The Euro Crisis is Simpler Than it Appears

Not long after I arrived at Stanford, our medical center entered into a disastrous union with the UC-San Francisco’s health care system which ultimately poured tens and probably hundreds of millions of dollars down the drain. I could tell an enormously complicated story about why it didn’t work, bringing in issues of risk-pooling, local cultures of clinical practice, patient preferences and integrated care models. That would make your head spin to the point that you would miss the obvious: The system was set up financially such that one party could spend far more money than it had secure in the knowledge that someone else would have to pick up the tab. That’s all you fundamentally need to know about why the merger was doomed from the outset.

I have read endless coverage of the Euro Crisis, and my head is now spinning as I learn of sovereign debt swaps, inter-market currency trades and European Central Bank-mediated transaction insurance schemes. I then go back to a much simpler analysis: The system was set up financially such that one party could spend far more money than it had secure in the knowledge that someone else would have to pick up the tab.

I generally have distaste for the populist sentiment that there are no experts and that all opinions are equal. Yet I find myself wishing that when all the genius economists got together and agreed on the euro, some plain-spoken fellow (Wilfred Brimley, if available from central casting) would have said “Now hold on people! I don’t know spit about European Central Bank-mediated transaction insurance schemes and all that, but from what I’m a-hearin’ it sounds like this Euro thing is settin’ up a system in which one fella can spend more money than he has because he knows someone else is gonna get stuck with the bill. Well that’s crazy folks. You pointyheaded types may know way more than me ’bout economics, but you got less understanding of human nature than God gave an ant.”

Author: Keith Humphreys

Keith Humphreys is the Esther Ting Memorial Professor of Psychiatry at Stanford University and an Honorary Professor of Psychiatry at Kings College Lonon. His research, teaching and writing have focused on addictive disorders, self-help organizations (e.g., breast cancer support groups, Alcoholics Anonymous), evaluation research methods, and public policy related to health care, mental illness, veterans, drugs, crime and correctional systems. Professor Humphreys' over 300 scholarly articles, monographs and books have been cited over ten thousand times by scientific colleagues. He is a regular contributor to Washington Post and has also written for the New York Times, Wall Street Journal, Washington Monthly, San Francisco Chronicle, The Guardian (UK), The Telegraph (UK), Times Higher Education (UK), Crossbow (UK) and other media outlets.

21 thoughts on “The Euro Crisis is Simpler Than it Appears”

  1. Well they did kind of realize that that would be an issue, which is why they set rules about maximum deficits and debt levels for countries joining the euro. They also agreed to a “stability and growth pact” which put sanctions on countries that violated the deficit and debt limits after joining. But what they didn’t count on was that the political desire to have a big, inclusive euro zone as a symbol of progress and unity, rather than just a contractual arrangement, would prevent sound enforcement of these rules. So Italy and Belgium were let in despite having excessive debt levels. And Greece’s statistical shenanigans were tolerated, because it just wouldn’t be nice to confront a fellow euro member about statistics. And Germany and France violated the deficit limits several times, but they weren’t sanctioned because, well, they’re Germany and France. The market quickly understood that everyone’s debt was mutually guaranteed, despite what the treaties and the politicians said, so they priced the debt accordingly (at least until it became clear that some countries might very well not be bailed out after all).

    One lesson is that rules just aren’t enough when political will, diplomatic niceties, and simple inertia are pulling the other way.

    Then there’s the fact that, as Krugman often points out, even countries that were fiscally sound (like Spain) are now in trouble because they experienced a massive (private sector) credit boom and now lack the safety valve (a weaker exchange rate and fiscal and monetary expansion) that would allow them to overcome the bust. True currency areas can overcome this by labor mobility from low-demand to high-demand regions, but Europe isn’t there yet. Everyone recognized this at the time but, first, they didn’t think the booms and busts would be so bad, and second, again, the political drive was just too strong.

  2. You’re describing the crisis Europe expected, not the one it actually has. Sure, Greece let its deficits get completely out of hand. But Spain was fiscally responsible, pre-recession; Ireland was in good fiscal shape before they tried a bank bailout they couldn’t afford; and Italy had high debt but low yearly deficits and a declining ratio of debt-to-gdp. The later three countries are in trouble because they no longer have the tools to fix their own economies, and Europe refuses to do it for them.

    This is what Larry Summers meant when he said, “If a generous sovereign from Mars paid off Greek debt, the fundamentals of Europe in crisis would not be altered.”

    Unfortunately, Europe is still trying to solve your problem.

  3. “I then go back to a much simpler analysis: The system was set up financially such that one party could spend far more money than it had secure in the knowledge that someone else would have to pick up the tab. ”

    And this party, of course, would be the bankers.

  4. Aside from the point you are making it is clear that when the euro was created almost instantly everybody broke the monetary rules. When countries are allowed to ignore rules that are set up to prevent disaster this is the result. Oh, and by the way, that is also the reason the world collapsed in 2008. No regulation of the financial world is allowed.

    As long as we let cowboys run our banking system it is inevitable that we as society get stuck with the bill.

  5. Isn’t the European experiment akin to going from a separate state system (the European Market was more rhetoric than anything else) to a federalist type of system? And isn’t the problem that Greece, Ireland, Spain and such were like the American Southeast, where they need federal help to avoid falling into a ditch?

    I see Humphreys’ point about the geniuses not doing what “common sense” should be, but I see the common sense that was lacking, was the failure of Germany and France and England to realize they needed to bail out those nations that put their faith in the Euro, and use the crisis to further tighten the relationships among the European nations so that they would compete far more effectively globally with the nations of China and India. The dithering and initial refusal to help is what makes the latest attempts to help that much harder to achieve.

    I agree with the commenter who recognizes the role bankers played in leading to the crisis. Bankers tend to use the Animal House defense, “Face it Flounder, you (messed) up, you trusted us.” But bankers then give you a lecture about not living on the debt they encouraged you to undertake and to buy stuff with that debt….

  6. The last time the Brits had a referendum of Euro-vs-Pound an opponent of Euro for Britain said he would rather have complete control of a small monetary system than partial control of a large monetary system. But then of course I guess Britain gets stuck with some of the bill (I think) as well as take a major hit from right across the chanel.
    I don’t undestand how the europeans think they can have a federal system and still keep national soverenty. The thought of ‘cake and eat it too’ comes to mind.

    1. I don’t think “the Europeans” think that at all. Some Europeans want a federal system, and have enough leverage to force the first steps towards one. Other Europeans can’t stop them from gradually constructing one, but have managed to prevent them from doing away with national sovereignty. That’s the basic problem of the EU: The national elites are trying to turn Europe into a federal system, without having the public on board, and the public still has some say in the matter.

    2. In actual operations pre-euro, most of the eurozone countries had no control over a small monetary system. Interest rates were effectively set in Frankfurt at the Bundesbank, with very little scope for the neighbors to engage in independent monetary policy. At least with the ECB, the other countries have a seat at the table in Frankfurt.

  7. Yglesias (and Barry above) nail the error here:

    It’s the banks that loaned money to Greece who are saying the German government ought to pick up the tab. It doesn’t say this in any of the EU’s founding treaties — it actually says the reverse. The Greeks would probably just as soon default and devalue as go through this nonsense. It’s the governments of northern Europe who, by offering to act as debt collectors for their domestic banks, have created this situation where they’re left partially holding the tab.

    The banks knew full well that Greece couldn’t afford to keep borrowing. They loaned the money anyway, confident that the fear of a collapse would lead their governments to bail them out.

    THAT is why we have to have banking regulation: because once the banks are in danger of failing, you can’t let the free market take its course.

    It’s not (just) about the euro; it’s about the failure to restrain the banks from making enormous bad loans.

  8. You wish that “when all the genius economists got together and agreed on the euro, some plain-spoken fellow would have said . . .” Plenty of smart and clear-speaking people, smart economists themselves, did analyze the issues surrounding optimal currency area, and foresightedly critiqued the euro’s problems and prospects. The powers that be pushed it through anyway. As an non-economist, I have to say that on subjects like this I am happy to have access to the popular writings of Krugman, DeLong, et al., and need not rely too deeply on Humphreys and Brimley.

  9. “…The system was set up financially such that one party could spend far more money than it had secure in the knowledge that someone else would have to pick up the tab…”

    Good line. Works just as well when the subject is CALPERS as when it is Greece.

    1. If I hold that comment up to the mirror and squint, and then blink really fast, and then squint some more . . . Nope. Still doesn’t make a lick o’ sense.

      Nice try, though!

  10. It wasn’t a question of genius economists who didn’t know shit from shinola. The problem is that the EU economic management is done by the Germans, a people with many virtues and only a few vices. One of their virtues is that they follow sensible rules simply because the rules are there, and following sensible rules is what a good German does. They therefore promulgated many sensible rules for the EU, which would have worked just fine if they were followed. Unfortunately, one of the few vices of Germans is that they do not realize that other people don’t work this way, and obey rules (even sensible rules!) only when it is to their advantage to do so.

  11. KH,

    Simple national income accounting arithmetic will tell you that you’re way off base here. From Dean Baker: “The Germans apparently have not yet come to grips with the accounting identity that implies that if they run persistent trade surpluses with the other euro zone countries, then Germany will have to continually lend them more money. The only way to avoid this situation would be if the deficit countries within the euro zone had massive surpluses with non-euro zone countries.”

    Similarly in the US. We don’t call states that reap more spending from the federal government than they contribute in federal taxes (cf. many red states) “profligate”.

  12. You write very well, but you don’t make your point clear — it’s Greek to me. Who exactly was able to spend a lot knowing someone else would pick up the tab ? Are you talking about the Greek and maybe Portuguese governments or Irish and Spanish homebuyers ?

    Ireland and Spain had llow national debts in 2007. Italy had a budget deficit similar to Germany’s. The Growth and Stability pact worked with one exception (Greece).

    The fact that banks bear much of the loss when a housing bubble bursts isn’t new. It has nothing in particular to do with European Union institutions or the Euro. You live in California. You must understand that.

    What agent was like the UCSF Health Care sytem ?

    I think that you have decided to ignore not only obscure things such as “inter-market currency trades” but also rather large things: Ireland, Spain and Italy. If you think that noticing the existence of Italy (where I live) makes me an egg head with “less understanding of human nature than God gave an ant.” then I hold up my ant-wise head with pride.

  13. Yo. Those people, the ones who are spending all that money, borrowed that money from bankers. And the bankers had a scheme in mind to get their money back, plus interest. Now, I don’t know what the scheme was, but there was a scheme. Whether the bankers thought the loans, themselves, were sound, or whether the bankers thought the loans could/would go bad, opening up a pillage-fest where Greek public assets would fall into bank pockets, or whether it was some other scheme to cash in/out, I don’t know. But I’d bet big that there was a scheme in mind.

  14. i think it was Kindly Uncle Albert Einstein who said “in a good explanation, everything should be as simple as possible, but no simpler.”

    The urge to seek the simplest possible explanation is commendable. You may have gone past and violated Al’s warning.

Comments are closed.