By: Declan Walker
Many tend to think that the failures of the eurozone can be attributed to the crises which have dominated headlines for the better part of three years. Events like the 2008 financial crash and the Greek debt crisis of 2010 are often designated as causal factors. However, the assignment of blame on contemporary crises is incorrect, with the reality being that the failure of the eurozone had its roots in its original structuring and implementation in 1992 and 1999, respectively. The fallacies of the eurozone can be attributed primarily to three key structurally-related outcomes: the emergence of a false fixed exchange rate, which is based on trade imbalances; driving debt-to-GDP imbalances and permitted irresponsible fiscal policy; and the inability of individual countries to impact their own monetary policy to combat inflation. In that regard, it can be concluded that the economic crisis currently plaguing the eurozone is not the result of contemporary events, but rather the failures of the mechanisms which have been present from the system’s very origins.
The original goal of the eurozone’s proposal as a mechanism of the European integration process was the convergence of European economies. During the early stages of the euro’s inception, there was optimism that the economies of the ‘periphery’ countries in Europe would converge rapidly and successfully. However, after the idea of a singular monetary policy, insisted upon by the Germans (one which emphasized low inflation) was agreed upon, the eurozone was essentially doomed. A unitary aggregate currency, interest rate, and inflation rate – or essentially a ‘one size fits all’ monetary policy – is not realistic for such a diverse group of economies. By agreeing to adopt the German norms of monetary control, the economic wellbeing of countries such as Greece, Portugal and Spain became contingent upon their ability to replicate German monetary and fiscal discipline – an entirely unrealistic notion.
1. THE EURO HAS PRODUCED A FALSE FIXED EXCHANGE RATE (BASED ON TRADE IMBALANCE)
A crucially detrimental aspect of the euro is that it has resulted in a false internal fixed exchange rate. By utilizing the dual mechanisms of a single fixed exchange rate and single monetary policy in combination with excessive wage suppression, Germany was able to gain a profound trade surplus at the expense of the rest of the eurozone, exacerbating the detrimental trade imbalance. Consider the following: the ECB initially set a target inflation rate of 2% for eurozone countries – a figure which in itself was reflective of Germany’s labour market. In sound macroeconomic policy making, unit labour costs should rise in harmony with the rate of inflation. Between 1999 and 2008, while the Italian, Portuguese, Spanish, and Greek unit labour costs rose above the target (while suitable for Germany, unrealistic for Southern Europe), Germany actually held down their unit labour costs via wage suppression. Essentially, Germany took advantage of the system by holding down unit labor costs below the eurozone target set by the ECB and below their own inflation rate; as a result, Germany’s exports were cheaper than those of their eurozone counterparts. This resulted in Germany gaining a massive advantage in trade and racking up capital surplus while its eurozone counterparts grew less and less competitive; the outcomes of German opulence and accruing debt in Southern Europe were interdependent. Indeed, in 2011, Germany had a trade surplus of nearly $200 billion in addition to a current account surplus of five percent of GDP. In stark contrast, other eurozone members had cumulative trade deficits totaling that same figure of $200 billion, while Greece had a current account deficit of 10 percent.
2. THE EURO HAS DRIVEN DEBT-TO-GDP IMBALANCES AND PERMITTED FISCAL IRRESPONSIBILITY
From the time of its inception, the singular monetary policy established by the ECB has been one which emphasized anti-inflationary measures. In recent times, this staunch anti-inflationary approach has resulted in interest rates being too high in countries with rising unemployment and too low in countries with rising wages. Thus in countries with rising wages such as Ireland, Greece, and Italy the interests rates were lower than they should have been, and the result was that they were borrowing beyond their capacity while banks loaned out too much. This resulted in massive inflation (especially in the housing market), which explains the rise in debt-to-GDP ratios in deficit countries, like the ones aforementioned. Had the interest rates been more realistic, the countries would have borrowed less, banks would have leant out less, and inflation would not have been so rampant. To the extent that this can largely be attributed to fiscal weakness and irresponsible international lending, this particular aspect of the crisis (ie, growing debt-to-GDP ratios) also has its roots in the trade imbalance based on fixed internal exchange rates, as it was exacerbated by the fact that Germany leant its surplus capital to deficit countries at incredibly low rates. Additionally, the common monetary policy also gave way to the false perception that there was no difference in risk between bonds from different governments belonging to the EMU – that they were all equally safe, regardless if a country had a high level of debt. As a result, the interest rates of the bonds of deficit countries like Greece, were almost identical to the interest rates on German bonds, differing by merely fractions of percents.
By being members of the eurozone, the deficit countries had access to capital at a cheaper price than their national economies would have predicted. With that cheaper capital they embarked on ambitious expenditure and infrastructure initiatives that ballooned out the national deficit, eventually leading to much higher debt. The investment initiatives did not substantively increase economic performance hence debt-to-GDP ratios skyrocketing. This in turn lead to a crisis of confidence in national bonds which quickly manifested itself into a crisis of the eurozone as a whole. Consequently, interest rates on Greek debt rose substantially. In turn, the expectation of a higher future interest payment meant that Greece would be plagued by an even larger debt burden in the future.
3. THE INABILITY OF INDIVIDUAL COUNTRIES TO IMPACT THEIR OWN MONETARY POLICIES IN ORDER TO COMBAT INFLATION
Establishing that these countries have effectively been crippled by trade imbalances brought on by a fixed exchange rate and by rising debt-to-GDP ratios as a result of EMU policy, it is now worth looking into what practical options these countries have to remedy the situation – or rather, the lack thereof. Normally, a country’s main macroeconomic tool to remedy the issue of a lack of competitiveness in trade is currency devaluation. However, the eurozone has robbed deficit countries of their abilities to resolve these issues. For example, if Greece or other deficit countries’ were not tied to a single currency, their independent currencies would decline in value – making their respective exports cheaper (and thus raising the demand of foreign buyers). As a result, the deficit countries’ respective exchange rates would adjust accordingly over time, and this would of course mediate the growing trade deficit. However, since the deficit countries are, in fact, tied to the singular currency – the automatic adjustment mechanism of currency devaluation is absent altogether. The only options that deficit governments have within the constraints of a singular EMU monetary policy are to reduce wages, and to reduce both private and public expenditure, which would result in reduced levels of aggregate demand, and is simply impractical.
The real question at hand will be whether or not Greece stays in the eurozone; the long term results of this could effectively spell its end. Consider the following: if Greece is indeed forced out, and the drachma is reimplemented in place of the euro, the immediate or short term effects will, as expected, be dire. However, consider the long term effects, or at least a few years down the road; a greatly devalued drachma, as the economy slowly stabilizes, has the potential to attract a lot of foreign investment. If Greece does indeed end up on the ‘winning side’ of the euro debacle, struggling countries such as Spain for example might look onward and say “What might a new peseta look like?” It sure seems like a more attractive alternative to austerity in the long run.
Declan Walker is a graduate of the University of Toronto (’15), where he studied Political Science and Economics.