Eurozone: A Recipe for Recovery
No. 1 2014 January/March
Vladislav Inozemtsev

PhD in Economics; he is Head of the Department of World Economy at the Faculty of Public Administration, Lomonosov Moscow State University, and Director of the Center for Post-Industrial Studies.

How to Combat Its Debt Crisis

For years the economic situation in Europe has been a matter of deep concern to politicians and economists. The European Union remains the largest economic power in the world, accounting for more than 20% of global gross product, possessing a huge export potential generating up to 16.4% of international trade with 161 of the world’s top 500 companies, and with ample technological and financial resources. However, the EU economy is growing way too slow and its problems are becoming increasingly noticeable. The reason for this has been mentioned many times: poorly regulated public finance in the eurozone countries, which became particularly obvious during the global crisis of 2008-2009.

Unlike other economies, Europe has not yet recovered from the crisis of five years ago because of the internal problems in the eurozone. In 2013, Russia’s GDP in constant prices was 5.3% bigger than it was in 2008, America’s GDP increased by 5.7% from five years ago and Canada’s by 6.3%. However, a decline of 0.9% was registered in the European Union as a whole and the eurozone sagged by 1.8%. What needs to be emphasized is that while GDP in the U.S. grew by $1.8 trillion in current prices between 2008 and 2013 with the overall federal government debt increasing by $7.32 trillion (that means the debt grew 4.1 times faster than GDP), the gross domestic product in the eurozone expanded by €347 billion with government liabilities rising €2.38 trillion (that makes a 6.9 ratio). And although all eurozone economies are expected to grow in 2014, the combined deficit of their national budgets may reach €368 billion or 3.9% of the eurozone’s GDP. So the crisis is far from being overcome. Can one hope that the traditional methods used by the European financial authorities will bear fruit at least in a distant future? They will most likely lead to stabilization, but no one can say, at what price.


The euro experiment should be recognized as one of the most audacious undertakings in global financial history. The idea of introducing a single currency for several countries linked with each other by close economic ties looked quite rational. Theoretically, it was based on the works of Canadian economist Robert Mundell who received the Nobel Prize in the same year the euro started circulating.

It was believed that the transition to a single currency would accelerate the development of peripheral eurozone countries, which, in turn, would expand markets for the leading European economies. It was further firmly believed that this would also reduce transaction costs (which stood at 0.4-0.5% of the member countries’ combined GDP at the time the euro was introduced), which should have spurred consumption and investment. However, the fundamental problem of discipline remained unresolved: according to the so-called Maastricht criteria, participation in the eurozone was conditioned on several requirements: the budget deficit has to be kept under 3% of GDP, the overall state debt should not rise above 60% of GDP, and inflation must not exceed the average eurozone level by more than 1.5%. Two problems loomed large from the very beginning: it was unclear how the eurozone authorities would be able to punish the violators (a Central Bank was being created in the eurozone, but not a finance ministry, yet all major levers were in the hands of the European Union, which included non-eurozone countries as well). On the other hand, the eurozone, just like the European Union, did not and still does not have a mechanism for borrowing, which is crucial at a time of crisis. These two problems were mentioned in one of my articles of more than ten years ago, and they have manifested themselves quite vividly now.

We must give credit to the Europeans, though: the first several years of the currency union were a period of exceptional success. Having started at $1.17/€1 and fallen to its minimum of $0.825/€1 in October 2000, the euro then almost doubled its value in less than eight years to a maximum of $1.603/€1 in September 2008. By 2004, the euro had become the most widely used liquid currency in the world (there are €945 billion worth of banknotes and coins currently in circulation). Starting in 2006, the biggest share of corporate bond offerings in the world markets was nominated in euros. The share of the euro among the world’s reserve currencies increased from 17.1% (the share held in 1999 by the currencies that were later replaced with the euro) to 27.6% by 2008 (going down to 23.8% in the second quarter of 2013). The internal effect was just as important: for example, the Spanish economy growth rate jumped from 2.3-2.5% in 1995-1996 to 5% in 2000 and 3.6-4.1% in 2005-2008, while unemployment in 1995-2006 decreased from 23.8% to 7% of the total labor force. Combined export of the eurozone countries increased by more than 46% in the first seven years after the introduction of the euro. And yet, problems began almost immediately after the creation of the currency union.

In 2004, it was reported that Greece had falsified its financial accounts when entering the eurozone. Italy started to experience problems in 2007 as its actual government debt exceeded 100% of GDP. Prior to that, in 2003, France and Germany had broken the 3% deficit ceiling rule. And soon the process got out of control. Taking a look back, we can say that the 60% ceiling for public debt was broken 92 (!) times in 2001-2012 by 12 of the 17 eurozone countries, with Germany, France, Italy, Belgium, Portugal, and Greece each exceeding it more than ten times; the 3% ceiling for budget deficit was breached 75 times by 15 countries, with Germany, France, Italy, Spain, Portugal, Ireland, and Greece each doing so more than five times. None of the countries was ordered to pay a fine of 0.5% of GDP as was required by the initial terms of the European Monetary Union Agreement, but it became clear that it was virtually impossible to exclude any one country from the eurozone. As a result, by the middle of 2013, government liabilities of Greece, the most problem-ridden member of the eurozone, had reached 169.1% of GDP and the financial assistance provided to it by other countries and organizations had exceed €163 billion. It must be said that Greece was in recession (with GDP declining by 23%) since 2007, while all the other Southern European countries experienced a rapid rise in unemployment, which by the beginning of 2013 had exceeded levels that existed before the advent of the single currency.

What were the causes of the crisis that killed the recovery expected in the European economy in 2010-2012? In my opinion, it was the determination of the Southern European countries to preserve the pre-euro economic model under new financial restrictions entailed by the creation of the monetary union. For 30 years prior to the introduction of the euro, Spain, Italy and Greece had had high inflation rates and had constantly devalued their national currencies against Europe’s leading currency – the Deutsche mark. While in 1970, one DM could buy 8.2 Greek drachmas, 19 Spanish pesetas and 171 Italian lire, their exchange rates had dropped to 158, 84 and 987 (!), respectively, by 1998. This constant devaluation allowed the “southern” economies to stay relatively competitive while high inflation (averaging 9.4% a year in Italy and about 11% in Spain in 1965-1985) encouraged consumer spending and fairly low saving rates. After the introduction of the euro, growth was spurred mainly by low interest rates that enabled investors in those countries to economize on loan servicing costs and the governments to borrow for bigger budget spendings. As a result, by 2009 the Italian government’s overall debt had swollen to 132.2% of GDP versus 89% in 1996 but the amount of funds used for servicing it decreased from 23.8% to 9.9% of all budget expenditures. This situation benefited less developed EU countries but it could continue only as long as investors’ faith held. But faith was running thin as European treaties were constantly violated. And as soon as Ireland and Greece encountered problems, the process got out of control. Essentially, the main achievement of the eurozone – the treatment of all member countries as a single economy with common risks – had vanished. And recovery from the crisis is not going to be feasible until this practice is restored.

But there is still a long way to go as the European fiscal authorities prefer to deal with the crisis in a manner that inspires no optimism. They still rely on the accumulation of funds for restructuring the debts of problem-ridden countries. The overall amount of assistance to Ireland has reached €84 billion, and €163 billion have been provided to Greece. Loans were conditioned on the reduction of domestic expenditures and budget deficit. However, spending cuts drove down consumer demand and stricter tax collection had a negative impact on business operations. The problem of Greece, which accounts for less than 2% of the European economy, appears to be local, but if similar processes occur in Italy and Spain, the situation may become critical. Therefore, the challenge facing the Europeans is how to overcome the public finance crisis without dramatic cuts in current expenditures. It may seem unsolvable at first glance, but it’s not quite so.


Most Western economists say that the European problems can be solved using traditional methods, specifically by cutting public spending, reducing monopoly power, making market mechanisms work in high gear, and, as a last resort, restructuring the debt and arranging for its partial relief. Actually, many of these steps have already been taken in Greece and investors have even written off 30% of the debt, which equals €107 billion. But this raises two questions. On one hand, this leads to an economic decline of 20-25% and more, with delayed recovery; on the other hand, this solution will most probably fail if problems begin in larger economies. Finally, it is highly unlikely that economic growth in the eurozone will be durable if its key members keep building up their debts (as they have been doing up to date).

Moreover, delayed recovery seriously impacts consumers and entrepreneurs. Faced with the prospects of hard times, people spend less and switch over to less expensive goods and services. As a result, manufacturers have to cut prices to keep their sales, which lowers inflation, pushing it down to zero. This, in turn, discourages consumers because inflation keeps people think that the same goods will cost more tomorrow, but if one expects prices to go down, he will postpone his purchases. Faced with selling problems, manufacturers cut down production and lay off employees. Alongside limited employment support programs from the government, this leads to further drop in consumer spending. The economy comes to a standstill. This is precisely what happened in Europe in the past several years: the eurozone’s GDP grew by 1.6% in 2011 and then dropped by 0.7% in 2012 and by 0.4% in 2013; inflation decreased from 2.2% in 2006 to 1.4% in 2012 (and was a mere 0.7% year on year in October 2013 and once again in January 2014), while unemployment rose from 9.2% to 11.4% of the labor force. By the end of 2013, the Europeans started saying quite openly that deflation could be the main threat to their economy, which is quite correct, judging from the drawn-out crisis in Japan in the 1990s caused largely by similar factors: extremely sluggish consumption and unnaturally low interest rates.

This is why traditional measures are unlikely to work in Europe these days. Even if the Greek economy grows in 2014 (as Ireland’s did in 2013), the negative effects of the crisis will continue to bear down on the European economy. However, there is an example of alternative strategy that has proved quite effective, and by that I mean the United States, of course.

The American government responded to a liquidity crisis by injecting more than $2.3 trillion into the economy under the quantitative easing programs. As a result, the public debt increased by $3.4 trillion, banks got access to liquidity, and major troubled companies were either bought out by competitors or could restructure their debts and continue operation. Contrary to 2008-2010, when America was the main contributor to the global financial crisis, its GDP declined by no more than 3.7% and recovered as soon as in 2011.

The comparison of the American and European responses to the crisis helps understand what the Europeans are lacking. They need both a central authority that would make responsible and prompt decisions and their enforcer, that is, a ministry of finance and an efficient central bank. Problems in Ireland and Greece could have been solved quickly if the European Central Bank had bought their bonds from the holders and restructured the debt. Had it delegated the management of this debt to a consolidated finance ministry’s agencies that would have proposed a rehabilitation program, it would have been even better. But Europe has neither. Second, the Europeans need to empower their central authorities to borrow for urgent response to problems. It would not have been a problem for the European Commission, which manages a €13.2 trillion economy and a €148 billion budget, to raise €60-100 billion in international markets and nip the Greek crisis in the bud, so to speak, avoiding prolonged and hard talks between Germany and Southern European countries. Third, the Europeans need the will to reject the dogma that low inflation is absolute good. Frightening visions of hyperinflation, which have been bothering German financiers since the 1920s, are one of the main reasons for current problems in today’s Europe.

A possible alternative approach implies several basic points. First, the main objective should be ensuring economic growth and reducing unemployment, not keeping prices stable. Second, it has to be admitted that the European debt crisis was caused by objective problems in the countries of Southern Europe and that it cannot be resolved without an ambitious debt restructuring program. Third, given Europe’s self-sufficiency in terms of most goods and services, even a significant fall of the euro’s exchange value can hardly cause any serious disruption in the European economy or lead to a decline in the Europeans’ living standards. In saying this I want to argue that the Europeans have a full choice of anti-crisis measures, and if there is something that prevents them from taking decisive steps to deal with financial problems, it is their dogmatic mentality that keeps them from using inflationary measures for economic recovery. But if they have the guts to go beyond their ideological limitations, they may find a very different kind of perspective.


I believe that the financial authorities could take radical measures to solve the eurozone’s debt problems. However, there are several nuances to be taken into account while doing that. First, this method of “rehabilitation” suggests that the problem was caused by the economic shock suffered by Southern Europe and therefore it can be used just once. Second, over decades Europe’s leading currencies were constantly reevaluated: the Deutsche mark at first and then the euro (one DM could buy $0.27 in 1970 and $0.82 in 2008 [after conversion into the euro]; the euro itself appreciated annually by 7.6% over the U.S. dollar in 2001-2008). So a certain decrease in the exchange value appears to be quite justified. Third, one must be aware of the risks created by low inflation, which may lead the European economy to the same problems Japan experienced in the 1990s, and it would be particularly likely in Europe where people tend to save more and where the credit burden bearing by companies and households is quite low if compared, for example, with the U.S. figures. In other words, Europeans should not fear one-time measures that may spur inflation and weaken the euro.

These measures could be applied in the following way. Today the overall face value of government bonds issued by the eurozone countries stays at €8.8 trillion and over 50% of them will mature before 2020. Almost 68% of the bonds are currently on the books of EU banks and companies. Given this, a central solution would be for the European Central Bank to purchase most of the securities maturing in the next five to seven years, at a minor premium (1-3% of the nominal value) to the current price. There is no doubt that their holders will only be happy to accept this offer. The ECB may also announce a debt restructuring plan, under which the bonds will be purchased on condition that the issuers pay the Bank 0.25% of their nominal value every year and their maturity period is extended for five years. This service could be provided on certain strict conditions.

First, the countries that have decided to use this option will have to stop all public borrowing until 2020. Second, they will have to appoint ECB officials to senior positions in their finance ministries to oversee compliance with these terms. Third, in the second or third year of the program, these countries will have to start forming their reserve funds to guarantee the repayment of the restructured debt by 2020-2025. Fourth, all countries will have to state their readiness to create, after 2020, a single EU finance ministry and approve new financial stability criteria that will limit the government debt ceiling to 35-40% of GDP and the maximum budget deficit to 1% (given the current location of the ECB, they could be called Frankfurt criteria).

If implemented, the program would give almost immediate results. The purchase of €4.2-4.5 trillion worth of bonds (the amount has to be determined more precisely and may vary depending on the financial situation in a certain country and its current liabilities) will result in an explosive increase in money supply (M3 may grow by 42-45% of the current level and M1 by almost 80%) and a massive influx of free funds into banks. This may lead, first, to the increased lending to the manufacturing sector (especially when no new government bonds will be issued); second, to an inflation surge caused by the increased money supply; third, to higher value of fixed assets, real estate and stocks; and fourth, to very low interest rates over a long period of time due to the oversupply of loans.

Soaring inflation (which could reach 3-4% in the first year and 4-6% year on year in the subsequent period) would have a number of consequences. First, the bulk of pension and savings funds would be reoriented from fixed income instruments to shares and real estate, which would allow European markets to pick up and eliminate the commercial and residential estate overhang in Southern Europe. Second, people would spend more money as near-zero interest rates cannot make up for deferred demand. This would spur current consumption, and an inevitable decline of the euro would switch this demand from imported goods to domestically made ones. Third, having access to relatively cheap loans and driven by growing demand, entrepreneurs would be more willing to invest in the development of their businesses, which, in turn, would create jobs and reduce unemployment. Fourth, better economic conditions in the eurozone and the expected growth of assets’ value would bring more direct investment into Europe from abroad. All this could accelerate European economic growth from the current near-zero level in 2012-2013 to 2-3% and further to 3.5-4% annually by 2016-2017. Unemployment rates could return to pre-crisis levels over a period of 3-4 years and go further down to 5-6% in the eurozone as a whole and to 1.5-2% in the most successful countries by 2020 (if some find this scenario improbable, they should recall the Federal Republic of Germany of 1965-1972 when its unemployment rates were about 1% of the labor force). This program would give Europe what it has long been in need: significant acceleration of economic growth and stabilization of the labor market.

The public finance sector would change just as much. In 2012, the Italian government spent €78.2 billion on the state debt servicing, which made up 13% of all budget expenditures (5.6% of GDP); France, Spain and Greece spent €50.6 billion (5.9% and 3.0%); €22.3 billion (7.8% and 3.9%); and €17.4 billion (14.3% and 7.7%), respectively. The measures stated above would cut these expenditures 6-8 times on the average. Since Italy, France, Greece and Spain ran a budget deficit of 3.0%, 4.8%, 9.0% and 10.6% of GDP, respectively, in 2012, all these countries could achieve a zero-deficit budget right away or in one to two years at the latest. Moreover, up to 4.7% of budget funds in 2012 were used to support employment programs and/or pay unemployment benefits. Halving unemployment alone would help save at least 2.5% of budget funds or up to 1.2-1.4% of GDP in the majority of European countries. However, there is more to this. Public budget revenue would grow much more substantially due to economic upturn and, most importantly, with relatively high inflation budget revenues would grow in nominal terms practically without additional efforts on the part of the government. With shrinking obligations, larger incomes could be used to motivate business by cutting taxes. But we would not go that far (in part because such liberalization is unlikely to be approved by the European authorities, and in part because it could lead to real economic overheating). However, we can say that eurozone countries will get a sustainable budget surplus of 2-5% of GDP within two to four years after the commencement of the proposed measures. And this will allow them to save enough funds (30-60% of GDP) in 6-8 years to repay their debts to the ECB after the program expires by 2022-2025.

Naturally, one should not underestimate the impact the proposed measures may have on external markets and European export operations. A dramatic increase in supply on the eurozone’s money market will improve the terms of borrowing for foreign investors in Europe. The euro may be used more widely as an international borrowing tool, which will guarantee high demand for the European currency in the future as a loan repayment instrument. This will make the euro more stable in the future (it is quite obvious now that the U.S. dollar is strengthening in global markets amid the crisis in America because demand for it is being driven by the need for guaranteed repayment of dollar-denominated loans). In the short term, the euro will fall against leading world currencies, of course, but this is actually a positive development as it will make European goods more competitive abroad and raise the cost of imports. The resulting increase in exports will further facilitate economic recovery in Europe. Therefore the fall of the euro against the U.S. dollar from the current rate of $1.36-1.38/€ to $1.20-1.22/€ in the first 12 or 18 months after the start of pro-inflationary measures and further to the parity level could provide a means for accelerating economic growth in Europe. The only category of imported goods that would become more expensive in Europe, notably energy resources, would make no difference. There are several reasons for that. On one hand, a slight decrease in excise taxes can make up for price rises; on the other hand, an increase in the nominal value of energy resources would boost European environmental programs and technological achievements in this field. At any rate, one should not forget the fact that oil and gas consumption in Europe does not exceed 4.5% of the European Union’s GDP in terms of value, and higher energy prices will not stall economic growth.

In other words, I see no serious flaws in the proposed approach. In my opinion, keeping very low interest rates amid relatively high inflation levels – which means a negative return on bank deposits for 5-7 years – must be a crucial condition for its implementation. This situation cannot last forever, but it can be maintained for a certain period of time, and it would be easier for Europe to do so now than it was for Japan, where long-term zero inflation sometimes required negative interest rates, which looked irrational. However this situation is very unlikely to occur in the eurozone, where the ECB can keep interest rates at 0.5-1.5% even if inflation goes up.

At the same time, we should admit that the proposed approach does not appear to be sustainable in natural conditions, and this is yet another of its advantages. Hyperinflation, which is so much feared by the European fiscal authorities, always occurs for a good reason: it can be insufficient economy, which causes shortages of varying degree on the consumer market, or the government that cannot balance the budget and allows unjustified emission of money. But neither can be found in Europe, and the economy will not fuel inflation but will actually curb it. This is why going back to normalcy should not be a problem.

Seven to eight years after the commencement of the program, the euro will lose 35-40% of its today’s value. European countries will run a budget surplus from its second or third year. By 2020-2022, the governments will start paying off bonds on the ECB books, thus indicating that tighter fiscal policies are in store. Investments will go back from the stock market to fixed-income instruments, the euro will stabilize on the global market, and economic growth will decelerate to 2.5-3%. This program will not turn Europe into another China or a new economic center of the world, but it will enable it to overcome structural and budget problems caused by the introduction of a single currency – the right step but taken a bit hastily.

Of course one may ask how much Europe’s reputation would be damaged by publicly admitting the mistakes made in the course of the euro’s introduction, and by investors’ growing disillusioned? But I think this is a separate issue to discuss.



For decades Europe has been developing politically and economically under the strain of some sort of “inferiority complex.” For years it was divided into fighting political blocs, with the western part of the continent oriented towards the United States and the eastern part toward the Soviet Union, and each perceived as an area dependent on its patron. Since the 1980s, after America had overcome serious economic difficulties of the previous decade, Europe was traditionally portrayed as an anemic economy with an aging population and anemic growth. In the 2000s, when the U.S., China and Russia experimented with traditional geopolitics, many would point to Europe’s lacking a clear geopolitical strategy and dwindling role in international affairs.

However, these perceptions are misleading and Europeans should disregard them. Over the past 50 years, labor productivity in leading European economies has increased from 35-45% to 90-100% of the American indicators. Europe is a much bigger industrial manufacturer and exporter than the U.S. The quality of life in Europe is higher than in America even through Europeans spend less of their GDP on health care and education. Unlike America, Europe has lately been pursuing a much more balanced foreign economic policy: it is not overburdened with corporate and private debts and there is no significant balance of payments deficit. We have already mentioned this cursorily but have to say it again: Europe’s economy had its most successful period when it sought to achieve the fastest rates of development rather than sticking to economic dogmas. From the middle of the 1950s and to the end of the 1970s, a period that went down in history as La trente glorieuses, the European economy grew by 4.3-5.5% a year on the average, with inflation rates being 3.8-7% and unemployment staying below 2.5% of the labor force in leading European countries. Europeans were preoccupied with their own problems at that time trying to overcome the consequences of the war and paying little attention to compliance with economic “rules” or to how their financial policy affected the rest of the world.

Importantly, Europe demonstrated and – as I have shown above – keeps demonstrating all these successes, while strengthening its currencies despite numerous devaluations by its trading partner countries: Mexico in 1994, the Republic of Korea, Thailand, Taiwan, and Indonesia in 1997, Russia in 1998-1999, Argentina in 2002, and Brazil in 2004. Why can’t Europeans use the same methods to increase their competitiveness in the current situation? I believe that doing so would not be reprehensible.

Europe has been the most attractive supranational institution in the world in the past decades. While the U.S. has been “democratizing” Iraq and Afghanistan, without much success, and Russia endeavoring to restore the bygone Soviet greatness through “integration” of Belarus, South Ossetia, Abkhazia, and Transdniestria, the European Union has enlarged its membership from 15 to 28 nations and keeps expanding. Void of the American “cash printing” capacity and Russia’s enormous oil and gas revenues, it has managed to ensure accelerated development of its new members and provided the world’s largest volume of humanitarian aid to peripheral regions. I think the proposed financial crisis management plan would show the Europeans their real possibilities, which, in my opinion, are such that the very issue of granting €20 (or €40, or €60) billion to Ukraine to ensure its integration into Europe is not even worth debating. Fiscal conventions constrict the Europeans’ thinking and prevent the European Union from turning into a major global policy actor it should be.

When announcing that the U.S. dollar would no longer be exchanged for gold in 1971, John Connally, the then U.S. Secretary of the Treasury, uttered a phrase that became known around the world: “It’s our currency, but it’s your problem.” I think that now, forty years after, the Europeans have every reason to do the same. The euro is a new young currency that has all chances to make Europe a global player if the problems associated with its “premature birth” are addressed and solved in a decisive manner, rather than driven deeper down to become chronic. This is why the eurozone’s fiscal authorities should resort to extraordinary measures in order to accelerate economic growth, reduce unemployment, increase export and boost the continent’s competitiveness, even though in a somewhat unnatural way. Countries in Southern Europe can be criticized for their “irresponsible” financial policies in the 2000s, but I would like to look at those who would have acted responsibly in that situation. What is done is done, and it would be more appropriate now to search for ways to deal with the looming stagnation rather than for someone to blame, and not to look around. In fact, Europe has a mission and a purpose to fulfill.