Monday, April 15, 2013

The effect of the Euro on southern European countries

A new paper from Villaverde (U. Penn), Santos (Harvard) and Garicano (LSE) theorizes about the consequences of the introduction of the Euro on the Southern European economies. The introduction of the Euro together with a common monetary policy left Southern European economies with one unique economic policy available: structural economic reforms. That would, on the long term, bring economic growth and productivity to peripheral economies. However, such thing never happened. The reason, “the steep financial boom derived from the drop in exchange rate risk and from the Euro wide financial bubble meant that the budget constraints that these countries faced were loosened, rather than tightened. Countries that could cheaply borrow delayed painful reforms” “As a result, the financial bubble fueled the deterioration of governance and of the institutional arrangements on the Euro’s periphery”

So, the Euro brought the idea that the whole Europe was similar and high in efficiency and productivity. However, the truth was that countries were still very different. The easy credit was misused by most peripheral countries and when the crisis came those countries were the ones who suffered, and still suffering, the most.

This explanation raises two possible questions: First, why the markets misjudged the productivity and risks of Southern European economies? And secondly “Are all situations where financing is plentiful and cheap conducive to the lowering of standards, the deterioration of governance and the abandonment of economic reforms? If so, this situation is currently the one the United States, at the zero lower bound, is facing, in which case [the] analysis suggests that a similar deterioration public and private governance may occur.” That would mean that any fiscal expansion or QE affects negatively to quality of government and sound economic decisions.

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