Deciphering the Eurozone crisis

The ongoing global financial and economic crises, including the one in Euro Zone, have unleashed a passionate debate over the design of a new architecture of finance, capitalism and globalisation.

However, the trouble has been not so much with the inter-temporally evolved architecture as with how it was actually worked in practice. The apocalyptic denouement happened not because the existing systems and best practices failed, but because those responsible for implementing and enforcing them failed.

After all, of all risks to regulators and regulatees alike, human resources risk is by far the most serious as it is the source of all risks as confirmed by the ongoing financial and economic cataclysm.

Effective and credible systems are not about right architecture but about right people, for right people can make a wrong architecture work while wrong people cannot make even a right architecture work.

What we need is not more, or less, regulation, but good regulation and governance. This has been the undoing of regulators/supervisors and financial firms/banks alike.

But unfortunately broad-spectrum and generic failure of an inertial regulatory and supervisory system worldwide, especially in the West, precipitated the unprecedented global financial crisis and the resulting great recession.

Asset-price inflation

The cataclysmic financial crisis has thrown into sharp relief, as never before, the critical and important role of ‘asset price’ inflation/asset bubbles also, as opposed to that of shop-floor/products/services inflation alone, as a key variable, in monetary policy response.

For what happened was unprecedented in that with monetary policy focused only on traditional CPI, interest rates were kept low in spite of exploding prices of assets such as real estate/property, credit assets, equity and commodities.

And this was all made possible because of the huge pre-crisis current account surpluses in China and other emerging market economies (EMEs), and huge private capital inflows into EMEs in excess of their current account deficits, getting recycled back as official capital flows into government bonds of reserve currency countries, especially the US. This resulted in compression of long-term yields which, in turn, translated into lower long term interest rates even for riskier asset classes.

This chasing of yield, due to global savings glut, in turn, led to a veritable credit bubble, characterised by unprecedented under-pricing of risk as reflected in the all-time-low risk premia with junk bonds spreads becoming indistinguishable from investment grade debt.

Such a low interest rate environment coupled with luxuriant supply of liquidity, created enabling environment for excessive leverage and risk taking.

This financial syndrome was a classical case of ‘too much’ and ‘too little’ — too much liquidity, too much leverage, too much complex financial engineering, too little return for risk, too little understanding of risks.

This syndrome created a massive ‘financial sector – real sector imbalance’ which, being, intrinsically unsustainable, culminated eventually into the now-all-too-familiar apocalyptic denouement.

Replicated in Euro Zone

Significantly, the above pre-2007 story was almost replicated in the current on-going Euro Zone crisis with large and persistent current account imbalances between the core, proxied by Germany, and the Netherlands, and the crisis-hit periphery, with the surpluses of the core being almost mirror image of the current account deficits of the periphery.

Indeed, it is noteworthy that current account surpluses of the core increased dramatically after the launch of the single currency because of significant depreciation of the real exchange rate in the core and appreciation of the real exchange rate in the periphery.

Such large, and persistent, current account imbalances between the core and the periphery would not have been possible but for the explicit moral hazard of fixed and stable exchange rates created by the single currency because the respective national currencies of the periphery would have depreciated in real terms resulting in timely automatic rebalancing of the current account imbalances.

China, US example

So the way out of the current crisis is unwinding these imbalances through higher productivity and competitiveness in the periphery relative to the core.

This is exactly what happened post-crisis in the case of unwinding of the imbalances between China, on the one hand, and the US, on the other, with the US current account deficit halving from almost 6 per cent in 2007 to 3 per cent currently.

And that of China’s current account surplus shrinking steeply from 10 per cent in 2007 to 2.6 per cent currently.

Thus, in the framework of “unshared-unearned prosperity”, it was the case of ‘unearned’ prosperity for the ‘deficit’ periphery and ‘unshared’ prosperity for the ‘surplus’ core.

But, as in the case of China and the US, there is some good news that real wages in Germany have gone up by 3 per cent and those in Greece have gone down by 7 per cent.

Going forward, this then holds the promise of unwinding such imbalances by export of goods and services from the ‘periphery’ and import of goods and services by the ‘core’.

Such ‘unshared-unearned’ prosperity was inherently unsustainable, and unstable, from the word go. But the greatest good of sustainable globalisation is that, it does not permit, except in the very short term, ‘unearned’ and ‘unshared’ prosperity, but delivers ‘sustainable prosperity’ only if they are ‘earned’ and ‘shared’ prosperity.

Sustainable globalisation

Sustainable globalisation is about macroeconomic equilibrium, balance and harmony. In fact, the whole thing can be likened to cosmic balance/equilibrium/harmony where stars, suns, planets, all orbit within the inviolable discipline of their elliptical orbits which do not permit deviant behaviour beyond the shortest and the longest distance from suns and stars of orbiting planets.

Any deviant behaviour/conduct, inconsistent with the cosmic harmonious balance and equilibrium, will invite, and inflict, retributive backlash.

The more severe and prolonged the disequilibrium and imbalance, the more wrenching and excruciating will be the resulting pain as is currently being experienced, especially in the Euro Zone. It is no-brainer to see that, in the event of the break-up of the euro, it is the surplus/creditor ‘core’ that has far more to lose than the deficit/debtor ‘periphery’.

For if the surplus/creditor ‘core’ exit the euro, value of what is left of the euro will be worth much less in terms of national currencies of the exiting surplus/creditor countries.

On the other hand, if the deficit/debtor ‘periphery’ exit, they will simply default on their euro-denominated debt owed to the surplus/creditor ‘core’ because of the collapse of their national currencies against the euro.

In other words, in sustainable globalisation, there can be both winners, and losers, only in the short term, for such is the nature of sustainable globalisation that, in the long term, there can only be all winners and no losers.

Therefore, if we earn and share, we prosper together, and if we don’t, we perish together.

(Edited excerpts of the keynote address delivered by V. K. Sharma, Executive Director, RBI, on November 30, at the International Leadership Symposium organised by World Forum for Ethics in Business in partnership with World Bank Institute at European Parliament, Brussels. Belgium. The views expressed are those of the author and not of the RBI.)

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