The Euro:
What went wrong, and how do we move on?

The euro is a failed project. European politicians should focus on saving the European project, the European Union, rather than saving the euro, writes professor of economics, Jesper Jespersen.

Guest post written by Jesper Jespersenprofessor of economics,  Roskilde University, Denmark

European politicians should focus on saving the European project rather than saving the euro, writes professor of economics, Jesper Jespersen.

Will history repeat itself? The verdict of history is harsh, but irrefutable: currency unions that have not been closely linked with some state-like political structure have all collapsed sooner or later – most of them sooner rather than later. This is because when the member states’ economies begin to drift apart, and the adversarial relationships between the nations are deepened, the incentive for the deficit countries to give up the joint monetary policy is intensified. For these countries the monetary union is increasingly seen as a straitjacket, which retains them in their deficiency, and in time this position develops into an actual debt crisis. This development is characterized by jobs, income and money pouring out of the deficit countries and into the profiting nations, who in return are content with the development and do not see any urgent reason to change their economic policy. However, it is overlooked here that a monetary union is a linked economic community where a surplus in one or more nations’ balance of payments (BoP) will necessarily lead to a deficit for one or more other member nations.

The fact that surplus causes deficit is a theoretical conclusion that cannot be modified; this is simply the circumstance as regards accounting. Because of the Euro’s floating exchange rate towards the rest of the world, the Euro-zone’s BoP is more or less in equilibrium with  the rest of the world. Consequently, the large BoP surpluses in Northern Europe – first and foremost represented by the German surplus, which is nearly equal to the EU’s entire budget – are counterbalanced by correspondingly large deficits in Southern Europe. On this basis it does not make sense to ask any country unilaterally to  put its own house in order by reducing the BoP deficit – there will always be (at least) two countries involved when settling the balance of payments imbalances.

If the monetary union is to work, it requires that the economic policy is coordinated on an unprecedented scale. Among other things, this will need to entail that the surplus nations are willing to reduce their surplus – yes, for periods of time accept a deficit in their BoP. Will Germany, the Netherlands and Finland do that? Or do they merely wish to sustain the competitive advantage they have achieved through the 12 years the Economic and Monetary Union (EMU) has existed? In the latter case, history will repeat itself.

Too little focus on BoP imbalances

Ever since the EMU was established in 1999 the Northern European countries have striven for an economic development that curbed the growth of costs through low wage increases and high efficiency; in return, though, a relatively modest growth. Up until 2008 Germany was one of the EMU-countries with the lowest economic growth; since Germany is meanwhile one of the union’s richest nations measured by national income per capita, however, this was a deliberate priority. In contrast, the Southern European countries (except Italy) were more interested in creating growth in an attempt to catch up with the rich Northern European countries income-wise. As a consequence, the cost grew in those Southern European countries that primarily focused on economic growth (Spain, Ireland and Greece)  2-3 percent more speedily than in Northern Europe. A difference of 2-3 percent in cost growth over a single year does not have any noticeable effect, but if the development continues through 10-12 years, then the  cost levels between North and South run in separate directions. Today it is 20-30 percent more expensive to produce in the South compared to the North, which is obviously causing  surpluses and deficits in the nations’ BoP.

Throughout the years of the EMU the Southern European countries have indebted themselves to the Northern European surplus countries. The foreign debt in the South has been growing year by year. This growing imbalance was not taken very seriously in the beginning, since these imbalances, it was thought, would be of minor importance now  the nations had a single currency. Here, a misguided analogy was drawn between the balance of payments between in example ‘Funen and Zealand’ (two Danish regions), which are significantly evened out. They  have a strong integrated labour market and  these two regions are part of a political structure that contains a significant economic solidarity and reciprocity (regional evening out as well as considerable block grants financed by the state). Within the EMU the labour markets are strongly divided geographically, linguistically, legally and culturally – it is still a problem to get Northern and Southern Italy to function together even though Italy has existed as one (unified) nation for more than 150 years. There has not been built any mechanism into the construction of the EMU that secures that the BoP imbalances are evened out. On the contrary, the different cost levels mean that the situation is locked tightly while the growing interest expenses (deficit nations) and interest incomes (surplus nations) increase the imbalances between North and South.

Yet, so long as the general economic development in the EU appeared positively with growth rates at 2-3 percent, the political decision-makers were willing to neglect these growing imbalances. Surprisingly, the otherwise so fearful financial markets continued to give loans to Southern Europe on terms that did not deviate much from the interest rate in Northern Europe. Until 2007 the added interest rate that investors demanded to give loans to Greek debtors was only 0.5% percentage point higher than an equivalent German loan. Retrospectively, we can state that the financial markets (and the credit rating agencies) were to put it firmly sleeping on the job; anyone with an insight in macroeconomics should be able to see that the BoP situation was fundamentally unsound, cf. Figure 1. In the figure we can see how imbalances increased from the beginning of the EMU in 1999 and up until 2008 between the North (represented by Germany) and the South – though not catastrophically in France and Italy, but the tendencies were also clear in these countries. It is critical that – except from Ireland – no notable changes have occurred the last three years in achieving a better balance between the surplus and deficit nations. The indebtedness is continuing, and the problems are growing for every year.

Figure 1.

Balance of payments, unemployment and budget deficit

Those EMU countries with the largest BoP deficits were most badly hit by the financial crisis that began in 2008. They had become dependent on foreign borrowing. When the international capital markets dried out in the wake of the Lehman Brothers’ collapse, these countries found themselves in an acute financing problem.

The interest rates leaped to great heights, especially for those countries that borrowed abroad. It was also in these countries that the financial sector was most severely afflicted: Ireland, Greece and Spain.

In these countries the national governments needed to step in and support, which became a grave burden for the public budget, in that the private banking debt was hereby converted into public debt. But this step was necessary to obtain loans from the EU’s and the International Monetary Fund’s (IMF) bailout funds.

The public budgets were also burdened by growing unemployment. Here, as well, it was soon evident that it was those countries with large BoP deficits that were most vulnerable. To a varying degree they had based their national growth on imported goods and an extremely boomed building sector, which collapsed when the interest rate began to grow.

The budget deficits, where do they come from?

When the economic policy is to be organised, it is important to know the correct causal relations. The questions that thus should have been asked in the present situation are why there are budget deficits at the same time in nearly all EMU countries?, and furthermore, why these deficits have grown much more in some EMU countries than others?

The number one cause of today’s public deficits is the fact that there is a significant imbalance in the private sector between savings and investments. When more money is saved than invested the private sector has a financial savings surplus, which in bookkeeping terms is matched by a public budget deficit. This is pure accounting: surplus and deficit must sum to zero – this is not debatable. If we want to find the reason for a public sector budget deficit, the answer then often lies in the private sector in the form of savings surplus and unemployment. Those EMU countries that have witnessed a severe reduction of the public budgets have without exception also had the largest increase in unemployment. This increase can be attributed partly to a collapse in private (building) investment, and partly to large BoP deficits.

Once these causal relations are recognised, it is also easier to understand why a one-sided focus on budget deficits in especially Southern Europe will not be able to overcome the economic crisis. Public spending cuts will primarily have the effect that unemployment increases further. A higher unemployment rate burdens the social budgets and reduces tax income. It is the so-called automatic budget stabilisers, which are about 0.5 percent of GDP for every 1 percent the unemployment rate increases. This means that for every time the unemployment rate increases by 1%, the public budget is increased by another  ½% of GDP. In Spain the unemployment rate has increased by 14% since 2007, cf. Figure 2, which explains about 7% of the deterioration of the Spanish public budget.

If the ambition of the economic policy is to overcome unemployment, budget deficits and the BoP deficits (in Southern Europe), these imbalances need to be regarded as an interrelated problem. It is the over-saving – the lacking of private investments – that is the primary cause for unemployment and thereby budget deficits. Investment is held back by a weak demand for goods across the EU, by the banking sector’s lacking equity and by a lot of bad loans, as well as by a weakened competitiveness in Southern Europe. These three circumstances have together burdened the European economies and overburdened the public budgets to such a degree that it has evolved into a public debt crisis.

When the macroeconomic imbalances have grown so large as it is the case today – with an unemployment rate reaching 30, a public debt at much more than 100% of GDP and continued large BoP deficits – no easy nor quick solutions are available. Both an economic insight in the causes of the crisis’ development and a significant political will on both a national and European level are required to redirect the course away from a further growing imbalance. The one-sided focus on reduced public deficits and the debt, which the fiscal compact contains, seems only to have worsened the European crisis in the form of growing unemployment.

Figure 2.

Possible solutions

The two figures above together illustrate the core of the EMU countries’ balance problems. They have a single currency, but macro-economically they develop more and more diversely. This is not sustainable in the longer run. So what to do?

1. Business as usual

The fiscal compact is as mentioned no solution; it is not the public budget deficits that hinder a revitalisation of the private investments and the competitiveness in Southern Europe – it is the continued public spending cuts, which have been imposed on nearly all countries because of ‘too large’ budget deficits. Whether the budget deficit is ‘too large’ cannot be regarded in isolation. As discussed above, it is closely linked to unemployment and lack of public investments. It therefore might lead to incorrect conclusions when an unconditional limit of 3 percent of GDP is considered as the maximum permitted  public sector deficit, regardless of other macroeconomic developments. The permitted deficit should as a minimum be adjusted in regard to extraordinary unemployment and lacking private investment (the savings surplus in the private sector). If the fiscal compact requirement of a maximum limit of 3 percent is kept, there is a substantial risk of the countries beginning to undertake an economic policy that creates further macroeconomic imbalances. During a recession with high unemployment and significant budget deficits the fixed budget rules easily undermine the recovering process. And conversely, when there is a boom in public finances, the European Commission neglects to demand cutbacks that could stem the financial overheating – which for instance was the case in Denmark in the period 2005-7.

Additionally, the fiscal compact takes neither the development in cost levels nor the status of the balance of payments into account, which can drag the countries further apart, while unemployment continues to increase.

2. A more federal EU

Fortunately, an understanding of the fiscal compact not entailing a solution to the euro crisis is, however, gaining ground among economists. The mainstream theory has moved towards a necessity to a much stronger coordination of the economic policy within the EMU if the single currency is to be saved. Brussels should have more power to ensure that each country actually complies with the recommendations/demands of the fiscal compact. An additional instrument to ensure that political support of such centralising of the fiscal powers can be achieved could be a significant enhancement of the structural and cohesion funds and of the European Investment Bank’s lending capacity. These proposals are referred to as project related EU-fiscal policy, which to some degree can be a replacement for the lacking private investments. It is part of a ‘growth package’, which on initiative of the French President Francois Hollande was passed at the summit in June 2012.

As part of the more centralised decision-making structure, which moves in a more federal direction, a proposal has also been made to issue Euro-bonds. These are government bonds that are guaranteed by all EMU countries, but which can be used by the separate countries to cover (part of) their national public debts. This proposal has not been agreed upon, since those countries with a small public debt feel that they will bear a disproportionate part of the risk without actually gaining influence on how the money is spent. The advantage for the weak Southern European countries would be a significantly lower interest rate, which is to be paid on Euro-bonds – the risk seen from Northern Europe is that this lower interest rate could result in a new building boom, an even larger BoP deficit in the South with the possibility of a repetition of the preceding crisis evolvement.

Times are with other words not politically mature for the more federal decision-making structure in the euro zone, which economists still see as a possible solution. These economists overlook, however, that this federal structure maybe does not contain the answer to how the differences in the countries’ competitiveness can be evened out. It is as if the economic understanding of how important it is that those countries that participate in the monetary union have a fairly balanced BoP has not yet sufficiently gained foothold. This means that a federal structure aimed at securing balance on the public budgets, partly financed by the other member states, still lacks a mechanism that takes into account an uneven distribution of surplus and deficit, respectively, on the BoP.

3. Greater national flexibility and a more regulated financial market

This leaves us the question whether it was too early and therefore mistaken to introduce the single currency in those countries even though they fulfilled the relatively moderate admission requirements – the so-called convergence criteria. Anyhow, we have subsequently witnessed that even though the original 12 EMU countries – which later grew to 17 countries – were declared convergent, these countries still drifted apart on a range of macroeconomic parameters – meanwhile, the degree of imbalance within the member states has in most cases been increasing. Moreover, despite the fact that crisis summits have been held every third month throughout the past two years, the initiatives that have been decided have not been sufficient to stem these tendencies towards a break-up. We should remember here that a necessary precondition for the participating (sovereign) countries to continually have an interest in sustaining their membership is that the countries to a larger degree are balanced out cost-wise and income-wise. If not, a growing demand for more flexibility and national orientation in the economic policy will arise.

As initially mentioned, monetary unions have been attempted many times before in history; these countries have rarely succeeded in marching in step, however, after which the monetary union has been dissolved. Has it then been a catastrophe when the monetary union (partially) dissolved, as it e.g. happened with the gold standard in the 1930s? This is naturally difficult to give a precise answer to, in that it depends on which macroeconomic conditions are prioritised the highest. If a reduction of unemployment is highly prioritised, then the lesson from the 1930s is that those countries that first broke out of the ‘golden’ straitjacket also achieved a competitive advantage, which could be utilised to lead a more expansive economic policy, by which unemployment decreased. But through the 1930s, it developed into quite chaotic conditions on the international currency markets where each country tried a little larger currency devaluation than the others – a situation of competing devaluations, which no country could win in the end.

On the basis of that experience the British economist John Maynard Keynes proposed that after the war there should be established more orderly conditions on the international currency and capital markets. His proposal, which was more or less followed in 1944 by the Bretton Woods agreement between 44 participating countries, implicated that the countries committed to having fixed exchange rates, which by mutual agreement (and relatively fixed rules) could be adjusted. This meant that countries that lagged behind because of too high costs (or other conditions that were unfavourable for foreign trading) could adjust their exchange rates, by which balance on the BoP could be re-established. Keynes would also have liked an agreement where countries with a BoP surplus being committed to revaluate their currency, and if they did not, they should pay a fee to the IMF, proportionate to the size of the surplus. This would have created an inducement for the surplus countries to reduce the surplus and thereby contribute to a better balance in the world economy.

Along with the agreement of the exchange rate cooperation, Keynes accomplished an international prohibition against speculative capital movements. From the experience of the 1930s he had learned how a massive speculation against one country could force it to lead a restrictive policy, which made it more difficult reduce unemployment. No country can build its policy on speculative capital flows, since it often disappears just as fast and disturbingly as it come – there is no welfare economic loss in prohibiting these speculative capital movements.

The Bretton Woods system functioned quite well the first 20-25 years after the war, where Western Europe and the United States experienced the fastest growth in any longer period. But then the system began to be eroded. The US had a rising inflation, among others as a consequence of the Vietnam War, which was a hindrance for the Dollar continue as the undisputed anchor within the international currency system. Also, the financial capital had found ways to evade the prohibition against speculative transactions. An European Dollar market had in attempt to avoid the US jurisdiction been established in London. President Nixon therefore decided in 1971 to cut the Dollar from its fixed gold exchange rate and to open for free financial transactions in and out of USA. The decision hit the international markets as a chock; but shortly after it turned out that the greater flexibility had some advantages; there were also, however, significant disadvantages linked to a floating exchange rate of the Dollar and to the flood of speculative capital movements. The value of the Dollar became unstable, without creating a better  balance on the American BoP. On the other hand, Europe became less dependent on the American policy, which boosted the European integration process with the establishment of the internal market through the 1970s and 1980s.

The EU should probably have paused here and thoroughly considered whether the EU economies were actually sufficiently integrated to take the next big step – the single European currency. The experience from post-war times should have led to cautiousness because the EU countries were still very diverse, even in Western Europe. The step towards a monetary union was as we know taken with the passing of the Maastricht Treaty back in 1991.

The EMU in its original construction has shown to be prematurely and therefore mistakenly put together. Economists are beginning to agree on this. The question that is now discussed is, as mentioned, whether this mistake can be corrected through political and economic structural reforms, or whether it will be necessary to take a step back towards national currencies with a coordinated flexibility similar to the Bretton Woods Agreement.

I have to admit that it is hard to see how a continued increase in unemployment can be avoided as long as  the cost levels between North and South have driven so far apart and the financial markets still have the role of judging the economic policy, both internationally and on a European level.

The third solution model therefore entails a greater national flexibility. It entails that some of the Southern European countries break out of the EMU. This can happen in various ways, but will always begin with a temporary closing of the breakout country’s financial borders and banks. The big question is then how foreign assets and debt shall be calculated in the new national currency. As soon as that is clarified, the financial markets will determine a new and lower exchange rate of the national currency, and the country will regain its international competitiveness. Not until then can an economic growth policy be lead. But the solution will also mean quite large capital losses – not least for those who have borrowed internationally in Euros. These contracts will be difficult to renegotiate, which, as was the case in Iceland, will probably entail that several private banks (and firms) go bankrupt. On the other hand, those who have foreign assets will reap large rewards. The currency reform can therefore not stand alone. It needs to be followed up by both a tightened currency control and taxation of capital gains on currency contracts.

Of grave importance to the development of such a (partial) dissolving of the Euro-zone will be whether the EU’s institutions play ball or try to prevent an exit. There are fortunately many examples in history of monetary unions being dissolved under orderly conditions and with continued mutual respect. For instance, one can point to the United Kingdom and Ireland, who in 1979 dissolved their monetary union because Ireland wished to go into the European fixed rate cooperation – the European Monetary System (EMS). When Czechoslovakia was dissolved in 1992, this also happened peacefully on the basis of a mutual decision. If the dissolving happens in mutual agreement, then the subsequent cooperation is more easily established. Nobody says that withdrawing from the EMU is also a goodbye to EU – the advantages for all parties of a continued participation in the internal market are evident. In this case a quite significant solidarity from EU is necessary; those countries that need to abandon the EMU after unsuccessfully having struggled for several years in an attempt to stay, and have undergone severe austerity measures, are in more need than any other EU country of a helping hand.

Finally, the entire EU system should reconsider whether the dogma of free and almost unregulated financial transactions between the countries and in and out of EU at all promotes ‘growth, welfare and sustainable progress’. The speculative capital movements drive the exchange rate hither and thither on especially the weak countries’ bonds. Meanwhile, the fear of the financial markets’ reaction makes European politicians almost paralysed and very market conforming in their suggested solutions.

There is also a need here for both political and economic innovation, where it to a larger degree should be about how the European project (EU) is to be saved from dissolving than about saving the Euro from dissolving. The former is a project of peace and democracy. The latter is after all merely a payment unit and a common calculation unit. This we should be able to overcome.

 

Brief CV of Jesper Jespersen:

Dr. scient. adm., Ph.D. and cand. polit. Jesper Jespersen is a professor of economics at Roskilde University.

As member of the EMU committee formed by the Council for European Policy, in 2000 he submitted a minority statement concerning the EMU’s lack of stability and advised at the time (as now) that the Danish membership be put on hold. 

Has among others written Dansk Valutakurspolitik (Danish Exchange Rate Policy) in an EMU perspective, NyAgenda, 2009 and contributed at the Danish Parliament’s hearings on the EMU in January 2009 and February 2012, respectively. 

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