The EU-Euro connection
To fully grasp the issue at hand, the euro needs to be seen in the context of the European Union. When Monnet, Spaak, Spinelli and Schuman (to name a few) were forming their designs for a unified Europe, a single European currency was more or less a given. However, where nations normally form first and impose their chosen currency later, the Monnet group chose to do the opposite. By introducing a single currency first, problems would arise, demanding further concessions and changes from its members (“never waste a good crisis”). This “reverse order” tactic has so far been very successful. The amount of sovereignty that has been transferred has been impressive and totally beyond de general zeitgeist at the time the Monnet group formed their plans.
The Monnet group probably knew beforehand that to have a single currency with very different member states, problems would arise. This would require a single government, and a single fiscal authority; the ultimate goal. But to understand what makes a good currency union, the economists Lerner and Mundell must be mentioned. In the fifties and sixties, they showed that a currency union has to meet certain conditions to be successful /meaningful (Optimum Currency Area, OCA).
- A) Labour mobility: ability to travel, work anywhere within the currency area, lack of cultural barriers to free movement (culture, language, et cetera) and lack of institutional barriers (transferability of pensions, no-claim discount and so forth).
- B) Capital mobility, price and wage flexibility: if capital can move freely and prices and wages change quickly according to circumstances, economic dislocations will be few and short lived.
- C) Similar business cycles: the economy moves in cycles, with every cycle requiring a different set of (interest rate) policies. If cycles do not coincide, then one-size-fits-all policies will not generate the intended outcome (i.e. economies will diverge).
- D) Homogeneous preferences: all members of the single currency should share the same vision of what constitutes good fiscal policy, monetary policy, social policy, and so forth. With so many steering wheels in one car, everyone should have the same idea about which route to take, in order to make it work.
It should be clear that all that the 19 Euro zone members (Austria, Belgium, Cyprus, Estonia, Finland, France, Germany, Greece, Ireland, Italy, Latvia, Lithuania, Luxembourg, Malta, the Netherlands, Portugal, Slovakia, Slovenia, and Spain) do not meet these criteria by a long shot. The reason for these criteria is rooted in logic: a single currency means one-size-fits-all policies for all member states, and applying that to very different countries by definition gives very different outcomes. In short, a (monetary) union requires homogeneous members to get economic convergence; economic divergence will be a given in a union with heterogeneous members; something the Monnet group would have been very well aware of.
Due to the high degree of differences between its member states, the eurozone has caused significant economic divergence. Where Germany was at or near record low unemployment rates, Spain and Greece were testing theirs at the other end of the spectrum. On account of economic growth, credit growth, unemployment, deficits, current account balance, innovation, economic reforms and so forth, differences are there and getting bigger. These divergent economic outcomes were putting further strain on an already strained relationship between the strong and weak eurozone members. The situation required recurring rescue efforts.
Fix 1: ECB
So far there has been one institution that has consistently come to the rescue and that is the European Central Bank. Sadly, the rescue has merely been a case of buying time, but at a cost. With a looser monetary policy, the ECB has prevented a lot of credit from going bad, it also stimulated further credit growth. Furthermore, due to its unconventional monetary policy, the ECB has in fact increased the economic divergence between member states (for example: Germany will always benefit more from a cheaper euro than Italy). Again, one-size-fits-all monetary policy in the eurozone equals divergence. But it did buy time; time for governments to get their act together and make the necessary economic reforms. But with the ECB’s loose monetary policy, most governments no longer felt the need for reforms, making the whole exercise self-defeating. But the ECB has now painted itself into a corner, if it stops its loose monetary policy, yields from government bonds to corporate bonds will rise and with it will come the inevitable defaults, jeopardizing the eurozone’s very existence. If it decides to loosen monetary conditions even further, member states will feel even less need to reform.
Fix 2: Economic reforms
While the ECB was buying time, member states were supposed to implement economic reforms. More flexible labour, decrease government spending and increase tax income, reform the pension systems, privatize government assets, decrease subsidies and so forth. Funnily enough, the countries which were least in need of reforms, reformed the most. Weak euro member states were less than enthusiastic to implement all these changes (with the exception of Spain perhaps). Furthermore, to get the right kind of economic results, changes have to be made to legal systems, education, investment climate, tax systems, infrastructure, political stability, regulatory stability and so on. Most of these changes take generations to effectuate and not months. Even with these changes, homogeneity with the other euro members will still not be met, as demographic, cultural, geographic, topographic, and linguistic differences will remain. The economy, industrial structure and business cycle will therefore always run their own course rather than the one envisaged by the eurozone.
Fix 3: treating the symptoms
The first part of this approach to the Eurozone’s problems, is the frequent bailouts. Spain, Portugal, Greece, Ireland, Cyprus all received explicit and implicit bailouts. Basically, the euro has created a transfer union; the strong member states (northern European member. There is an irony to seeing the euro causing a classic north-south dynamic; quite the opposite of stated intentions. This situation is creating tensions; the electorate in the donor countries are somewhat fed up with bailing out the south, while the south is fed up being dictated to in return for that help. So, not only is the euro responsible for economic divergence, but also political divisiveness. In this light, other ways are being proposed to fix the divergent outcomes, that are electorally more acceptable. Germany, for example, should increase its wages, increase government spending, lower taxes and stimulate credit uptake, while a country such as Italy should do the opposite. This will restore balance between eurozone members, or so the theory goes.
Whatever one thinks of these fixes, it is clear that these can be better executed and effectuated by a single government than by 19 separate member states. By making a euro exit extremely painful (in the short term), the euro serves as a Trojan horse for the EU’s ambitions: The United States of Europe. This is what the Monnet group was after; a way to make the formation of a single European supranational state (a state above all states) a necessity. This United States of Europe can act decisively and promptly and solve all problems (that’s the rhetoric). This automatically entails a loss of sovereignty, while democracy is also dealt a blow. By increasing the scope of government (many different electorates diffuse resistance; divide and conquer tactic) and by increasing the distance between voters and government, this supranational state would entail a huge step back from making Europe a democratic bastion. People will lose touch with the persons who govern them and they will hardly have any say in what affects them on a daily basis.
Economically, a United States of Europe would further exacerbate the north-south divide. The ex post fixes applied to this problem, will only give short term relief but long term problems due to economic misallocations. As the measures taken to keep the euro alive distort economic reality and the economy’s self-correcting nature, capital will flow to the wrong kind of investments (wrong products and services at the wrong price, in the wrong locations and at the wrong time), setting the stage for secular economic stagnation, which will be tremendously hard to get out of (and impossible in conjunction with keeping the euro).
A true fix
If the EU is truly serious about unifying Europe by means of peace and prosperity, it should abandon the euro (or alter the composition) and model itself after the Swiss government model (direct democracy), which offers decentralisation as the default setting and centralisation only where needed. But this is a subject which I will address in my next IDDE contribution. The eurozone’s current course is one that will destroy economic potential and undo decades of democratic evolution.