The Scars of the Euro Crisis

Op-ed in El Pais

May 3, 2015

The euro crisis is over. The Greek tragedy continues in the background, and a Greek exit from the euro could deal a mortal blow to the single currency project. But a "Grexit" is not a likely or realistic scenario. No one (except the British press, always keen to report the failure of the euro) doubts the future of the euro any more, and economic policy has taken a turn towards normalcy with the European Central Bank's quantitative easing program and the neutrality of fiscal policy. The European economy is beginning to show positive signs: It has shifted from being a persistent concern of downside risks to being a source of upside risks to global growth. Financial markets understood this several months ago, as reflected in the sharp rally in European equity markets.

The euro crisis is history, but it has left deep scars. The casualties include both the economy, especially the millions of people who have lost their jobs and whose standard of living has suffered a sudden downward shift that can inflict permanent psychological damage, and the economics profession, unable to agree on causes, consequences, and solutions. This lack of agreement among economists has created deep confusion that clouds the decision making needed to solve the structural problems arising from the crisis, generate a robust recovery to alleviate the suffering caused by the long recession, and create the conditions to prevent their recurrence.

The casualties of the euro crisis include both the economy, especially the millions of people who have lost their jobs, and the economics profession, unable to agree on causes, consequences, and solutions.

The problems are complex: high levels of debt, insufficient investment, stagnant wages, rapidly increasing poverty, and zero interest rates. Normal recessions—caused by the overheating of the economy—and those caused by financial crises differ in that the former do not affect the structure of the economy, and economic policy can just modulate the recession with interest rate cuts and fiscal adjustment. Recessions caused by financial crises, however, alter the fundamentals of the economy, its potential growth, the unemployment and interest rate equilibrium levels, the stability and level of inflation expectations, and the degree of risk aversion. The present case adds the near record levels of income inequality resulting from the depth of the crisis, the divergence between the evolution of financial assets and the real economy, and the impact of technology on the labor market.

This complexity challenges governments in selecting priorities, which is compounded by strong ideological drives that sharply divide opinion and further confuse citizens. The traditional difference between the right and the left—where the right defends equality of opportunities, arguing income inequality results from differences in effort and therefore prefers to let the economy find its balance freely, and the left focuses more on equality of outcomes and is more willing to adopt interventionist policies to correct market failures—becomes clouded. The right cannot ignore the growing gap between the rich and the poor, and the left cannot ignore the need to liberalize the economy to increase potential growth. The the erroneous conclusion generated by the Greek crisis—that all problems were due to excessive debt and lack of competitiveness—further obfuscates the search for effective solutions.

In addition, the bubbles that precede financial crises are the perfect breeding ground for a culture of corruption because they eliminate budget constraints, allowing money for everything and everyone. And if the bubble culminates in a bailout, as in the Spanish case, the post-crisis examination is deeper and unearths scandals that in a normal recession would have remained unnoticed. Corruption is a scourge for growth and, along with the rapid increase in inequality, creates the breeding ground for populists who abandon the right-left axis and replace it with a new axis, "them against us," effective as a communication tactic but inefficient as an economic strategy. Having made mistakes handling the crisis and having tolerated corruption does not imply that the foundations of economic thought are no longer valid. Economic orthodoxy remains the same: the management of scarce resources. And if scarce resources are not increased, they cannot be distributed; that is the basis of inclusive growth.

Discussions during the IMF Spring meetings revealed that many doubts about the economy remain. It is unclear if the world is facing a secular stagnation or just the hangover after a deep crisis. The trauma of the crisis is at times interfering with the reasoning of policymakers. Fiscal policy fluctuates between the myopic German position of saving to infinity for an uncertain future against the overwhelming logic of taking advantage of zero interest rates to invest now and improve that uncertain future. Monetary policymakers have doubts weighing between the need to continue with the maximum possible monetary expansion and the unfounded warnings of possible adverse effects of low interest rates. It should be clear by now that the crisis was not the result of low interest rates, but poor supervision and financial regulation. Governments are slowly understanding that improving education will not be enough to solve the inequality problem, because the kind of technological progress we are experiencing is reducing the return on investment in education. And raising taxes on capital will only scare it away—property taxes are more efficient means of reducing inequality. Addressing high unemployment will require an intelligent combination of subsidies and incentives, such as earned income tax credits. Support for the poor will have to deal with accusations of class warfare and will require cunning, credible, and effective politicians.

The scars of the crisis will be long lasting, decisions will be difficult, and many mistakes will be made. Successful governments will be ambitious and have a vision defining what kind of country they want and a long-term plan to achieve it. Competition will be very strong. Improvisation, inexperience, and half measures will fail.