The Euro

Abstract

Bored with Brexit? Tired of Trump? You can always distract yourself by worrying about the euro instead. This may not seem obvious right now: GDP (a measure of the economy's total output) in the Eurozone grew at 2.3 per cent in 2017, the same rate as in the United States, and significantly faster than in the UK. But this superficially impressive performance masks a dismal reality, and the underlying structural problems of the Eurozone remain as intractable as ever. Is it not good that the Eurozone grew at American rates last year? Of course, but this is a case of better late – very late – than never. Lest we forget, 2008 saw the greatest economic crisis to hit the world economy since the Great Depression. GDP fell by an impressive 4.5 per cent in the euro area. Just as an elastic band snaps rapidly back into place when first stretched and then released, so you would expect an economy that has experienced a major decline in output to recover rapidly, as the malfunctions that led to the fall are remedied. In this perspective, the Eurozone's performance was abysmal. GDP recovered to its pre-crisis level in America in 2011. It recovered to its pre-crisis level in the UK in 2012. It only recovered to its pre-crisis level in the Eurozone as late as 2015, and if you exclude Germany from the statistics it only recovered in 2016. Indeed, if you consider the Eurozone outside Germany, GDP per head of population only got back to where it had been in 2008 in 2017, almost ten years later. This is an astonishing policy failure. The growth that is putting a stride in the step of the euro's boosters should have happened much, much earlier: we have experienced a lost decade. What went wrong? Any explanation has to consider both avoidable policy mistakes, and deeper structural flaws. First, the mistakes. It is true that the origins of the Great Recession lie in the exuberance of an out-of-control global financial sector. However, once it hit, the key problem was a lack of demand. Overly indebted households and firms were too scared to buy big-ticket items, and in some cases would have been unable to access the necessary credit, even had they been willing to take the plunge. The result was unsold goods, lay-offs, less income, and still less demand. This is a scenario that would not have surprised John Maynard Keynes, since he diagnosed precisely such a problem during the 1930s, and prescribed the economic remedies to cure the disease. One approach was to try to lower the cost of borrowing, by reducing interest rates – the hope being that access to cheaper credit might stimulate households or firms to buy cars or factory equipment. But Keynes was sceptical about whether such monetary policy manoeuvring could solve the problem on its own: what if the private sector was unwilling to borrow and spend, no matter how low interest rates went? In that case, he argued, governments had to step in and do the spending themselves. The lessons of the Great Depression seemed to have been remembered, when in 2009 world economic leaders gathered in London to agree a response to the crisis. They decided to pursue a coordinated policy of boosting demand, using both monetary and fiscal policy tools. The result was that, seen in a global perspective, the Great Recession lasted only a year or so. The world economy was already recovering by mid-2009, helping to explain (and perhaps partially justifying) Gordon Brown's famous Freudian slip in the House of Commons when he claimed to have saved the world. (He had in fact meant to claim credit for saving the banks.) From the beginning, however, Eurozone policymakers acted more cautiously. They were much slower in lowering interest rates, and took a long time before resorting to the money printing (or quantitative easing, as it is known nowadays) that had been adopted early on in both Britain and the United States. And then, in an appalling policy error, the bloc performed a rapid, premature fiscal policy U-turn in 2010. There had been some rather half-hearted attempts to use government tax and spending policies to boost demand, as well as an acceptance that automatic stabilisers would have to be allowed to operate where possible. (When an economy goes into recession, government social spending automatically rises as unemployment increases, government tax receipts automatically fall as incomes decline, and budget deficits automatically rise. These automatic responses to a recession help to stabilise the economy by limiting the fall in total expenditure: hence the term.) But none of this sat very well with EU treaty requirements that member states limit budget deficits and government debt, or with long-standing German suspicions of Keynesian stabilisation policy. When it emerged in 2010 that Greek government debt was much higher than had been previously suspected, this gave fiscal conservatives the excuse they needed. In the midst of the greatest collapse in demand since the 1930s, the world was treated to the bizarre spectacle of European economies introducing new mechanisms designed to limit government deficits, including fines to be imposed on governments deemed to be spending too much money. The predictable consequence of the Eurozone's 2010 lurch to austerity was the macroeconomic catastrophe referred to at the start of this column, and all the human and political costs that flowed therefrom. And the attempt to legalise the requirement that governments run their budgetary affairs in a ‘prudent’ manner has done nothing to reduce the perception of a European democratic deficit.1 Despite the political toxicity of rules administered by the European Commission, and limiting the ability of democratically elected governments to run their own budgetary affairs, it is important to recognise that not everything in the rules is stupid. If you think that governments should borrow and spend more in bad times, then you should also believe that they should borrow less, and reduce their debts, in good times. Otherwise they risk finding themselves being unable to borrow at all in the depths of a crisis, as investors shy away from lending to countries with debts that are too high relative to their incomes. Such was the fate of Greece, for example: when this happens, not only can you no longer allow automatic stabilisers to function, since these involve borrowing, but you will find yourself automatically destabilising the economy, raising taxes and cutting expenditure at the worst possible moment. Those who would be Keynesian in the downturn should be German in the upturn. The rules reflect this simple logic. But even if they are followed to the letter by individual countries, this does not guarantee that things will be any better next time around – and there will, most certainly, be a next time around since there always is. First, the most striking feature of the Eurozone is that, while it is an extremely big economy, it is composed of many small countries. When the government of a small country spends more money, this inevitably leads to extra spending on imports, which will create jobs elsewhere. This is true even when expenditure programmes are more carefully crafted than the Irish government's response to the 2008 crisis, which inter alia involved a subsidy to car purchasers. (Ireland does not produce any cars.) Not all governments are as eager to create jobs elsewhere as the Irish government apparently was in the last days of the Celtic Bubble. When the next crisis hits, therefore, European governments may prefer to free ride, letting their neighbours do the spending and incur the resulting debts, rather than borrowing and spending themselves. That is certainly how they will behave if they follow the lead of Germany, which was notoriously reluctant to boost demand during the Eurozone crisis, even though it was one of the countries best able to do so. If everyone behaves like this, then demand will be much too low again, and everyone will lose. Second, ideas matter. Peer pressure matters. Institutions that promote economic worldviews, such as the one that dominated Eurozone policymaking from 2010 onwards, matter. The actually existing Eurozone is unlikely to act in a significantly more Keynesian manner next time around. Indeed, if Mario Draghi – who made an enormous difference for the better when he replaced Jean-Claude Trichet as head of the European Central Bank in 2011 – is replaced by a more conservative figure, Eurozone policy could be even more dysfunctional in the future. And third, the next major crisis may only hit one or two countries, not the Eurozone as a whole. There may therefore be a need for expansionary policies, not right across the bloc, but in just one or two crisis-ridden countries. Indeed, elsewhere in the Eurozone conditions may call for policies designed to cool overheating economies, rather than attempts to boost demand. This is the classic ‘asymmetric shock’ scenario made famous by economists such as Robert Mundell, Ronald McKinnon, and Peter Kenen.2 Asymmetric shocks mean that it is impossible for the central bank to do the right thing for everyone: to lower interest rates in the crisis-ridden economies, so as to boost expenditure, while simultaneously raising them in the booming economies so as to choke off excess demand. (This was a problem in the early 2000s, for example: Ireland desperately needed higher interest rates to cool its runaway housing market, but conditions in Germany and elsewhere dictated looser monetary policy.) Nor is it possible for an economy in crisis to boost its competitiveness by devaluing its currency, since it has no currency to devalue. One solution in theory might be for people from the crisis-ridden economy to pick up sticks and migrate to the booming economy, but even in the US, where people are more mobile than in Europe, many unemployed workers remain stuck in the ‘wrong place’. A classic recommendation is for a centralised Eurozone fiscal authority to be established, that could transfer money from booming to crisis-ridden countries. This could happen automatically, via tax-funded welfare programmes – these would automatically send more money to states with higher unemployment rates, while receiving fewer taxes from those countries. Emmanuel Macron and his advisers are not wrong to argue for a Eurozone Finance Ministry with a sizeable budget: this makes sense from an economic point of view. In addition to transferring resources between countries in the event of asymmetric shocks, a central Finance Ministry could engage in Eurozone-wide expansionary policies when required, thus helping its members to surmount the free rider problems described earlier.3 But the budget would have to be very sizeable in order to make a difference, and that in turn suggests Eurozone-level governance structures to provide the fiscal authority with democratic accountability. In other words, such a scheme would require political union at the Eurozone level, and for some proponents of the idea this is its main attraction. But there are two big objections to such ambitions, both of them political. First, at a time when Brexit is reminding everyone of the value of the twenty-seven member European Union, it would seem utterly perverse to divide the bloc from within by deepening political integration in just a subset of it. And second, you couldn't take such a step without the consent of the governed. The probability of getting the populations of all nineteen Eurozone members to agree to a big increase in the share of GDP going to the centre, let alone to political union, seems to me to be vanishingly small. To this objection, some enthusiasts reply that recalcitrant Eurozone member states should be presented with an up or out choice: sign up to fiscal and political union, or face expulsion from the single currency. Assume for the sake of argument that all nineteen governments signed up for this. Some of them at least would be obliged to put the matter to their electorates, and what would happen then? At the first sign of opinion polls suggesting that voters might say no, money would flee the country concerned: otherwise investors would be taking the risk of having their euros converted forcibly into new and untested currencies. With banks coming under pressure as depositors withdrew their money, government would be forced to adopt emergency measures to protect their financial systems: capital controls (bans on people taking money out of the country), or restrictions on people withdrawing money from the banking system. The result would be financial chaos, which is why (although they are always capable of surprising us) politicians are unlikely to agree to such a foolish scheme. Does this leave the Eurozone more fragile economically than it should be? Yes, it does – and I haven't even discussed the bloc's banking problems, which deserve a column of their own. Blame the euro's architects, who thought that a currency without a state, and all that goes with statehood, was a sensible idea.