. pushed to save more)
Without taking into account the
collective problem
Has led to deflationary bias: effects of
which were shown earlier
This failure has been made possible by
misperception of the nature of the crisis
i.e. by the official view that it is foremost a
supply side problem
After crisis
Before crisis
Failure or Eurozone policies
in one picture
 Que faire?
Stop trying to fix the supply side and
fix the demand side
Start with public investment
Why?
It is one of the major victims of ill-
advised macroeconomic policies in
Eurozone
Austerity programs led to strong
decline in public investment
Figure 8: General government gross fixed capital formation (%GDP)
 Leading to less aggregate demand
today
And less supply in the future
Thus, start public investments
These can be initiated everywhere,
but especially in Germany, a country
that can borrow almost for free
 We have to free ourselves of dogmas
One such dogma: balanced budget, i.e. no
bond financing of investments
All investments should be financed by current
revenue
No well run company follows such a rule
Result of this idea is that governments are
reducing their responsibility to provide
essential public goods (infrastructure, energy
investments, environmental investments)
This reduces long-term growth of the
Eurozone