The so-called architect of the euro monetary system – died recently in Rome. I guess architects like to leave behind objects of style and beauty that also function well. There is a huge debate among architects about form and function and whether ornamentation is functional. Form follows function has been the catch cry of modernists in architecture and I am most familiar with the debate when it is applied to software development (and its architectural characteristics). Anyway, the euro architect has left behind a monetary system that neither has form or function. It is an ugly creation that is increasingly revealing its dysfunction. But try telling that to the EU leadership who have just finished another summit in Brussels, where I suppose the cuisine and setting was sumptuous and the wine was top class. And like all previous summits all that was forthcoming was further political rhetoric about the irreversibility of the euro and the political commitment to defend it. In real terms this translates into imposing a state of more or less permanent unemployment and austerity on millions of Europeans. Eventually the gap between the leader’s rhetoric and the underlying reality will become so wide the system will crumble. But in the meantime the EMU is a bankruptcy machine.
The Financial Times reported (December 19, 2010) that:
Tommaso Padoa-Schioppa, who has died in Rome aged 70, was a former Italian finance minister and founding member of the executive board of the European Central Bank who was regarded by many as a central architect of the euro. A passionate advocate of European integration, he was highly intelligent, well-versed in economics, and a first-rate financial technician. A central banker by training, he was witty, charming, deeply cultured and steeped in European history … He coined the phrase “a currency without a state” in 1999, to describe the euro. “Our new currency unites not only economies, but also the people of Europe,” he said … In earlier evidence to the European Parliament in 1998, however, he also spelt out a realistic view of the challenges: “I do not think that a single currency is an event for the last days of the history of mankind that simply crowns perfection,” he said. “It is something that has to be in reality while reality evolves.”
Padoa-Schioppa’s proposal that the euro would unite economies and the peoples of Europe is turning out to be true. The common unifying element is the entrenched unemployment that the system has delivered which will define the European landscape for years to come unless nations take the only sensible step and exit the defunct and unworkable monetary system.
Related unifying features will be the savaging of pension entitlements, loss of wealth and savings (therefore reduced personal risk management capacity), and an increasingly violent social fabric.
Some “building”. The EMU is nothing that I would be proud of as a legacy of my professional capacities and foresight.
Last weekend, the Eurozone leaders had yet another “leadership” summit and once again demonstrated that their concept of leadership has nothing to do with advancing the welfare of the people of Europe nor providing a solution to the on-going crisis that will worsen.
At the end of each of these summits we get the same message. This weekend they agreed to (Source) add the following “limited Treaty amendment”:
The Member States whose currency is the euro may establish a stability mechanism to be activated if indispensable to safeguard the stability of the euro area as a whole. The granting of any required financial assistance under the mechanism will be made subject to strict conditionality.
The EU boss sent a message to private sector creditors saying that “the EU will continue to adhere strictly to standard IMF and international practices”. The communique from the Summit reaffirmed that the leaders of the euro area “… stand ready to do whatever is required to ensure the stability of the euro area as a whole … [and the euro] … is and will remain the central part of European integration”.
So once again the same old words – “a political commitment to economic and monetary union and the irreversibility of the euro” (Source).
It gets fairly boring to an outsider and must be very depressing to the growing number of people without work and those who are having working conditions and pension entitlements cut.
All this tells us is that the bailouts will become part of the treaty and nations that suffer aggregate demand shocks which drive their fiscal parameters beyond the Stability and Growth Pact rules will be forced by the EU “leadership” to invoke harsh pro-cyclical fiscal policies which damage their domestic economies even further.
This is no future. And there is no alternative given the history of the system; its member states; and the way they have designed the system. The EMU is a perfect example of a system designed to fail. It is big on political rhetoric but at the level that matters – economic structure and behaviour and the capacity of governments to stabilise their own economies it fails badly and will always fail under the current leadership.
The following graph uses OECD Main Economic Indicators data for standardised unemployment rates and compares the average for the OECD with the EMU and some of the struggling Euro nations from January 2005 to October 2010 (the data is monthly).
The Eurozone overall has failed to produce low unemployment rates. A feature of the system has been the persistence of high unemployment.
This point is made by Martin Jacomb in his recent Financial Times article (December 19, 2010) – Europhiles risk ignoring the jobless tide. Jacombs, by the way, is not a believer in government intervention and has recently proposed privatising Oxford University.
But he is correct in saying that the flaw in the EMU was that there was “no central economic government” which could provide fiscal transfers to attenuate the reality that some regions are more succesful economically than others.
He said of the Eurozone design:
The flaw was this: productive activity always tends to migrate to centres of economic success and prosperity. This tendency is inevitable and visible in every single currency area. Within a sovereign country that has its own currency, a large proportion of taxes raised by the government goes to benefit the less economically successful areas. This does not happen through regional aid, although this may help a little. It is achieved through wages paid to public sector employees, capital expenditure by central and local government and welfare-system transfer payments and so forth. Taxpayers tolerate this in the interests of social harmony. In a single currency area, with no central economic government, as in the eurozone, there is no possibility of this.
While his conception of “taxpayers” funding government spending is erroneous the point remains that the ideologues who strut around as the Euro leaders deliberately eschewed the creation of this central fiscal capacity. They thought the Maastricht rules would be sufficient. Unfortunately, they didn’t consider what would happen when a large negative demand shock hit the system.
Even the normal (and welcome) operation of the automatic fiscal stabilisers blew the budget outcomes way beyond the SGP rules. It was no surprise to anyone who realised that these rules were more or less plucked out of the air and didn’t reflect any sensitivity to what might happen when a large demand shock arrived.
While the rules were bad enough the reaction of the Euro bosses once they were breached demonstrated their ideological obsession. They then required pro-cyclical discretionary fiscal policy to be introduced which was just the cat chasing its tail – that is, the contractionary fiscal strategies forced on these ailing nations worsened their real economic outcomes which, in turn, drove the budget further into deficit via the automatic stabilisers.
In forcing pro-cyclical fiscal stances onto nations these “leaders” were following exactly the path that mainstream economists argue is the problem with using fiscal policy in the first place. So it became a case of burying that argument for a while because it was more convenient to rehearse their public debt obsessions.
Fiscal policy can sometimes become destabilising and pro-cyclical if it pushed nominal spending growth beyond the capacity of the economy to absorb it via real output increases. In general, expansionary fiscal policy that is supporting real growth is desirable.
Contractionary fiscal policy at a time of private contraction and rising unemployment is never desirable or justified. It is this strategy that the Eurozone bosses think demonstrate their “leadership”. They are wrong … it just demonstrates that they are terrorists who use the most disadvantaged citizens of Europe as pawns in their political machinations.
The problem facing the poorer Euro nations which are being forced to increase taxes and cut public spending is that the only adjustment offered to them is deflation – cutting nominal wages and hoping that eventually they will export their way out of the mess. Historically, nations which face falling external competitiveness allow their currencies to depreciate. This is not possible for the Euro members.
So it will be a grinding process over the next decade or so – with chronic depressed domestic conditions and no certainty that sufficient restructuring will occur to allow these nations to export their way out of the mess.
Jacombs noted that such deflations are “not usually possible on a sufficiently wide scale without a prior economic collapse. Devaluation of a national currency is a more practical proposition” and while:
… leaving the eurozone, being against the rules, is a very expensive and disruptive procedure … if this is the only way to prevent the national economies of the peripheral countries becoming mired in failure, and save millions from falling into long-term unemployment, then it may begin to look like a price worth paying.
I agree with that assessment.
There are other possibilities as outlined in this Bloomberg Op Ed (December 21, 2010) – Five Ways to Start the Euro Rescue – by one Matthew Lynn.
Another summit, another messy compromise. With the euro facing renewed crisis, and with Portugal, Spain, Belgium and Italy all under the same kind of pressure that forced Greece and Ireland into a bailout, the stage was surely set for a clear and decisive defence of the single currency. And what did the European Union’s leaders come up with after high-level talks in Brussels? A two-line treaty amendment. It’s crazy. It might be the case that the euro isn’t worth saving. This column has certainly argued that it has turned into a bankruptcy machine. It would be better for the peripheral nations to get out now — and better in the medium-term for the EU as well.
In criticising the lack of any “real” leadership among the EU bosses, Lynn outlines five steps that he considers are “required to save the euro”.
First, “boost public spending in Germany and run bigger budget deficits” – which would stimulate demand for exports from the “peripheral countries”. While the Germans hate budget deficits, but Lynn says that “either you want to save this thing or you don’t”. While this will help stimulate demand in the Eurozone, a more obvious solution is to allow the struggling member states to defend their own domestic economies directly via fiscal expansion.
Second, “double the size of the 750 billion euro ($980 billion) bailout emergency fund” because the “EU is engaged in a battle with the markets over the future of the euro” and it needs “ammo in the locker”. He correctly observes that the “markets” will only keep “hammering away” until the leadership makes “it clear they can’t win”.
This should never be a problem for a sovereign nation. They can always dominate the markets even though there is very little recognition of this fact. Please read my blog – Who is in charge? – for more discussion on this point.
However, this is more difficult in the EMU and requires the ECB to work with the national central banks to ensure that governments can “fund” their own spending. While the ECB is fulfilling this function in a roundabout way at present a central fiscal redistribution fund would also work. The problem is that the way the “treaty” is currently conceived (including the proposed amendment from the recent summit) any nation seeking assistance from this fiscal fund have to endure IMF structural adjustment style rules which just make matters worse.
Third, “create Eurobonds” which would pool “the debts of the peripheral and core nations into single euro-area bonds” and raise “enough money on reasonable terms to salvage the single currency”.
Again this is a move towards a central fiscal strategy. The problem is that richer nations don’t want to become the source of bailout for the struggling Eurozone nations. Lynn correctly notes that ultimately “Germany and France are on the hook for Greek, Irish and Spanish debts anyway” and “may as well raise money together” because it “will be cheaper” among other things.
Fourth, “rewrite the treaties so that euro-area governments cede ultimate control over budget and tax policies to Brussels”. So create a European monetary union fiscal authority and eliminate the fiscal role played by the individual states. For a multi-regional economy to function there has to be an alignment between the fiscal and monetary authorities. You cannot effectively have many fiscal authorities without currency sovereignty and facing a fixed exchange rate and one monetary authority with currency issuance powers.
The absence of a central fiscal authority was the glaring design fault in the initial EMU creation. The system cannot survive without it.
Lynn correctly notes that Greece and Ireland, for example, haven’t much “economic sovereignty … left anyway”. I read the Irish press daily and there is a continual thread coming from the government that they will not give up their sovereignty. This is pure political posturing aiming to appeal to some misguided nationalism.
The reality is that the Irish along with all the other EMU member states surrendered their economic sovereignty the day they entered the Euro and abandoned their currency issuance capacity, ceded monetary policy to the ECB and fixed their exchange rate. The further reality is that these economies are only surviving (if we can call it that) and their governments remaining solvent because the ECB is buying their debt (along with bailout money from the EU and the IMF).
It would be far better to create a central fiscal capacity if these nations really value the euro. I would personally consider that a retrograde step given the extreme heterogeneity in culture, history and economic structure that exists within the current EMU. But I don’t live there and I would now have national referendums throughout the zone (as was initially conceived until the Euro bosses realised the people would reject the creation of the zone).
I would ask straight out – do you value the euro enough to endure persistent recession and to cede all fiscal authority to Brussels? Yes or no!
Finally, Lynn says that the member countries have to “prepare for austerity”. He quotes research findings that suggest that:
… Greece, Ireland, Spain, Portugal and Italy will need to cut government spending by 10 percent, and consumer spending by 15 percent, to stay within the euro. That is slightly more than the 14 percent drop in consumption the British endured during World War II. It is going to involve massive sacrifices, so it would be better to lay out now what kind of pain is involved. People will be angry, but they will be a lot angrier if you don’t level with them.
I will comment more on that research report another day. The scenarios outlined are chilling.
They confirm my view that while it would be disruptive and very challenging to exit the euro, the southern nations will be better able to address their appalling domestic situations if they make that move. I suspect that in the medium term it will be cheaper (in real resources) to exit than to stay in.
Lynn agrees and says:
Of course, when you lay out starkly the things that need to be done to rescue the euro it becomes clear that it is hardly worth it. Few people in Europe are likely to sign up to that package of measures.
So the appropriate leadership initiative from Brussels would be to arrange national referendums throughout the EMU. Yes or No! Simple. The existing crop of politicians would find out quick smart that their rhetoric doesn’t match the desires of the voters.
Yes or No? Bankruptcy machine or not?
That is enough for today!