ACE1037. What does economic integration mean?

1. Trade integration and PTAs.[Cleaver, Chapters 4 & 6]
2. Financial integration, the Credit Crunch and the Euro Crisis [Cleaver, Chapter 1, 7 & 9]
3. What went wrong?

1. TRADE INTEGRATON

As we have already seen (in the introduction), Global trade has increased very substantially since WWII. This demonstrates the increasing economic integration between countries, driven by:

Post war reconstruction (Bretton Woods Agreement,1944, and the GATT, 1947, aimed at both preventing the disaster of the Great Depression, and associated descent into protectionism, and avoiding further armed conflict. The WTO site (GATT link) has a potted history of the multilateral trade negotiations. The Brookings Institute (undated) provides a "Principled history of the GATT & WTO" (21p), which is the opening chapter of a book on the WTO and developing countries.
Technology - especially the development of the container, and more recently the spread of air freight, global communications, the internet and the web.

(source: Economist: "In a set of 22 industrialised countries containerisation explains a 320% rise in bilateral trade over the first five years after adoption and 790% over 20 years. By comparison, a bilateral free-trade agreement raises trade by 45% over 20 years and GATT membership adds 285%."

economic growth - symbiotic with increasing trade
GATT/WTO Principles:
- - Most Favoured Nation (MFN) (A.1) (the principle of not discriminating between one’s trading partners - the rules and barriers applied to your country's 'most favoured nation' should be applied to everyone else too). However, as Brookings (op.cit) notes: the GATT/WTO does permit members to sign preferential trade agreements (PTAs) between one another and thus offer lower-than-MFN tariff rates to preferred partners provided that this covers “substantially all trade.” Furthermore, the GATT/WTO also encourages members to offer lower-than MFN tariff rates to developing country exporters through the Generalized System of Preferences (GSP).” (p 17). - e.g. the EU's "everything but arms" agreements
- - National Treatment (A.3) (The principle of giving others the same treatment as one’s own nationals. GATT Article 3 requires that imports be treated no less favourably than the same or similar domestically-produced goods once they have passed customs. GATS Article 17 and TRIPS Article 3 also deal with national treatment for services and intellectual property protection. Again, as Brookings (op cit) notes: "“Evidence that the coverage of the national treatment principle is broad and powerful is that it is the core issue in a large number of the formal WTO disputes. In fact, in almost any dispute in which a WTO member is alleged to have differentiated unfairly between domestic and foreign-produced goods—whether it be because of a discriminatory tax code, an explicit or implicit subsidy, or a regulatory barrier motivated by concerns over environmental or consumer safety—the heart of the issue is the applicability of and the potential limits to the national treatment principle.” (p18)
- - Tariffication & Binding
- - Prohibition of Quotas
- - Prohibition of Dumping & Export Subsidies
- - Safeguards for national interests.

VanGrasstek, 2013, The History and Future of the WTO, WTO Geneva, (625 pages of very detailed documentation and analysis) provides an intersting and illuminating chart of the influence and dependence on international merchandise trade (p. 31).

VanGrasstek's commentary on this chart is as follows (p31): "The data on trade dependence show that Germany is, in addition to being the largest trader in the group and the third-largest in the world, also the median country in the trading system: at 76.4 per cent, its trade dependence is exactly equal to that of the global average. As a general rule, the other large EU member states tend to be less trade-dependent than Germany, as in the case of France, Italy and the United Kingdom, while smaller members such as Belgium, the Czech Republic, the Netherlands and the Slovak Republic are among the most trade-dependent countries in the world. With trade having been the original area of competence for the EU machinery, and having played such a central role in the bloc’s existence, it is not surprising that the European Union places a higher priority on this area of public policy than the other large players do. The differing interests of EU member states nonetheless make for a sometimes unstable negotiating stance, not least on divisive and sensitive issues such as agriculture, and it is the larger and less trade-dependent members, such as France, that are more prone to apply the brakes even when smaller, more trade-dependent members would prefer to step on the accelerator.
Compared with their EU counterparts, US policy-makers place a lower priority on this subject. The United States is one of a handful of countries that are more important to the trading system than the trading system is to them. Whereas this country accounted for 10.2 per cent of global merchandise trade in 2011 (the highest of all), US trade in goods was the equivalent of just 24.8 per cent of the domestic economy (the third-lowest of all). The relative share of trade vis-à-vis the domestic economy was about three times greater in the average country than in the United States, and for many of them it exceeded 100 per cent. The situation of Japan is similar to that of the United States. Whereas this country was the fourth-largest trader in 2011, controlling 4.6 per cent of the total, trade was the equivalent of just 28.6 per cent of the Japanese economy. Some of the more prominent emerging and transitional economies share that same characteristic of being more important to the trading system than the trading system is to them. Consider Brazil, China, India, the Russian Federation and South Africa. These five countries collectively controlled 16.3 per cent of global merchandise trade in 2011, and individually ranged from 0.6 per cent (South Africa) to 9.9 per cent (China), but for each of these countries the value of total trade in goods (imports plus exports) in 2011 was equivalent to a smaller share of GDP than the global average of 76.4 per cent. That point is especially notable in the case of Brazil. It was in fact the least trade-dependent country in the world in 2011, with merchandise trade being equivalent to just 19.9 per cent of its GDP. Trade dependence was also below the 76.4 per cent global average in India (40.5 per cent), the Russian Federation (45.5 per cent), China (49.8 per cent) and South Africa (53.5 per cent). To be sure, not all emerging economies meet this description: Malaysia, for example, is among the most trade-dependent of all economies (148.8 per cent). On average, however, the largest emerging economies are, together with the United States and Japan, among the least trade-dependent."

The implications are that the most influential countries (for global trade) are now the least dependent on trade, which makes further multilateral trade agreements under the WTO much more difficult (even without the US adopting a more independent and potentially protectionist stance) - witness the slow to zero progress with the 'current' Doha round of WTO negotiations.

Have the GATT/WTO rounds of agreements promoted/encouraged moreTrade?
Arvind Subramanian and Shang-Jin Wei (2003): "The WTO Promotes Trade , Strongly But Unevenly", IMF Working Paper, conclude that - Yes, it has - "the GATT/WTO has had a powerful and positive impact on trade. The impact has, however, been uneven. GATT/WTO membership for industrial countries has been associated with a large increase in trade estimated at about 40 percent of world trade. The same has not been true for developing country members, although those that joined after the Uruguay Round have benefited from increased trade. Similarly, there has been an asymmetric impact between sectors, with WTO membership associated with substantially greater trade in sectors where barriers are low. These results are consistent with the history and design of the institution, which presided over significant trade liberalization by the industrial countries except in sectors such as food and clothing; largely exempted developing countries from the obligations to liberalize under the principle of special and differential treatment; but attempted to redress the latter by imposing greater obligations on developing country members that joined since the Uruguay Round."

The WTO's World Trade Report, 2011, Chapter 3, documents the historical background and current trends in preferential trade agreements.
Some key facts and findings - a huge number of PTAs, but, perhaps surprisingly, covering only a fraction of total world merchandise trade.
• Almost 300 preferential trade agreements (notified and not notified) were in force in 2010.
• 13 is the average number of PTAs that a WTO member is party to.
• Only 16 per cent of global merchandise trade receives preferential treatment.
• Less than 2 per cent of world trade is eligible for preference margins above 10 percentage points.
“Creation of the GATT did not diminish the attraction of bilateral or regional approaches to international trade relations. On the contrary, the push for new regional agreements, especially in Europe, re-emerged less than five years after the GATT was launched, ushering in a long period of creative tension between regionalism and multilateralism, and paving the way for dramatic advances in both approaches. If the mid-nineteenth century marked the first major phase of regionalism, the last 60 years have witnessed three additional phases or “waves”. Each has been driven, at least in part, by a perceived need among groups of countries to go “further and faster” than the broader GATT system in order to manage “deeper” trade integration (Carpenter, 2009). Although the widening and deepening of the European Union has been at the centre of each successive wave of regionalism, North America and now Asia have also joined the race. At the same time, each wave has tended to coincide with – or be immediately followed by – significant advances in GATT negotiations, leading some to argue that there is a process of competitive liberalization, or “domino effect”, not just among the various regional agreements, but more fundamentally between regionalism and multilateralism.” (p. 51/2)
1st wave: 1950s and 60s ECSC (’51)-> EEC (’57) (&EFTA, for the others) + Africa, Caribbean, Central and S. America – though most collapsed by end of ‘70s. "The launch of the Dillon Round of trade negotiations in 1960 was prompted in part because the adoption of the EEC's common external tariff required the renegotiation of certain members' bound tariff rates (i.e. the upper limit for members' tariff rates) – a process which encouraged these members to seek reciprocal tariff reductions from trade partners in a broader multilateral context. Likewise, the more ambitious Kennedy Round between 1964 and 1967 coincided with negotiations to expand the EEC to include Britain, Ireland, Denmark, Greece and Norway (which did not join) – and was motivated in part by US concerns about being excluded from an ever-broader and more unified European market (Anderson and Blackhurst, 1993). Thus, GATT tariff cutting and membership enlargement moved in tandem with the widening and deepening of Europe's integration project, as well as with other regional initiatives. (p.52)
2nd wave: (mid’80s – ‘90s) – again EU led –1st enlargement, 2nd Iberian expansion (’86)-> EEC->EU (Mastricht) & single market ’93, Austria, Finland and Sweden accession ’95, Eastern preparation and expansion ’04, and Romania Bulgaria ‘07, and subsequently by the US: "Having eschewed regionalism in favour of multilateralism for almost 40 years, the United States suddenly shifted strategies, embarking on an ambitious programme of bilateral negotiations that included, first, a free trade agreement with Israel in 1985, and then, more dramatically, the Canada-US Free Trade Agreement in 1988, later trilateralized to include Mexico in NAFTA in the early 1990s (Anderson and Blackhurst, 1993). Much of the “new” trade policy agenda that the United States had been seeking in the multilateral arena – such as investment, services trade, intellectual property rights, and government procurement – was incorporated first in these bilateral and regional talks, and then taken up in the Uruguay Round negotiations." (p. 52) Latin America followed suit (Mercosur), as did some of Africa (e.g. SADAC), and somewhat later, Asia as well. "After several failed attempts, the Uruguay Round was launched in 1986, including for the first time a negotiating mandate on services, intellectual property and, to a more limited extent, investment. Despite concerns about the GATT being eclipsed by regional deals – or because of them – the Uruguay Round was successfully concluded in 1994, crowned with the creation of the WTO, effectively taking some of the
energy out of this second wave of regionalism." (p. 53)
3rd wave: " most recent “wave” of regionalism covers a much wider network of participants – including bilateral, plurilateral and cross-regional initiatives – and encompasses countries at different levels of economic development – including “developed-developed”, “developing-developing”, and “developed-developing” alliances. And although these new agreements, like previous PTAs, also involve preferential tariff reductions, they focus even more on WTO-plus type issues, such as services, capital flows, standards, intellectual property, regulatory systems (many of which are non-discriminatory) and commitments on labour and environment issues." (p. 53)

Some Key Charts from this report:
60 years of PTAs

For an impressive interactive representation of the proliferation of PTAs, see the GED Project page.

However, there is another explanation for the growth in world trade, as measured by these data on merchandise trade: global value chains and 'distributed manufacture' - illustrated by the iPad 'value added' story.
iPad

"iPads are assembled in Chinese factories owned by Foxconn, a Taiwanese firm, largely from parts produced outside China. According to a study by the Personal Computing Industry Centre, each iPad sold in America adds $275, the total production cost, to America's trade deficit with China, yet the value of the actual work performed in China accounts for only $10. Using these numbers, The Economist estimates that iPads accounted for around $4 billion of America's reported trade deficit with China in 2011; but if China's exports were measured on a value-added basis, the deficit was only $150m."

The OECD & WTO now have a joint intiative to examine 'value added trade', (watch the short video, top right of this page), and develop measures and statistical databases to reflect these chains.

Essentially, the development of these global integrated supply chains can be seen as a logical development of the comparative advantage/specialise and trade logic as communications systems improve, as transport costs decline, and as trust in offshore partners increases (as people learn by doing).

A footnote on the latest (and first) WTO agreement: The Trade Facilitation Agreement (February, 2017) "which seeks to expedite the movement, release and clearance of goods across borders, launches a new phase for trade facilitation reforms all over the world and creates a significant boost for commerce and the multilateral trading system as a whole. Full implementation of the TFA is forecast to slash members' trade costs by an average of 14.3 per cent, with developing countries having the most to gain, according to a 2015 study carried out by WTO economists." "Spread out over 12 articles, the TFA prescribes many measures to improve transparency and predictability of trading across borders and to create a less discriminatory business environment. The TFA's provisions include improvements to the availability and publication of information about cross-border procedures and practices, improved appeal rights for traders, reduced fees and formalities connected with the import/export of goods, faster clearance procedures and enhanced conditions for freedom of transit for goods. The Agreement also contains measures for effective cooperation between customs and other authorities on trade facilitation and customs compliance issues."

One illustration of economic disintegration is the collapse of the USSR in 1990: (see, Cleaver, p 16-18, and e.g., Harrison, University of Warwick, 2003, and Lin, The Brookings Institution, 2004.
FSU growth

In contrast, China's internal and external economic integration shows a much more successful transition from central planning to a modern market economy (Cleaver, pp18 - 20, and e.g. Zhu, 2012, and for a current (Dec. 2015) view, FocusEconomics China Outlook
China's Growth

Source: UN National Accounts Main Aggregates Database.

FOR AN EXCELLENT REVIEW OF TRADE (Economic Integration) AND SOCIO-ECONOMIC DEVELOPMENT, SEE LOVE & LATTIMORE: International Trade: Free, Fair and Open?, OECD, 2009.

2. FINANCIAL INTEGRATION

Cleaver (Ch 7) provides a sensible account of money, banking and international finance. He explains the "global explosion of finance" since the major financial deregulations of the '80s (especially in the US and UK under Reagan and Thatcher respectively) as being caused by:

Trade and the need to both finance trade and recycle surpluses: Cold war development of essentially unregulated 'EuroDollar' markets through offshore banks operating outside domestic exchange and monetary controls - operating wholesale (large transaction volumes) "large turnovers, small margins and regulation avoidance -> commercial success and strong competition to domestically based banks. The collapse of the fixed exchange rate regime, and the oil price boom (and associated trade surpluses and deficits) generated major opportunities for international finance companies. Subsequently, the rapid growth in Asia, especially China, largely on the basis of exports, further generated trade imbalances and the need for offsetting capital account financial flows.
Technology: - computing and communications -> virtual and virtually instantaneous trading.
Deregulation: - once begun becomes progressive as banks and financial intermediaries (such as insurance companies) press their governments to allow them to compete effectively with less regulated foreign competitors -> mergers and acquisitions to generate global banks and insurance companies. See, e.g. Sherman, 2009, A Short History of Financial Deregulation in the US. (highlighted by your lecturer)
Innovation, risk, customisation & computer modelling/trading.

The consequences of these changes in the world's finance markets led to an explosion of financial contracts and associated assests and liabilities, as well as growth and global consolidation in the number and inter-relationships between the financial 'intermediaries' and bank activities, setting the scene for a succession of debt crises and credit crunches.
What are these banks and financial intermediaries trying to do? (short answer - make money) The Finance Watch page provides a basic account of financial markets (though beware - while FW has the laudable aim of "making finance serve society", it can get things wrong (e.g. excessive speculation on agricultural commodity exchanges causing commodity price spikes, on which there is very limited if any substantive evidence).
The Economist - history of financial crashes (below) - says: "finance does just two simple things. It can act as an economic time machine, helping savers transport today’s surplus income into the future, or giving borrowers access to future earnings now. It can also act as a safety net, insuring against floods, fires or illness. By providing these two kinds of service, a well-tuned financial system smooths away life’s sharpest ups and downs, making an uncertain world more predictable. In addition, as investors seek out people and companies with the best ideas, finance acts as an engine of growth."

facilitate trade - providing for the exchange of money and credit, typically 'across the exchanges (i.e. involving the exchange of one currency for another) - the easier the better for trade, and thus for economic development;
match savings with investment (the 'capital market' function) - harnessing trading and other surpluses with demands for loans (to finanance both physical and productive investments, and consumption); as GDP grows, so, too, does the demand for and supply of 'loanable funds' (savings and borrowings), see, e.g. Domestic credit provided by the financial sector as a %GDP, World Bank
preserve and enhance wealth (accumulated savings of clients, and manage pension funds), the demand for which also grows with GDP;
spread risk - insurance is the classic example, but now massively expanded to include insurance against adverse price and exchange rate movements.

How do they try to do it?

Borrowing (savings) v. Lending rate margins: traditional bank earnings stream - competiton obliges these margins to be as small as possible, given the transaction costs and necessary returns to risk of default.
arbitrage: essentially, buy cheap and sell dear - both for commodites and financial assets (whose value depends on their future earnings and on interest rates), so extending to borrow cheaply and lend expensively. Given sufficient competition in the markets, this activity should result in an efficient market
hedging: offsetting opposing risks, as in the traditional commodity futures exchanges which offset, or balance, the different risks of the buyers and sellers of e.g. wheat. (note, especially, that commodity futures exchanges rely on speculators (who only bet on one-way movements in prices) to maintain liquidity in the market (frequency and ease of trading (exchanging) futures contracts) which preserves their price formation and discovery functions, and require traders to cover their margin (good faith deposits required from trader or investor entering into a long or short position on a futures contract.)
portfolio management: Spreading risk through construction and management of diversified portfolios of investments - balancing different risks and risk exposures (and charging a fee for these services) -> to creation of novel forms of 'derivatives' to spread risk
speculation: i.e. betting on future price movements -> also leads to the development of 'derivatives' and spread betting etc.

The Economist essay on the history of financial crashes provides a sketch of how finance markets have been prone to booms and busts since their inception. This history illustrates the fundamental problem: Commercial Banks provide the lubricant (money) for the modern economy to work, but they are prone to take on excessive risk in the pursuit of private profit. Since runs on banks (where all depositers demand their money back at the same time, when there is simply not enough money to meet the demand) will lead to economic depressions, governments are persuaded to underwrite the banks and hence underwrite the risks. This creates a moral hazard - people likely to take more risks if they are insured than if not - so banks (insured by Governments) take more risks, especially if they are regarded as 'too big to fail'. Furthermore, governments try to keep interest rates as low as possible (other things equal), to encourage investment, and subsidise banks. (Economist, April, 2014). The result is Hyman Minsky's financial instability hypothesis (as in previous notes on stock markets), which describes three kinds of financing:

"The first, which he called hedge financing, is the safest: companies can repay debts with their earnings. They have limited borrowings and good profits.
The second, speculative financing, is a little riskier: companies can cover their interest payments but must roll over their principal. This works fine normally but not in downturns.
The third, Ponzi financing, is the most dangerous. Earnings cover neither principal nor interest; firms are betting that their assets will appreciate. If not, they are in trouble.

Economies dominated by hedge financing—those with strong cashflows and low debt levels—are stable. When speculative and, especially, Ponzi financing become popular, economies are vulnerable. If asset values fall, overstretched investors must sell their positions. This further hits asset values, causing pain for even more investors, and so on—a downward spiral now sometimes called a “Minsky moment”. Investors would have done better to stick to hedge financing. But over time, particularly when the economy is healthy, debt is irresistible. When growth seems guaranteed, why not borrow more? Banks add to the dynamic, lowering their standards the longer booms last. If defaults are minimal, why not lend more? Mr Minsky’s conclusion was unsettling: periods of stability breed financial fragility." (Economist, ibid) The differential tax treatment of capital gains (increase in the value of assets such as stocks and shares) versus the treatment of dividends (the annual yields from these stocks) can also affect stock market bubbles - such as the dot.com bubble 1997-2003.

The 2008 Credit Crunch and the Financial Crisis.
Cleaver, ch. 9 provides the background, including synopses of previous debt and financial crises and lessons learned (or not).Good accounts of the 2008 crisis are the Economist (2013) and Bill Robinson, Citywire Money, Sept, 2008.
The Economist says "it is clear the crisis had multiple causes (the Congressional Research Service, Mark Jickling, April 2010, records 26 plausible reasons, and brief counter-arguments)

The most obvious is the financiers themselves—especially the irrationally exuberant Anglo-Saxon sort, who claimed to have found a way to banish risk when in fact they had simply lost track of it: (irresponsible mortgage lending (encouraged by government), sub-prime mortgages repackaged in special investment vehicles (SIVs), otherwise known as Collaterised Debt Obligations (CDOs), and sold on as assets and backed up with Credit Default Swaps (CDSs) as supposed insurance on the mortgage bonds, - see Dan Wang's explanation): Dominoes:
The banks (including Lehman Brothers, Merrill Lynch, and J.P. Morgan) and the insurance companies (including AIG), all either owned CDOs or sold credit default swaps. They found that their CDOs had failed, and were on the hook for billions of losses because they bet wrong.
Dozens of banks failed, the most high-profile of which are Lehman Brothers and Bear Sterns. AIG declared bankruptcy. Merrill Lynch was sold to Bank of America. People started to panic, and credit markets seized up. Businesses struggled to keep their loans and get new ones.
It was at this time that Congress passed TARP, the Troubled Asset Relief Program, a $700 billion bailout of the big banks and the insurance companies. Citigroup, for example, received $45 billion; AIG received $40 billion; J.P. Morgan and Wells Fargo both received $25 billion; Goldman Sachs received $10 billion; and so on. Meanwhile, the hedge funds that saw the crisis coming made billions.
Central bankers and other regulators also bear blame, for it was they who tolerated this folly (perhaps, especially, the Credit Rating Agencies (paid for by Finance companies), who incorrectly rated risky mortgage bonds as AAA etc., while Central Banks perhaps kept interest rates too low).
The macroeconomic backdrop was important, too. The “Great Moderation”—years of low inflation and stable growth—fostered complacency and risk-taking, and was associated with US Government encouragement of house ownership, and relaxed mortgage rules.
A “savings glut” in Asia pushed down global interest rates. (Low interest rates created an incentive for banks, hedge funds and other investors to hunt for riskier assets that offered higher returns. They also made it profitable for such outfits to borrow and use the extra cash to amplify (leverage) their investments, on the assumption that the returns would exceed the cost of borrowing. The low volatility of the Great Moderation increased the temptation to “leverage” in this way. If short-term interest rates are low but unstable, investors will hesitate before leveraging their bets. But if rates appear stable, investors will take the risk of borrowing in the money markets to buy longer-dated, higher-yielding securities - an architypical Minsky progression).
Some research also implicates European banks, which borrowed greedily in American money markets before the crisis and used the funds to buy dodgy securities.
All these factors came together to foster a surge of debt in what seemed to have become a less risky world."

Bill Robinson ascribes the underlying cause to "a global surplus of savings. The most famous symptom is China’s large current account surplus.This represents the net savings of the Chinese nation, which has been consistently used to buy US government bonds. The oil exporting countries run similar surpluses, which have grown as the oil price has risen, and are also large purchasers of bonds. The resulting strong demand for bonds has driven up their price and driven down real yields to extraordinarily low levels. The resulting availability of cheap credit fuelled the long boom since 2000 and had a particularly strong impact on the housing market." Though, as the Economist (op.cit) notes: "Hyun Song Shin, an economist at Princeton University, has focused on the European role in fomenting the crisis. The glut that caused America’s loose credit conditions before the crisis, he argues, was in global banking rather than in world savings."

The immediate consequences of the Credit crunch - commercial banks calling in loans and unwilling to lend because of uncertainty about their assets - was an underwriting of the banks and insurance companies (Troubled Asset Relief Programme (TARP), and the effective transfer of private sector borrowing to the public sector. Subsequent fiscal stimulus added to the public sector deficits - Treasury Borrowing - to offset an econonomic depression.
US Credit Market

Source: Understanding the Flow of Funds Systemand the Financial Crisis of 2008, David Nawrocki and Fred Viole, Dec. 2012.

The Euro Crisis.
Again, Cleaver, ch 9, provides a synopsis, while the European Commission also provides a brief account, and the New York Times has a graphical illustration of the continental and global interactions. Economics Help also has a readable explanation, as does Der Spiegel. The Economist, Nov. 2015, comments: " that the euro-area crisis was not a sovereign-debt crisis. If it had been, one would have expected Belgium and Italy, which entered the crisis with extraordinarily high debts, to have landed in serious trouble. As it turned out, they made it through without troika programmes, while Ireland and Spain, which entered the crisis with low levels of sovereign debt, needed bail-outs. The problem, instead, was one of massive capital flows across borders, which encouraged high levels of private borrowing in the economies that eventually got into trouble. When the global financial crisis generated a reversal in those flows, private borrowers and banks got into big trouble. That trouble translated into serious economic downturns and bank failures, both of which led to explosive growth in sovereign debt burdens. Exploding sovereign debt was the symptom rather than the cause of the crisis."
One graph illustrates the eventual nature of the crisis.
EuroZone bond rates

The BBC provides a timeline., and charts (GDP growth, unemployment, public (government) debt and budget deficits) for EU countries from 1999-2014 (complete with the Masstricht Treaty limits on debts and deficits as % of GDP (now under the Stability & Growth Pact for the Eurozone)

As widely expected, and as simple theory suggests, the formation of the Euro meant a convergence of Eurozone interest rates (here measured as the implict rate from the price of 10 year Government bonds. Notice, Greece was not admited to the Euro immediately, and even when allowed to join was clearly in breach of the Maastricht Treaty limits on both budget defits and public (government) debt as proportions of GDP (see BBC charts), but then so too were several other members of the Euro.
However, it took the banking crisis triggered by the credit crunch in late 2008 to fully expose the economic nonsense of a single interest rate throughout the Eurozone.
The credit crunch collapsed property prices, especially in Ireland and Spain, and left all European banks exposed to the huge uncertainty about what their assets were actually worth, and about the extent of their liabilities. To prevent a complete collaps of the banking system, virtually all member governments had to step in to underwrite their banks exposure, and hence assume their debts. As in the US (above), public (government) deficits and debts increased as a consequence (again, see BBC charts).
The fiction of a single interest rate for the Euro members was now brutally exposed. Would and could the Euro survive? If not, what would the finances of member countries (especially the PIGS (Portugal, Ireland, Greece and Spain)) look like? The finance markets responded as shown in the graph above, immediately reducing the price (and hence raising the implicit interest rate) on these countries public debt (as represented in the value of their government bonds).
Greece, especially, was seen as the most likely country to leave (or be evicted from) the Euro, because its domestic economy was the most obviously unsustainable (large external (BoP) deficit, substantial government debt and large budget deficits - the latter two heavily disguised with the help of international finance companies to partially conceal their full extent).
Without leaving the Euro, and hence denied the possibility of a substantial devaluation of the Greek currency, what options are there to relieve the Greek (and other PIGS) problems?

Debt relief (writing off the public debts - meaning that the creditors, widely dispersed throughout the global financial system, would loose, and these (and other) countries would not be penalised for their excesses - creating a substantial moral hazard - encouraging othe countries within the Eurozone to also behave profligately, especially in times of low interest rates);
Stronger growth to provide the income streams to allow debts and deficits to be reduced (which means both fiscal and monetary policy to expand the economies);
Structural and policy reform to improve the performance of the domestic economy - necessary in any event in Greece, and also elsewhere, to reform tax policy to capture more of the economic activity, and reform government spending to eliminate unproductive and extravagent spending (overblown public services etc.);
Fiscal Austerity - to reduce government spending - not exactly consistent with stronger growth.

The "Troika" comprising the International Monetary Fund (IMF), the European Commission and the European Central Bank, although finding it difficult to agree, did provide bailout assistance to Greece - arranging a 'haircut' on some public debt, providing additional monetary reserves to finance internal reforms, on heavy conditions about the nature and extent of these internal reforms. These succesive bailouts are still going on, and mirror to a large extent what the international community had already done to developing countries with large debts in the '90s.
The ECB has also embarked on 'quantitative easing' (against some considerable opposition, especially from Germany (see Martin Wolf, FT, May 2016), buying Eurobonds, and hence driving their prices up and reducing the interest rate, while injecting additional money into the banking sector, which is supposed to encourage bank lending and hence reflate the economy - though mostly through the reflation of housing and property markets (helping Ireland, especially).
However, at least in the 'short term', internal reforms are difficult and anyway take time to happen. Meanwhile, growth is not happening - the very reverse (again, see BBC graphs above). Fiscal austerity is making the situation worse, not better - we need more growth throughout the EU and Eurozone. While the Irish have managed to regenerate economic growth, and hence eased their difficulties, the other vulnerable and exposed countries have not.
The key problem facing the Euro is that it is inherently unbalanced, and lacks any fiscal means of assisting the rebalancing of the Erozone economies (no large scale transfers of public funds between the prosperous and lagging regions - the EU budget is fixed by treaty to be no more than 1.4% of GDP - tiny in comparision with other national/single currency areas such as the UK or the US).
In addition, the reluctance of Germany (especially) to recycle its substantial trade surplus to other countries with large deficits, and its additional reluctance to countenace relaxation of fiscal austerity (reflecting its history of the problems of fiscal excess financed by monetary expansion) makes the problem even more difficult.
On the other hand, preservation of the Euro (and thus the Eurozone) is a political imperative, especially in Germany, which has benefited substantially from being in the Euro and part of a wider and larger economic entity. Its exchange rate has been the Euro exchange rate, rather than the much stronger D'mark (at least after recovery from the economic trauma of German unification at parity), hence benefiting its exports and making imports cheaper than otherwise.
Without full fiscal union, and hence full political union, the Euro will always be vulnerable to disintegration - a realisation which makes it even more vulnerable, since political union to, effectively, a European superstate, is very far from the ambitions and aspirations of many, if not most, of its citizens.
From its inception, the Euro has been a bold political experiment - intended to foster trade, economic activity and convergence and bolster European unity in the face of very substantial, if not insurmountable economic reality. It remains a political aspiration rather than an economic foundation (see Jo Stiglitz, August, 2016, the Problem with Europe is the Euro). If Germany (or France or Italy) had been obliged to hold a public referendum prior to joining the Euro, it would probably never have happened. If the UK government has decided that joing the Euro was a good idea, then it would almost certainly have been obliged to hold a referendum to ratify its decision, and would again almost certainly have lost. Perhaps the only way the British public might have been persuaded that joining the Euro was a sensible thing to do woujld have been to demand that the EU adopt a common language as well as a common currency, and that it should be called the pound, and not the Euro. Even then ....

3. Why did no one see this coming? What went wrong?

Paul Krugman (NY Times, Sept, 2009) explains How Economists got it so wrong: (quotes below are from this article)
i) Macro-economists were complacent: they had got over their 1960s quarrels about whether monetary or fiscal policies were more important (stable monetary policies, targeting inflation were all that was needed, re-inforced by the experience with stagflation in the 1970s); fiscal fine-tuning (counter-cyclical) policy was counter-productive; leading to a complacency largely born out by the 'great moderation' - a sustained period of growth, low(ish) unemployment, and low inflation. "Between 1985 and 2007 a false peace settled over the field of macroeconomics." "The Fed (US central bank) dealt with the recession that began in 1990 by driving short-term interest rates from 9 percent down to 3 percent. It dealt with the recession that began in 2001 by driving rates from 6.5 percent to 1 percent. And it tried to deal with the current recession by driving rates down from 5.25 percent to zero."
ii) with a pervasive belief that finance markets are (always) efficient - the efficient market hypothesis, (Lo, 2008) and closely related 'capital assets pricing model' (CAPM). "Finance economists rarely asked the seemingly obvious (though not easily answered) question of whether asset prices made sense given real-world fundamentals like earnings. Instead, they asked only whether asset prices made sense given other asset prices."
Krugman argues: "So here’s what I think economists have to do. First, they have to face up to the inconvenient reality that financial markets fall far short of perfection, that they are subject to extraordinary delusions and the madness of crowds. Second, they have to admit — and this will be very hard for the people who giggled and whispered over Keynes — that Keynesian economics remains the best framework we have for making sense of recessions and depressions. Third, they’ll have to do their best to incorporate the realities of finance into macroeconomics."

How does this fit with the 'basic principles' (DRH's 'rationalisation')

Capital 'markets' are conceptually different from Finance markets, and largely disconnected in models of the macroeconomy. The basic macroeconomic models (from the CFoI and the notion of an aggregate supply function or aggregate production function), capital markets are those which mediate between the flows of savings (earnings not spent on current consumption) and flows of investment (additions to the productive capacity of the economy (new plant, equipment, infrastructure, labour and management skills etc.). Finance markets, on the other hand, are largely concerned with the valuations and exchanges of stocks of both paper and physical assets, since the total stock of physical (and human) capital assets does not change at all quickly, and can be considered more or less fixed in the short term.
Neither of these markets establish 'the rate of interest' for the economy - this is established in the Money market, through the actions of the Central Bank (the Federal Reserve in the US, the BoE in the UK and the ECB for the Euro area).
Typically, the macroeconomic models used by treasuries, finance ministries and departments and central banks do not include any aspects of the finance markets - they focus on the interaction between monetary policy (the money market) and the real economy as the circular flow of income (aggregate demand), and some notion of supply capacity. This ignorance of the finance markets is justified by the belief that these markets are 'efficient' - that they accurately determine the prices of assets and associated relative risks, and hence the constellation of interest rates accounting for the differences in risk, and hence mediate appropriately between the money market and the capital markets.
But the efficient market hypothesis (EMH) is NOT about the social efficiency of the finance markets - whether or not they actually lead to more secure and stable savings opportunities, or more intelligent and productive investments for our collective futures. It is ONLY about whether or not finance markets 'correctly' price stocks of capital (and all their derivatives). Recent history strongly suggests that they don't, at least not reliably. As Lo, 2008, (the link above) says, the EMH is, essentially: “individual investors form expectations rationally, markets aggregate information efficiently, and equilibrium prices incorporate all available information instantaneously.” However, stock markets cannot be perfect in this sense, as Grossman and Stiglitz, 1980 argue. “Because information is costly, prices cannot perfectly reflect the information which is available, since if it did, those who spent resources to obtain it would receive no compensation (and hence would be unable to survive and persist). There is a fundamental conflict between the efficiency with which markets spread information and the incentives to acquire information" (p405). Grossman, S. and Stiglitz, J. 1980. “On the impossibility of informationally efficient markets”, American Economic Review 70, 393–408
As Lo (op cit.) observes, in making the case for an evolutionary approach to finance market behaviour (the adaptive markets hypothesis): “The extraordinary degree of competitiveness of global financial markets and the outsize rewards that accrue to the ‘fittest’ traders suggest that Darwinian selection – ‘survival of the richest’, to be precise – is at work in determining the typical profile of the successful trader. After all, unsuccessful traders are eventually eliminated from the population after suffering a certain level of losses.” Instead of doing what the markets for goods and services do, which is to ensure the survival of the fittest, finance markets essentially ensure the survival of the fattest.
Unfortunaely, but predictably (according to Minsky's Financial Instability Hypothesis), a boom and crash cycle is practically inevitable. Central are then obliged to underwrite commerical banks, since not doing so could only make matters worse - hence regulation of the finance markets to ensure that they remain prudent is essential. Deregulation of the finance markets in the 1980s and 90s led, eventually, to the Credit Crunch and subsequent Sovereign Debt crises.

A more complete account of this logic can be found in "Reflections on the state of Capitalism" (DRH, Corvinus paper, 2010)

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