"The fundamental conclusion that the Euro was a stillborn child and cannot, in its present form, be rescued may have dawned on distant bystanders."
Most people around the world—laymen and seasoned investors alike—seem confused and bemused by the unfolding saga of the troubled Euro. Though I'm a distant observer of the Euro experiment, nothing has surprised me so far.
The political and bureaucratic elites of Europe had been promoting a common currency since a European summit at The Hague in December 1969. When, as a Senior Fellow at the Kiel Institute of World Economics in Germany, I wrote my PhD thesis about international monetary affairs, it became clear to my colleagues and me that an imposed Europe-wide currency would be a stillborn child. The foundations of a shared currency have to grow organically from the bottom up. These foundations consist not only of government-made rules, such as similar taxation and fiscal policies, credible rule enforcement and a commitment to fight corruption. They also consist of deeply ingrained attitudes and social institutions, such as similar work practices, a tradition that deals are fulfilled honestly, and many other such bourgeois and entrepreneurial virtues. It could be predicted that these essential foundations would not evolve quickly among so many countries with such diverse cultural traditions.
In a paper for a conference of eminent monetary experts during the Kiel Sailing Week in 1970, a young colleague and I summed up our conclusions as follows:
[Should] one first peg intra-Community exchange rates or ... first try to harmonize policies and wait till stable exchange rates come about almost by themselves [?] A premature fixing of exchange rates would lead to
- unwanted waves of imported inflation in the more stable countries and imported deflation and unemployment in the less stable countries,
- regional problems in those parts of the EEC [European Economic Community] that have a tradition of wage push, and the danger of undue industrial concentration in those parts that have a tradition of relatively high labour discipline, and
- the necessity for sizeable intra-EEC fiscal transfers in favour of cost-push regions to counterbalance the negative effects of high wage costs. These transfers might easily overstress the European solidarity, that is readiness to pay, of the more stable national regions.
These problems appear to be bigger if one thinks of an enlarged EEC.
Contrary to the costs and risks of premature exchange rate fixing, the benefits are ... frequently overestimated. (W. Kasper-H.-M. Stahl, "Integration through Monetary Union?—A Sceptical View," H. Giersch (ed.), Integration through Monetary Union? (Mohr-Siebeck, 1970), pp. 149-169.)
Read about currency areas in the biography of Nobel Laureate Robert Mundell and in the article Monetary Union by Paul Bergin in the Concise Encyclopedia of Economics.
Nothing has since changed my opinion about the Euro problem. Then, as now, I believe that one must first approach such politically complicated issues using simple, logical economic principles. What matters in the medium and long term are the cost levels in various regions of a currency area—i.e., the input prices (such as wage rates, energy prices, and tax rates) relative to the productivities of the various inputs (such as labor productivity, energy efficiency, and the quality of government services and institutions). Economists refer to these relativities as unit costs and consider international differences as decisive to long-run competitiveness. What matters here is not only the competitiveness of private producers, but also government and union support for competing producers: governments and trade unions can, after all, do much to help or hinder the capacity of export and import-substitution industries to compete. Exchange rates between nations with similar unit costs and similar cultural and governance conditions hardly move. Thus, the rate of the Deutsche Mark to the Austrian shilling remained at a stable 1:7, and to the Dutch guilder at 1.1:1, for many years before the launch of the Euro. Where, on the other hand, administrations are staffed by corrupt kleptocrats and led by opportunistic politicians who lie and engage in fiscal deception, pressures build for a devaluation of the currency. Thus, the Mediterranean currencies were repeatedly devalued and the northern currencies appreciated prior to the creation of the Euro. This flexibility maintained a reasonable equilibrium and facilitated the growing integration of markets and investment structures.
Read more about the history of the Euro in Foreign Exchange, by Jeffrey A. Frankel, and European Union, by Marian L. Tupy, in the Concise Encyclopedia of Economics.
Then, the political elites imposed a single currency, supposedly blocking all further exchange-rate adjustments. By political decree, and without electoral consent in most cases, the springs and shock absorbers were—figuratively speaking—removed from the European vehicle. From the beginning of 1999, the Euro became a shared unit of account, and, from 2002, the common means of payment. The construct was built on the Maastricht Treaty (1992), which obliged member states to pursue shared fiscal and monetary objectives. But the German Schröder and French Chirac governments promptly and blatantly violated these obligations, choosing to ignore EU warnings in the form of the famous 'Blue Letters.' National leaders wanted to demonstrate that national political priorities trounced EU directives when it mattered. Officials nevertheless hoped that the common currency would soon 'harmonize' the foundations of private and public behavior so that the single currency would become sustainable. The Euro experiment was reminiscent of the optimism of other, more-extreme beliefs in top-down social engineering: Lenin's and Stalin's optimism that 'new man,' devoid of selfishness, could be created by decree; and the contemporary optimism that the populace will abandon the convenience and comfort of energy use to save the planet.
In the expanding Eurozone (now 17 of the 27 EU members, plus a number of African hangers-on), ingrained cultural, work and business habits did, however, not change. For many potential investors in the South, the Euro initially meant low interest rates, which led to a borrow-and-build boom and lax cost controls in government spending programs. Spain now has unsold apartments sufficient to accommodate future population growth for decades (alas, in the wrong places), and government patronage in Greece and Italy has known no bounds. European travelers and traders welcomed the disappearance of exchange-rate risks and of the transaction costs of converting currencies and prices.
Gradually, divergences accumulated between North and South. Unit-labour costs in the South rose further and further above the German level, and travelers and traders soon realised that Greece and Italy were becoming very expensive. The Eurozone developed what experts long described as a 'Mezzogiorno problem,' so called after the intractable regional problem of Italy. The Italian South receives continuing wealth transfers, but still suffers from unemployment because the local work and administrative culture has proven immune to pressures for change, thanks in no small part to the perpetual flow of subsidies. Similar problems exist within Belgium and unified Germany, where voluntary private capital flows between disparate regions do not bridge gaps in competitiveness; instead, the national government uses massive tax-backed transfers to uncompetitive regions, which produces political ill will and mutual political recriminations. Nonetheless, national bonds have, so far, been sufficient to underpin these tax-and-transfer policies. In addition, the migration of labor and skills from the backward to the prospering areas also helps to maintain balance within such economically heterogeneous countries.
In the case of the disparate Eurozone, solidarity is much weaker, and language and cultural barriers limit migration. So, the political elites keep plowing growing amounts of borrowed money into central stabilization funds and 'reward' deficit countries with one subsidy tranche after the other. The problem is that any pool of government-guaranteed funds is sooner or later exhausted by ongoing outflows to prop up the uncompetitive regions and nations. As of November 2011, experts generally agreed that the huge European Financial Stabilisation Facility did not have even one third of what would be required to bail out Italy and Spain in addition to the present aid recipients, Greece, Ireland and Portugal. Private investors know this and have begun to speculate that an eventual devaluation of some Euroland regional moneys is inevitable, reinforcing the disequilibrium between North and South.
The growing North-South divergence was aggravated when the German national government initiated productivity-facilitating labor-market reforms (such as making hiring and firing easier and creating low-wage jobs outside the collective-bargaining framework) and stuck to a degree of fiscal discipline that must have looked exotic to Southerners. The intra-European transfers from the indebted, but still creditworthy, 'rich' demonstrated to the Southerners that there was little incentive to amend their lax ways. Even when the 'Merkozy government'—as pundits began to call the running of the EU government by ceaseless, hectic Franco-German crisis summits—threatened to send Euro inspectors to Rome and Athens, this had little effect. The inspectors come with even fewer enforcement powers than were foreseen in the long-abandoned Maastricht Treaty. As long as there are unconditional guarantees for upholding the Euro, they have no teeth.
It is easy to understand the incentives for happy-go-lucky borrowing and spending by national European governments if one thinks of an extended family in which everyone is entitled to take out loans whose repayment is collectively guaranteed by the entire family. Asymmetric incentives create irresponsibility, reward the irresponsible, and lead to a race into debt. It is also easy to understand that the big spenders now demand the creation of collectively issued bonds (called 'Euro bonds') and that the relatively disciplined members (such as the Germans and Dutch) raise furious objections.
By now, it is evident that the idea of a continent-wide Europe growing into a harmonious family is an illusion. In reality, solidarities are increasingly strained, and petty hatreds and resentments emerge and are exploited by political opportunists on the fringes. Crude protest slogans are scratched into Mercedes cars with German number plates parked on Athens streets; Greek politicians demand German compensation for Nazi crimes committed seventy years ago; street demonstrators in Berlin revile Spaniards and Portuguese; and the young, unemployed Spanish indignados become furiosos, occupying city centers and demanding that their government stop obeying directives from Brussels and the 'Berlin-Paris Axis.' As the political decision makers subordinate every other economic variable to the political goal of fixed exchange rates under a single currency, Southern job losses and enforced cutbacks in government programs impose harsh sacrifices on Mediterranean Europeans. With good reason, the Greek middle class now dreads anome (Greek for loss of order and trust in the future), and a young generation is profoundly cynical about all politics. This is likely to destabilize and weaken Old Europe in the long term.
The tensions in Euroland's economic structures are building exactly as I predicted back in 1970. The center still enjoys relatively good job growth, whereas the Southern periphery experiences massive unemployment and protracted stagnation. The initial transaction-cost advantages of the wider currency union, the Euro, have long been overtaken by the growing disadvantages of the costly and unpopular transfer union and the meddling with national sovereignty. What was initially touted as an 'optimal currency area' looks increasingly like an untenable economic, social and political albatross. As long as flexible currency-adjustment mechanisms are ruled out, matters will not change.
It is instructive to recall that the intra-German currency union has been propped up since the fall of the Wall by well over a thousand billion Euros in tax-financed transfers and that the need for more has not subsided. Resentful eastern Germans vote communist. By contrast, the erstwhile currency union between the Czechs and the Slovaks was abandoned with the 'Velvet Divorce,' and adaptable exchange rates enabled both countries to engage in catch-up with Western European productivity standards. At least that was so until the reform-friendly Slovak government adopted the Euro in 2010, after accepting big economic sacrifices. Shortly thereafter, the Slovaks were utterly annoyed that they now have to bail out less-rule-compliant Greeks. Meanwhile, Poland, which has so far resisted the siren call of Euroland, keeps competing successfully thanks to exchange-rate adjustments and is able to share bragging rights with Australia to have evaded the 'global financial crisis.' Like the British and the Swedes, the Poles are shaking their heads over the ceaseless crisis dislocations in their Eurozone neighborhood.
As long as the political elites guarantee that they will defend the Euro whatever the costs, there are only two possible solutions to the Euro crisis. Either the disciplined countries and regions drive up their cost levels by wage explosions and productivity-destroying regulations, or the lax South lifts its work, administrative and fiscal ethic to Prussian standards. If one is to attribute guilt, it is important to remember that the causes of the intra-European divergences are akin to the clapping of hands: it takes two to make a noise. Some of the present North-South imbalances may, of course, be disguised by cost inflation throughout Europe, as the increasingly politicized European Central Bank is pumping out Euros in exchange for junk-level government bonds to refinance commercial banks that are suffering 'haircuts' (politically decreed losses on shaky government bonds).
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For more on the European situation and options facing the governments, see Cowen on the European Crisis. EconTalk podcast, December 5, 2011.
Thus, the questions arise: Why do politicians and bureaucrats fail to accept the basic economic facts? Why do politicians such as Chancellor Merkel speak darkly of dangers of a European civil war, when renewed exchange-rate flexibility between North and South would relieve intra-EU tensions? Why do political elites equate the continued existence of the Eurozone with continued European integration and peaceful, free exchanges?
The answer is not that there might ever be another European civil war: I believe this will never happen again, and assertions to the contrary are plain silly. Rather, the reasons for such threats are that various special interests use the present regime to get their way. The influential German export industry, for example, fears a 'Swiss problem'—i.e., being driven out of markets by producing in a 'high-price island.' Many German industrialists were relieved to be rid of the Bundesbank's strict discipline when the Euro was introduced. This past summer, they placed advertisements in the press saying: "We need Greece." Greece and the other weak, debt-ridden European economies indeed help keep the Euro exchange rate low, favoring German exporters at least in the short run. Alas, behind this is the all-too-familiar illusion that German unit costs can be kept relatively low forever by governments paying transfers. Over the medium term, the growing job destruction and recession in the South are eliminating demand for German exports and, thus, everyone's costs will be inflated—possibly egged on by increasing regulatory density and government-mandated increases in energy costs.
One major reason that "Eurocrats" reject the idea of exchange-rate flexibility is that they want more influence and direct tax receipts. So far, they have had to depend on national tax collectors and remittances. If the Euro crisis produces plausible arguments for more Europe-wide regulations and new taxes that go directly to the unelected masters in Brussels—whether they are taxes on international capital transactions, airline tickets, or whatever—the crisis is welcome. Crises always favor politicians and bureaucrats. Just as "war is the health of the state," in Randolph Bourne's famous phrasing, so are crises in general the health of the state.
Europeans seem strangely ambivalent over the Euro crisis. Most still accept the goal of European political integration, including the imposed single currency, because the advantages of open, continent-wide markets are evident. On the other hand, they increasingly resist the uniformity imposed by decree from a distant center. In short: market integration is popular, political-bureaucratic integration imposed from above is resented. Diversity has been the hallmark of Europe and the traditional source of its creativity and progress. People are now discovering that the advantages of market integration can be had without the growing deluge of decreed EU standardization, even if standardization harmonizes productivity trends. The Spaniards do not want to abandon their many Saints days and long weekends; nor would Prussians want to subscribe to the Spanish calendar or adopt the siesta. The Swabians and the Dutch wish to continue with their parsimonious savings habits and will never subscribe to the view that paying taxes is 'un-Greek.' After all there is a long tradition dating back to the Ottoman empire, which considers tax evasion and disobedience to government directives part of the Greek national character. Nor will the citizens of Provence abandon their festivals and, instead, subscribe to the Finns' joie de vivre to enhance their labor productivity. All of these habits influence long-term productivity trends and, thus, the chance to maintain inter-regional balance-of-payments equilibrium.
It has now dawned on Eurolanders that their parliaments and governments must abandon their sovereign fiscal policies. But the European population, who learned to appreciate the benefits of the unitary coin with which to pay from Madeira to Crete, from the Baltic to Sicily, have not yet grasped the full implications of the growing, ceaseless transfers and of a weakening Euro that drives up import costs. Their gasoline is becoming more expensive, as are the components imported from the Far East and America, which European workers assemble into finished export products. Nor have they yet fully realized that the 'haircuts' imposed on their banks are related to the drying up of bank credit for productive private investment and job creation.
The fundamental conclusion that the Euro was a stillborn child and cannot, in its present form, be rescued may have dawned on distant bystanders such as the Chinese, Arab and Russian governments, who greeted Europe's and the International Monetary Fund's begging for Euro support funding with great reluctance. Other G-20 governments were less astute and eagerly offered potential bail-out money to the IMF bureaucracy.
Over the long term, there is but one solution to the Euro crisis: Flexible shock absorbers must be built into the Euroland cart again, as the road ahead may well become bumpier. This could mean that the Germans and some of their Northern neighbors quit the Euro, which would be a noble solution on the part of the strong economic regions. Or it could mean that the Greeks and Italians are invited to take 'a holiday from the Euro,' while the French and Spanish governments rein in their expensive welfare policies for citizens, industry and agriculture in order to keep pace within a new Hard Euro.
Both solutions would create hairy legal problems for owners of monetary assets and partners in credit contracts. But such problems are not new. They have been solved before when monetary unions were dissolved. Maybe European central bankers should apply for instruction in Singapore and Kuala Lumpur about how the split-up of the Straits dollar into the Singapore dollar and the Malaysian ringgit was handled, or they might learn how Prague and Bratislava did it during the 'Velvet Divorce.' Meanwhile, loan contracts are already being designed that anticipate devaluations after the introduction of the Nea Drachma, and wealthy foreigners in Tuscany are scrambling to match the value of their holiday homes with mortgages from Italian banks, so that their losses after the slide of the Lira Dura are minimized.
The technical and administrative problems with an introduction of a New D-Mark could also be solved: The government can declare that to forestall an imminent crisis, it has, most regrettably, no other option but to withdraw legal tender status for all Euro banknotes that do not carry a German identifier (all banknotes show a national code). All other Euro notes and coins will be exchanged at a fixed rate within three months. Political leaders can, after all, explain that it is free travel, free trade, free capital and enterprise movements, and the freedom for young Europeans from different countries to marry that matter for European integration, prosperity and lasting peace, not the artificial bond of an imposed unitary currency.