Saturday, May 5, 2012

We need to talk about the euro

Graph borrowed from Krugman's blog, who addressed
such issue in numerous recommended posts 
It is an increasingly mainstream opinion among economists that austerity is worsening the crisis rather than solving it. And nowhere is it more obvious than in Southern Europe, that is in Greece, Ireland, Portugal, Spain, Italy (Ireland doesn't share the latitude or the climate, but it shares the woes). But for Southern Europe, austerity is only part of the story. It is the euro that initiated the crisis, and it the euro that now makes things worse, and prevents any way out.
  • The exchange rate is the major problem. Not that the euro is globally over or under-valued: the trade balance of the Eurozone has been fluctuating in a narrow margin around the equilibrium ever since the creation of the currency. But what's true for the zone as whole is very different for individual countries. Trade balances (or current account balances, as it's not very different in Europe) plunged into deficits in the south, while recording heavy surpluses in the north (see graph).
  • It means that the German euro is overvalued and that the Spanish or Portuguese euro should depreciate (which is of course not possible, as euro is the one and only currency). Such imbalance is nothing abnormal in itself. It happens all the time in all integrated economies, i.e. in economies with a single currency, a unified fiscal system, harmonized labour laws, a single social benefits system, and substantial money transfers across regions. Apart from the currency, there's no such thing in Europe (which is not a country), and that's why regional exchange rate discrepancies matter a lot.
  • Monetary policy did not help. Interests rates and money supply are monitored by the ECB for the Eurozone as a whole. For the south, whose economic weight is lighter than that of the North, those rates were too low in the first half of the 00's, allowing for housing bubbles in Spain and Ireland, for public over-borrowing in Greece (in Greece only!).
  • In many crisis, exchange rate adaptation is the only way out. The concerned country needs to restore the equilibrium of its trade balance, which can happen only through an adjustment of its terms of trade (i.e. cost reduction with respect to international markets). In theory (that is, in the neoclassical theory), it could happen through prices and wages decreases. But there is mechanism that neoclassical theory is at odds to explain: price and wage stickiness. Prices and wages can only go up, not down (and it's typical of neoclassical economists of pretending that a mechanism that doesn't fit into their theory does not exist rather than trying to explain it).
  • Without exchange rate depreciation, the only adjustment could then come from inflation in the north. But that's very theoretical again, as there's little chance the ECB or the Germans might agree to pursue such monetary policy (although the ECB has been much more flexible since Mr Draghi took function).
  • And because they no longer have their own currency, southern countries are no longer able to print currency in order to finance their temporary budget deficits (remember they had on average balanced budgets before the beginning of the crisis!). Instead, they increase taxes and cut spending, which, in confirmation of old keynesian thinking, turns out to worsen the crisis.
So, because of the euro, Southern Europe is trapped in a downward spiral with no end in sight. The life of many people is already seriously affected, with record unemployment rates, bankruptcies, suicides, poverty and rise of extremist movements. The situation is only getting worse, and then there's the question of the long-run. In Spain and Greece, one young person out of two has no job. If they don't acquire the skills now, what are they going to do in 10 or 20 years? Certainly not working their countries out of a prolonged deep recession (there's a word for that, it's called hysteresis).

But if the euro is such a big problem, how come is it not more debated, especially in the Eurozone itself where mainstream opinion is a long way from discussing such issue? Well, for a variety of bad reasons:
  • First of all, the continental European establishment is economically illiterate. Maybe I shouldn't generalize, but for France at least, it's true. You just need to read the proposals of the candidates to the presidential election to get convinced (that was either austerity, social benefits, subsidies or protectionism, or a mix of all that!). Economists don't speak out much (just as they did not at the time of the creation of the euro), and there's not much of economic blogging either (or in English, which does not help much). As far as politicians are concerned, they never admit they've been wrong, no matter what.
  • Secondly, it does not help that the euro is contested by extremes (far-left and far-right in France, Geert Wilders in the Netherlands), that is the sort of people either with a low economic credibility or one should not want to associate with. Besides, such extremes may aim their attacks at the euro, but they make little mystery their real target is Europe.
  • More significantly, the euro is the big and only symbol of European integration. Despite all the civil servants in Brussels, and all of the good or less good European policies, apart from the euro, Europe looks like nothing more than a mere trade agreement. Europe so far has been unable to develop a real common defense or foreign policy. Touching the euro would leave a scarf, for sure. But the question is whether the economic health of Europe requires surgery.
  • In the 90's the euro had been strongly promoted not only by politicians, but also by business people who were looking for simplified trade and easy accounting at the end of the fiscal year. Such motivations may look marginal, but they remain nevertheless true, and business people (big or small) still like the euro.
Maybe there is a reason more fundamental than all of the above that explains why so few people want to talk about the euro. Everyone seems to be convinced that a euro break-up would be hugely complicated and hurt more than the alternatives (prolonged depression and substantial money transfers from north to south). It does not necessarily have to be that way, and that will be the object of the next post.

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