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Fools and Their Money – The Legacy of the Euro so Far

Only months before ending his term at the European Central Bank (ECB) this October, Mario Draghi pushed interest rates below zero for another year and is preparing a fresh expansion of the ECB’s 2.6tn QE programme, while the Euro reached a seven weeks high. Those measures come amidst growing concerns that the Eurozone’s economy will not generate a sufficient level of inflation and growth might remain stagnant. During last week’s ECB meeting in Vilnius, he also acknowledged the risks posed to the Eurozone by rising protectionism, the US-China Trade War, and vulnerabilities in emerging markets. This gives us the chance to reflect upon the single currency’s legacy so far before embarking upon this new chapter in its history.

The 2010 Eurocrisis was a dramatic illustration of the flaws that plague the design of the single currency. The Euro was originally envisioned as a way of bringing countries together, saving costs of exchanging currencies, and a way of coordinating economic policies between the countries using the single currency. The ECB, born out of the Maastricht Treaty, was created in order to implement a uniform monetary policy across the block. The single currency was supposed to bring growth and prosperity, and, eventually, it should have led to convergence and political integration.

However, it did neither of those. Milton Friedman already saw the Eurocrisis coming back in 1997 when he argued the one-size-fits-all currency is not appropriate for countries with vastly different conditions and policy regimes. His argument was simple. A common currency is an excellent arrangement under some circumstances, case and point being the United States, and a poor arrangement under others, such as the European common market. Despite being a free trade area, labor and capital are less mobile than in the US and regulation differs from country to country. Low labour market flexibility is also one of the reasons labour mobility cannot be used as an appropriate macroeconomic adjustment mechanism in lieu of exchange rates and monetary policy. However, the most noteworthy flaw of the single currency was the loss of powerful adjustment mechanisms such as flexible interest and exchange rates and currency devaluation. Bernard Connolly echoed many of the same arguments in his book originally published 1995, The Rotten Heart of Europe, albeit in a much more pessimistic tone.

…the most noteworthy flaw of the single currency was the loss of powerful adjustment mechanisms such as flexible interest and exchange rates and currency devaluation.

As both Ashoka Mody and Joseph Stiglitz pointed out in their respective critiques of the Euro, when one member country went into recession, it could no longer devalue its currency relative to others in order to make its goods cheaper and increase exports. Member countries also had to give up their ability to reduce interest rates and encourage domestic spending to stimulate growth. Imagine the German economy might be overheating and facing inflation. In such a case it might want the interest rate to rise. Now imagine Greece might be facing a recession at the same time and might want interest rates to fall in order to stimulate growth. The common interest rate set by the ECB, in this case, is too high for Greece and too low for Germany. Once economies within the Eurozone begin to diverge from one another, the common interest rate makes that divergence increase.

The single currency could’ve worked, and it could still. However, for the single currency to work it would imply the introduction of a fiscal risk sharing mechanism that would have member countries mutually insure each other. There would also need to be significant fiscal transfers between states, which could be achieved via a Eurozone budget, a proposal that has been hotly contested by the more fiscally conservative member states, notably the Dutch. Following the 2010 crisis, many changes have been made to the architecture of the Eurozone, including the banking union. However, the banking union still lacks an element that is central to its completion, a common deposit insurance scheme (EDIS). While the Euro is a safe medium for storing wealth, that’s not the case for Eurozone sovereign bonds. Granted Germany’s government bonds are a safe haven, its current account surplus leaves no room for an expansion of its government debt. Germany is also against one viable solution of introducing a safe asset in the Eurozone, the mutualisation of debts via Eurobonds. Those are only a few of the solutions that have been proposed and more in-depth analyses of Euro Area Reform have been written on the subject that what I am able to show here.

“The process of adjustment is compulsory for the debtor and voluntary for the creditor. If the creditor does not choose to make, or allow, his share of the adjustment, he suffers no inconvenience.” – John Maynard Keynes

Overall, the common currency also has to overcome the things that make it politically impracticable. Under the current system there are no political procedures to achieve resolution when financial crises occur. We just accept the fact that some countries will be winners and some will be losers. It’s also the case that Germany’s or the Netherlands’ trade surpluses create negative externalities in other European countries because they force other countries to run deficits and their excess savings need to be absorbed by other those countries. John Maynard Keynes had already recognized this problem back in 1941 by pointing out that, in the absence of a mechanism to recycle the surplus back into deficit countries, huge current account surpluses in one country are sucking demand out of other economies. Such imbalances in the euro area have been mainly borne by deficit countries which had to devalue real exchange rates by cutting wages and domestic demand. This is yet another problem with the Eurozone, “the process of adjustment is compulsory for the debtor and voluntary for the creditor. If the creditor does not choose to make, or allow, his share of the adjustment, he suffers no inconvenience.”

Uneven adjustment in the euro area is also one of the reasons for why both demand and inflation have been low since the Eurocrisis. Eurozone GDP adjusted for inflation has been fairly stagnant until 2017. This brings us back to the European Central Bank and Mario Draghi. The intervention of the ECB is what managed to hold the Euro together. The ECB has bought both corporate and government debt at a colossal scale in order to prevent deflation in what could be considered a de facto debt mutulisation, enriching some bankers and speculators in the process, but ultimately saving the euro. With Mario Draghi leaving office in October, the future the Euro is uncertain as it is unclear whether the next ECB president will be willing “to do whatever it takes to preserve the euro”.  Martin Wolf said in the Financial Times that Draghi’s successor “might determine whether there is a Eurozone, perhaps an EU, at the end of the term in 2027”. Appointing figures like Jens Wiedmann, the Bundesbank president and likely candidate for the job, might turn into a disaster as he opposed many of Draghi’s actions.

While the Euro might not fall in the near future, in the absence of solidarity between states and the unwillingness to reform, to share risks, and to build a genuine political union, it’s bound to waddle from crisis to crisis until it eventually collapses. While some think that “more Europe” will not solve the problem and an ever-closer union may be a political mirage, I think the solution to fixing Europe’s disunion is more Europe, not less. It’s clear that Europe cannot continue functioning the way it does now, but it could change faster than we think. The European Elections have shown that change is what people want. As Stiglitz said in his book, “Europe need not be crucified on the cross of the euro – the euro can work”. And if it can’t, it’s best to remember fools and their money are soon parted.

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