Posted on May 11, 2011 by Galileu Kim
Speculations on the European sovereign debt crisis abound. Whether Germany shall remain the main creditor for a collapsing European Union is in large part a political rather than an economic decision. Angela Merkel faces a strong domestic pressure and her March 27th electoral loss of the Baden-Württemberg constituency, traditionally an electoral stronghold of her Christian Democratic Union (CDU) party, sent a clear message to the tenacious Frau Merkel. Domestic and European politics are far from separated: embarking in the “ever closer union” may well prove to be a suffocating constraint on policy decisions by leaders of the European member states. Furthermore, integration implies a fundamental reassessment of the concept of sovereignty in the European Union.
Let us start with a few quick facts. The epicenter of the European sovereign debt crisis was in the birthplace of Western civilization, Greece. Faced with an exorbitant public debt that surpassed the 100% mark, a tax revenue marred by evasion, an unsustainable fiscal deficit that corresponded to approximately 10% of its GDP, Greece fell under the pressure of international financial markets. What is important to notice is that the fundamental shift was not of Greek economic policies – which remained in their BAU (business as usual) irresponsible mode since their entry to the E.U. – but a shift of investor sentiment. It is often with a spark that sovereign debt crises explode in a spectacular fashion: the Mexican default in 1982, Thailand’s unpegging of the bhat (the Thai currency) previous to the 1997 Asian financial crisis and so forth. The key word is, indeed, contagion. That is why the European member states hastily scrambled to create a 110 billion euro bail out fund for Greece, seeking to prevent the spreading of the sovereign debt crisis to other European Union member states.
After the announcement of the bail out fund, Greek sovereign bond yields dipped slightly, only to rise again as speculation revived around the possibility of a Greek debt restructuring. Furthermore, as a complementary package to the bail out funds, Greece was required to adopt austerity measures and reduce public spending – often involving massive public service lay-offs and tax hikes – stifling the short run prospects of economic growth. Greece’s economy contracted dramatically in the year 2010 with a 2% contraction followed by an estimated 4.8% contraction in 2011. The restructuring would imply a sharing of costs between bond investors and the country, the latter being part of the socializing of the costs of the debt. These so-called austerity measures cannot be simply vilified as unwarranted attempts by unmerciful financial markets. Rather, they must be seen as necessary steps to ensure the soundness of future fiscal policies and a healthier oversight of lending practices and government expenditures, which will hopefully prevent the reoccurrence of these sovereign debt crises. This does not mean recovery will be painless and perhaps the most frustrating of all the ensuing chaos is that it was, in its entirety, avoidable if the right decisions had been made at the right time. The short-sightedness of fast-track growth or financial integration without ensuring the mechanisms for sustainability is a reckless policy whose downturn, unfortunately, falls the heaviest upon the poor and, often times, undeserving.
It is not the first time we have observed a crisis of such a nature unfolding before our eyes. Yet it is, indeed, the first time we observe “developed nations” being confronted with the same agonies that Latin American and Asian countries have experienced throughout the 1980’s and the 1990’s. The previous invulnerability of developed countries and the “North-South” divide that had marked the intellectual conceptualization of international political economy from the 50’s to approximately the 90’s has been dramatically reversed in the spectacular financial explosion of Greece, Ireland, Portugal and, first and foremost, the United States. The crises that have occurred in the E.U. in 2010 and the yet uncertain consequences of proceeding negotiations on the European Financial Stability fund (EFSF) are a strong reminder that the sovereignty of nations are at bay. Whereas before, debts could be repaid by printing more money domestically, the reality of the 21st century has dawned upon nations that fully embraced the promises of global financial markets. A globalized world necessitates stronger safety mechanisms on the domestic front. To recklessly borrow from international creditors at the expense of sound fiscal policies at a national level is in the long-term unsustainable, even in a developed country that previously borrowed at an AAA credit rating (the highest of all).
Yet, as economists often preach, the devil is in the discount factor. Make the discount factor too low, and households (or whole nations) will rather consume more today than save for tomorrow. Make it equal to zero, and households will consume all their income today and save nothing for tomorrow. Frank P. Ramsey, a mathematician and economist at Cambridge University, published a model that incorporated this insight in a remarkable union between calculus and economic theory. The key insight to the now-called Ramsey model was simple: if a consumer is perfectly patient (meaning that the discount factor is equal to one), he will able to maximize his consumption and utility in the long-run, achieving what Ramsey appropriately calls bliss. It seems as if the fundamental insight of this 1928 economic paper still holds important lessons for countries today.
About Galileu Kim
Galileu is a sophomore in the College of Arts and Sciences at the University of Pennsylvania, coming from São Paulo, Brazil. He is currently pursuing a double major in International Relations and Economics, with a concentration in International Political Economy.
