In an Op Ed published in The Guardian on May 28, 2018, Yanis Varoufakis claimed that:
The first observation one should make, for example by looking at the peaks of the blue line, is about what is missing. There is no sudden drop in Italy's economic growth after 1999 as would be the case if Varoufakis was correct. Instead, we see a gradual decline that has been taking place since the 1960s. And as an economist, Varoufakis should know that Italy's performance is consistent with what economic theory describes as "catch-up growth". Namely, countries whose incomes fall due to an unusual circumstance such as a war or natural disaster are expected to grow faster right after these circumstances are removed, and their growth to slow down as they close the gap with the rest of the world. This is exactly what we see in Italy, following the end of WWII.
The second observation is that Italy's growth rate traces Germany's pretty closely both before and after the adoption of the Euro, and until 2005. For the eight years from 2006 to 2014 Germany does outperform Italy but in 2015 the two growth rates converge again. Hence, there is little evidence to support the idea that Germany is, through the Euro, strangling Italy's performance, unless it is doing the same to itself. In fact, contrary to Varoufakis' claims, it does seem that Italy's lackluster performance relative to Germany's is of its own making. Specifically, the divergence between the two countries occurs in 2006, which was an election year followed by two political crises, in 2007 and 2008, and an unstable political environment since then.
Now that we have established that Varoufakis is wrong, let's look at why he is dangerous. Surprisingly, it is precisely because the Euro's architecture is faulty, as he claims. One of its biggest problems is that there is no institution that can act as a lender of last resort when a country-member faces a bank-run. No government in the world has the ability to pay off its debt within a few years. Typically, every government rolls its debt over by issuing new debt and using it to pay off the old. A phenomenon similar to a bank-run can occur if lenders become worried and refuse to lend to a government except perhaps at higher interest rates. If the government can issue its own currency, it could ameliorate the situation by using newly-issued currency to pay off the debt that is maturing. Doing so is no free lunch as it can lead to much higher inflation, but it is a solution. A country belonging to the Eurozone, however, does not have that option. It's only option is to borrow at the higher interest rates, which makes less likely that it will be able to service the interest on the new debt. As its debt becomes riskier, lenders may demand even higher interest rates, making the debt even riskier and so on. If this process spirals out of control, the country may go bankrupt as a result of a so-called self-fulfilling prophecy: a situation that happens simply because people expect it to happen. So yes, reforms are necessary, including the establishment of a mechanism that prevents such self-fulfilling prophesies, for example by offering a line of credit to countries that find themselves under pressure despite adhering to fiscal rules that ensure the sustainability of their debt in the long run. If that was what Varoufakis is making a fuss about, I would be happy to join him.
Unfortunately, through his narrative of us-southerners vs. them-Germans, Varoufakis seems to be advocating for higher levels of government spending even though government spending in the EU is significantly higher than in the US, and in Italy much higher than in Germany. Varoufakis seems to believe that economic prosperity is driven by the government. The problem is that Greece, among other countries, tried his remedy in the 1980s. To increase its spending, the Greek government ballooned its debt from about 25% of its GDP to about 100% of its GDP in less than a decade, and pursued a faster monetary expansion than the rest of Europe. And yet, Greece's economic growth during that time fell below that of the rest of Europe, reversing a pre-1980s trend. Greece's unemployment rate actually rose, and all the country had to show after the massive increase in spending was much higher inflation relative to the rest of Europe. By advocating for the tried and failed policies of the past, Varoufakis is reducing the chances of practical and possibly effective reform and, even worse, fueling populist movements that, if they have their way, may make today's woes seem like happy times.
While it is true that Italy is in serious need of reforms, those who blame the stagnation on domestic inefficiencies and corruption must explain why Italy grew so fast throughout the postwar period until it entered the eurozone. Was its government and polity more efficient and virtuous in the 1970s and 1980s? Hardly.
The singular reason for Italy’s woes is its membership of a terribly designed monetary union, the eurozone, in which the Italian economy cannot breathe and which consecutive German governments refuse to reform.To understand why Varoufakis is wrong, let's look at exhibit #1 below. The blue line shows the annual percentage change in Italy's GDP per person, adjusted for inflation. The red line shows the same series for Germany after 1970, at which point the data become available. Keep in mind that Italy adopted the Euro on January 1, 1999.
The first observation one should make, for example by looking at the peaks of the blue line, is about what is missing. There is no sudden drop in Italy's economic growth after 1999 as would be the case if Varoufakis was correct. Instead, we see a gradual decline that has been taking place since the 1960s. And as an economist, Varoufakis should know that Italy's performance is consistent with what economic theory describes as "catch-up growth". Namely, countries whose incomes fall due to an unusual circumstance such as a war or natural disaster are expected to grow faster right after these circumstances are removed, and their growth to slow down as they close the gap with the rest of the world. This is exactly what we see in Italy, following the end of WWII.
The second observation is that Italy's growth rate traces Germany's pretty closely both before and after the adoption of the Euro, and until 2005. For the eight years from 2006 to 2014 Germany does outperform Italy but in 2015 the two growth rates converge again. Hence, there is little evidence to support the idea that Germany is, through the Euro, strangling Italy's performance, unless it is doing the same to itself. In fact, contrary to Varoufakis' claims, it does seem that Italy's lackluster performance relative to Germany's is of its own making. Specifically, the divergence between the two countries occurs in 2006, which was an election year followed by two political crises, in 2007 and 2008, and an unstable political environment since then.
Now that we have established that Varoufakis is wrong, let's look at why he is dangerous. Surprisingly, it is precisely because the Euro's architecture is faulty, as he claims. One of its biggest problems is that there is no institution that can act as a lender of last resort when a country-member faces a bank-run. No government in the world has the ability to pay off its debt within a few years. Typically, every government rolls its debt over by issuing new debt and using it to pay off the old. A phenomenon similar to a bank-run can occur if lenders become worried and refuse to lend to a government except perhaps at higher interest rates. If the government can issue its own currency, it could ameliorate the situation by using newly-issued currency to pay off the debt that is maturing. Doing so is no free lunch as it can lead to much higher inflation, but it is a solution. A country belonging to the Eurozone, however, does not have that option. It's only option is to borrow at the higher interest rates, which makes less likely that it will be able to service the interest on the new debt. As its debt becomes riskier, lenders may demand even higher interest rates, making the debt even riskier and so on. If this process spirals out of control, the country may go bankrupt as a result of a so-called self-fulfilling prophecy: a situation that happens simply because people expect it to happen. So yes, reforms are necessary, including the establishment of a mechanism that prevents such self-fulfilling prophesies, for example by offering a line of credit to countries that find themselves under pressure despite adhering to fiscal rules that ensure the sustainability of their debt in the long run. If that was what Varoufakis is making a fuss about, I would be happy to join him.
Unfortunately, through his narrative of us-southerners vs. them-Germans, Varoufakis seems to be advocating for higher levels of government spending even though government spending in the EU is significantly higher than in the US, and in Italy much higher than in Germany. Varoufakis seems to believe that economic prosperity is driven by the government. The problem is that Greece, among other countries, tried his remedy in the 1980s. To increase its spending, the Greek government ballooned its debt from about 25% of its GDP to about 100% of its GDP in less than a decade, and pursued a faster monetary expansion than the rest of Europe. And yet, Greece's economic growth during that time fell below that of the rest of Europe, reversing a pre-1980s trend. Greece's unemployment rate actually rose, and all the country had to show after the massive increase in spending was much higher inflation relative to the rest of Europe. By advocating for the tried and failed policies of the past, Varoufakis is reducing the chances of practical and possibly effective reform and, even worse, fueling populist movements that, if they have their way, may make today's woes seem like happy times.
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