Too easy to swallow the euro’s red herring
Published in Business Spectator (Melbourne), 9 May 2013
Last week, I gave a speech to Auckland University’s economics club called The never-ending Euro crisis – Anatomy of an economic policy disaster. It was a wide-ranging presentation in which I covered the history and pre-history of European monetary union, Europe’s fiscal and monetary problems, the eurozone’s governance issues and their political implications.
It was, essentially, a summary of three years’ worth of Business Spectator columns, packed into a lecture lasting a little over an hour. I didn’t leave out too much.
But in the ensuing discussion, one of the economics professors, a renowned Austrian School theorist, asked two questions that were both unbelievably simple and incredibly sharp. The first: “So what does this euro crisis really have to do with money?” And the second: “Why have you not talked much about markets in your presentation?”
At first, I was a little startled by these two questions. After all, when you give a whole lecture on the failings of a monetary union, surely this must have something do with money, right? And secondly, didn’t the euro crisis play itself out in the markets? Isn’t that where all the drama of these past years happened? How could I not have talked about markets?
After the initial shock, I managed to give a reasonable answer to both his questions. However, I have been thinking about them for the past few days. And the more I do, the more it seems to me that they are not only valid questions: they also provide the answers to many of Europe’s current problems.
One of Milton Friedman’s famous quotes is that ‘inflation is always and everywhere a monetary phenomenon’. Well, you might be tempted to say the same about the crisis of the euro. Of course, at first sight at least, it looks like monetary phenomenon. But is it?
In a way, the answer is not quite as straightforward. Of course, without the euro currency many of the problems we now observe would have never developed. Without monetary union, the richer European economies would have never felt the need to bail out struggling Southern European economies. A sovereign default in a small economy would have been a matter for that country – and no one else.
Similarly, trade imbalances between European nations probably would have corrected themselves through adjustments in the exchange rate. This is how such tensions had always been overcome when Europe still had many national currencies, and it certainly would have provided temporary relief.
So clearly, the euro crisis has something to do with money.
At a deeper level, however, the monetary crisis we are observing is not actually a crisis of Europe’s monetary order. It is a crisis of competitiveness – or rather of diverging competitiveness within Europe.
The euro crisis is worst in those countries with severe structural economic problems: countries such as Greece which are plagued by a bloated state apparatus. Countries such as France and Italy with overregulated labour markets. Countries such as Portugal which have not recorded any productivity gains for a long time.
All of these countries would have encountered economic crises sooner or later even without the euro. But their steady loss of competitiveness would have resulted in pressure on the exchange rates of their currencies. Under the euro regime, there is no such safety valve. Instead, all pressure resulting from their economic problems led straight to declining exports, reduced growth and rising unemployment.
What looks like a monetary crisis is really the crisis of the countries’ respective economies. These are economies that are in desperate need of economic reforms. Their problems have little to do with monetary union as such; the union merely brought their problems to light. Without the escape route of flexible exchange rates, their deep-seated problems could no longer be glossed over.
So the economics professor’s question was indeed appropriate. The euro, misguided and ill-constructed as it is, cannot be solely blamed for Europe’s woes. Deep down, what we are witnessing is a crisis of Europe’s social and economic model. It is a crisis of governments that have grown too big and of economies that have become too regulated. Both have reduced their competitiveness, and monetary union’s rigidity has mercilessly revealed it.
The professor’s second question is equally appropriate: Why did I not talk much about markets?
What he probably meant by this question was why markets did not correct the issues we observe? Monetary union has certainly stopped foreign exchange markets from working (although there is an implicit signal that a euro held in a Cypriot bank is worth less than the same euro in a German bank account).
But the power of markets could and should have disciplined European economies in other ways than this. If an economy suffers from poor competitiveness, why would it still have easy access to capital? If a government is constantly on the brink of default, why would it still be able to repeatedly refinance?
In both instances, the answer is that markets no longer matter. They have been substituted by political schemes and central bank mechanisms (it is sometimes difficult to tell where one ends and the other begins).
If private capital is no longer willing to pay for the gap between imports and exports, the Target 2 system makes up for the difference (Believing in Europe’s financial tooth fairy, 12 June 2012). And if yields on government debt are about to spiral out of control, we know that this is the moment when European politicians and central bankers usually start to intervene. The EU is even threatening to censure ratings agencies because it does not want to hear any more bad news.
Markets are never given the chance to work, and in this sense, the whole euro crisis has just been one big struggle of politics against market forces.
The economics professor was definitely onto something. This euro crisis is more than just a monetary crisis. It is way deeper than that. It really is just another episode in the epic battle of government against the markets. Typically it’s the markets that win in the long run.