The euro: a union too far?

Why a bright future for Europe did not depend on a common currency

When the Euro was launched in 1999, I was but a wee lad, barely over one year into an undergraduate degree in the dismal science. The common currency was something of a curiosity at the time as its ambition was unprecedented even for our globalized age. After all, it certainly seemed to be one giant step ahead of my country’s own feeble attempt (in comparison) at economic union: NAFTA, which had barely half a decade of existence at the time. For those who were worried about US hegemony, the launch of the Euro was a subtle reminder that a new and powerful economic force was being born, one which would hopefully shape the global economy into the more socially progressive image of Europe, rather than the rapacious gung-ho capitalism which Washington and Wall Street had shoved down our throats. More symbolically, it represented – at least in my eyes – a watershed event in history, whereby for the first time Europe was united not by Napoleon’s guns, or Hitler’s panzers, but by a common and voluntary belief that the path to future prosperity was one that no European country should have to travel alone.

It's time to question its existence

It’s time to question its existence

How the times have changed. I’m not going to dwell on the implications or even the possibility of a Euro breakdown (there’s plenty of that around), but it has come to a point where a economists we should really question whether the Euro was that great leap forward promised a decade ago by Europe’s leaders, or a colossal mistake whose benefits were overhyped and its potential drawbacks blissfully (or conveniently) ignored. For this I found a nice little PDF from the European Commission, probably written around 2007, right before the financial crisis exploded in everyone’s faces. With the benefits of hindsight let’s see whether the Euro has lived up to its lofty promises.

The benefits

Price Stability. One of the objectives of the Euro was to bring down inflation in some of the less “price stable” economies (notably some large ones like Italy and France) closer to the level of Germany. The reason for this was that in a free trade area like the EU where most trade is conducted among the member states, those which faced higher inflation would be forced to constantly devalue their currencies in order to maintain competitiveness. And since the ECB was ultimately modelled on the German Bundesbank (a poster child of monetary efficiency and political independence), it was expected that the greater confidence awarded to the ECB would also help keep inflation expectations anchored at a lower level for all countries – this would be akin to having the Germans run Italian monetary policy. Ultimately, inflation was indeed lowered across the board and in this sense the Euro succeeded in bringing German-style price stability to some of the more inflation-prone countries. But by tying inflation to the lowest common denominator, the Euro has restricted the policy options for countries seeking to boost employment and growth since any sort of expansionary monetary policy is impossible for countries that need it to get out of a crisis. More on this below.

Exchange-rate stability. This goes hand in hand with price stability. Eliminating currency fluctuations among Euro members makes trade and investment more attractive since companies no longer have to carry the costs of hedging their exchange rate risks. And for the Germans at least, it was a guarantee that its competitors would not resort to devaluation to give an artificial boost to competitiveness – they’d have to do it by making the structural reforms to make them competitive. As an added plus to the Germans, including its less competitive peers into the Eurozone would also help to weaken the new Euro relative to the old Bundesmark since all the member states would ultimately have some weight in the Euro’s value. Doubleplusgood for Germany’s export machine. Doubleplusbad for the countries seeking adjustment (i.e. Greece and the other Southern European economies), since the consequences of being stuck with the same currency as their more competitive trading partners is proving disastrous. In simple terms, they cannot export their way out of recession through a devaluation, and they can’t use that devaluation either to realign their balance of payments issues. With a common currency, they become trapped in a stranglehold of uncompetitiveness which can only be broken free from through a painful internal devaluation: falling wages and labour costs, deflation, and fiscal austerity which could well last for a decade.

Sound public finances. It’s almost a joke to see this as a plus point. Suffice to say that in yet another Germanic attempt to maintain economic discipline among its unruly peers, countries who joined the Euro pledged to keep their debt-to-GDP ratios below 60%, and their annual fiscal deficits under 3%. This was known as the Stability and Growth Pact. But guess which country constantly flaunted these targets? Yes, Germany itself, no less than three years in a row (and France did too). But in a cruel twist of fate, some of the countries which were actually running fiscal surpluses, like Spain, are now in the crosshairs of the bond vigilantes (more on this below). The ridiculousness of the Stability and Growth Pact was that it was ultimately unenforceable when its two biggest and presumably most responsible members didn’t set the example for the rest. And putting such rigid targets also ignored the fact that debt dynamics can go sour in a dramatically short period of time, Spain being the perfect example of a country which went from a fiscal darling in 2007 (three straight years of surplus) into the thresholds of a bailout by 2010-11.

Low interest rates. Apart from the public finances part, this is without question the Euro’s other massive failure, stemming ironically from the fact that it was actually a resounding success: the integration of the Eurozone’s capital markets effectively made it easier for banks to borrow and lend in Euros at nearly the same price in every country. The EC’s note claims that average nominal interest rates came down from 9% in the 1990s to around 3% by 2007. But more important than the actual numbers is to see where the money went. By far the benefits went to the less productive economies since banks could borrow cheaply in the North and then lend the same currency at higher profits in the South. But without any productive sector to lend to, the money ended up fuelling asset bubbles instead, the most colossal of which was the Spanish housing boom which in relative terms, dwarfed even that of the US. Of course, nobody complained at the time since the bubbles were helping boost employment and drive growth. Spain’s unemployment in the 1990s was actually not that much worse than it was today (just below the 20% mark), but by 2005 Spain was generating half of all new jobs in the entire EU. You read it right, half. Ireland went even further, transforming itself to one of the richest countries in the world in GDP per capita terms (surpassing even that of its former imperial master, Britain). And although the benefits to Italy and Portugal were less dramatic, the inflow of cheap capital helped address another important macroeconomic imbalance: the growing current account deficit that the South had been amassing and which could only be financed with money from abroad.

This, coincidentally, was one of the great lies that certain European politicians and economists kept reciting to themselves: that the imbalances didn’t matter since as a whole, the Eurozone was in equilibrium (i.e. the current account deficits of the South would be compensated by the surpluses of the North). But this is like saying that the Earth is in equilibrium because we’re even off with Mars. When financing dried out, and the current account deficits couldn’t be narrowed because these countries were woefully uncompetitive, then it was public money that has had to be used to plug the gap. This is one of the less publicised reasons why deficits have shot up so dramatically in so little time in countries that had been fiscally healthy in the past (like Spain, whose current account deficit is exceeded only by that of the US).

Investment and trade. Well, this was bound to be a success, albeit squarely for technical reasons. With a common currency, exchange rate costs become nil, and the movement of goods and capital as frictionless as it can get. Nevertheless, there is some evidence that cost convergence has not been entirely successful, particularly with respect to services: the dearth of Euro-wide retailers is worrying proof that the grand majority of European business is still done within borders. So if anyone is to benefit, it’s been precisely the large multi-nationals which are already involved in cross-border trade (and would be anyway, even without a common currency), and the big banks which can now move money across the Eurozone easier than air. But for us mere mortals, we’re stuck with the prices slapped by each country’s retailer. Adam Smith himself, for example, would be appalled to see that identical imported editions of The Wealth of Nations from the same retailer (Amazon) cost €13.68 in France but only €9.40 in Germany despite nearly similar tax rates (5.5% and 7% for books, respectively) and shipping costs. You wouldn’t see such differences between Kentucky and New York. But hey, at least we get free euro cash withdrawals!

Reaping full benefits of the EU’s internal market. This is largely a rehash of the exchange rate as well as investment and trade benefits. Although the note claims that there would be increased competition, this has not been so apparent in services, which I should add, represents the single largest economic sector in Europe, accounting for well over two-thirds of GDP. And price transparency matters little when you are basically buying products from national retailers who can charge national prices (well, at least you can see what your neighbor is paying). It is sad therefore, that the greatest success in this regard has been the creation of “large and liquid financial markets”, the same markets which are a default away from collapse and have sucked up billions of euros in cash injections and bailouts over the past four years.

The verdict

I try and think of myself as an objective economist, and certainly the polar opposite of the rabid Euro-bashing Anglo Saxons that when facing the intellectual failure of the free market fundamentalism they defended, pathetically seek vindication in the Euro’s demise. I’m a fan of Europe and I like the EU for what it represents at least in theory: economic integration, political harmony, and most importantly, the commitment to a common future. But for all my efforts at defending Europe against its insular detractors, I can’t but think that the Euro’s costs by far exceed its benefits and that this overly ambitious step in economic integration could have well been skipped without compromising the European project as a whole.

It’s almost cliché to bring up von Moltke but his legendary quote that “no plan survives first contact with the enemy” cannot be more appropriate to describe the Euro’s main problem: it was never stress tested. In the hubris of the Great Moderation – the period in which the market fundamentalists arrogantly believed they had harnessed the power to tame recessions – it was never considered that a crisis as deep and protracted as the one we are currently going through would ever occur, and that a Eurozone member potentially facing twin deficits (a fiscal deficit plus a current account deficit) would find itself in an inescapable trap if it was locked into a common currency arrangement with its trading partners, thereby losing the ability to independently manage its monetary policy. In the midst of this hubris, some very shaky assumptions (which in retrospect seem woefully naïve) were taken as a given. 1) That if the Eurozone was in equilibrium with the world, its member states would also be with themselves despite their huge structural heterogeneity. 2) That by making devaluation impossible, countries in the South would automatically adopt the structural reforms to become as competitive as the Germans. 3) That lower interest rates would channel capital from the North into its most productive – rather than most profitable – use in the South. And finally, 4) that debt dynamics would be so slow to shift, that a country sticking to the Stability and Growth Pact rules would never be close to default.

The fact is, none of these assumptions held, and the countries now stuck in the twin deficit trap only have one way out: austerity, a policy which disproportionally forces the middle and lower classes of the South to foot the bill for the mistakes made by the their leaders (both in their own capitals as well as in Brussels). In the supposedly democratic and progressive society which Europeans like to think of themselves as belonging to, this should be clearly unacceptable. But unfortunately, there is no clear mechanism in place for a country to consider exiting the Euro and taking the other path, that of inflation and devaluation (which though perhaps even more painful in the short-run than austerity, offers far more hope of a quicker resolution). This, after all, would be an admission of failure, and it’s better to let the Greeks stagnate for a decade than have Brussels admit it went a step to unity too far. Another alternative would be a Eurozone-wide policy of all-out monetary support from the ECB and some fiscal stimulus to boot. But god forbid German inflation goes up by 0.1% as a result and that German taxpayers foot part of the bill (a bill which would be paid back once Greece and the others get back on their feet). Small wonder the EFSF pathetically asked China to chip in.

Ultimately, I see the broader failure of the Euro largely stemming from the fact that it was not an economic project designed to maximize the growth potential of a structurally heterogeneous region but rather, an attempt to instil Germanic discipline among Europe’s more irresponsible economies by force – discipline which I should add, the Germans themselves did not always pay heed to. To the defenders of the common currency I ask you three questions: 1) Did the Euro actually boost Europe’s growth during the “boom” years to justify its implementation? The answer is probably yes but for all the wrong reasons (i.e. fuelling asset bubbles). 2) Is the Euro helping or harming the region’s efforts to crawl out of its current crisis? Clearly it has become a hindrance to the countries now facing a lost decade of austerity since the alternatives to combat recession all involve having independent monetary policies. A good counterfactual to this point is Britain. For all its debt and growth woes, it’s hard to argue that it is worse off because of holding on to the Pound. And finally, 3) is a common currency really necessary to fulfill the European project? I’d say no. The EU has already succeeded brilliantly in its first and most important goal: to prevent another war between European states. I’d argue further that in such a collection of culturally, historically and linguistically different nations, achieving anything like a “United States of Europe” is a delusion that is best left unpursued. Europe is best when it is close enough that its peoples feel the urge to trade rather than fight, but far enough apart that a Frenchman will always be a Frenchman and a Greek, always a Greek.

An example for Latin America?

In those bygone undergrad days, I dreamed of the day that Latin American would follow Europe’s footsteps, and bring itself closer to the unfulfilled dream of Bolivar: continental unity. I still dream it. But although we still have much to learn from the European project in order to achieve our own, I’d rather we skip the common currency part…

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