Away with the euro

[admin]

We wrote something very similar (if you must know, here) so we find it hard to argue with the damning article below. The euro has been a weapon of mass destruction..

---

Whither the Euro?

Finance & Development, March 2014, Vol. 51, No. 1

Kevin Hjortshøj O’Rourke

Historians may wonder how it came to be introduced in the first place

The euro area economy is in a terrible mess.

In December 2013 euro area GDP was still 3 percent lower than in the first quarter of 2008, in stark contrast with the United States, where GDP was 6 percent higher. GDP was 8 percent below its precrisis level in Ireland, 9 percent below in Italy, and 12 percent below in Greece. Euro area unemployment exceeds 12 percent—and is about 16 percent in Portugal, 17 percent in Cyprus, and 27 percent in Spain and Greece.

Europeans are so used to these numbers that they no longer find them shocking, which is profoundly disturbing. These are not minor details, blemishing an otherwise impeccable record, but evidence of a dismal policy failure.

The euro is a bad idea, which was pointed out two decades ago when the currency was being devised. The currency area is too large and diverse—and given the need for periodic real exchange rate adjustments, the anti-inflation mandate of the European Central Bank (ECB) is too restrictive. Labor mobility between member countries is too limited to make migration from bust to boom regions a viable adjustment option. And there are virtually no fiscal mechanisms to transfer resources across regions in the event of shocks that hit parts of the currency area harder than others.

Problems foretold

All these difficulties were properly pinpointed by traditional optimal currency area theory. By 1998 Ireland was experiencing an unprecedented boom, and house prices were rising rapidly. Higher interest rates were warranted, but when Ireland joined the currency union in January 1999 the central bank discount rate was lowered from 6.75 percent in the middle of 1998 to just 3.5 percent a year later. With the Irish party well under way the new ECB was busily adding liquor to the punch bowl.

Similar stories were repeated around the euro area periphery, where capital inflows pushed up wages and prices. But what goes up does not come down so easily when there is no independent currency. Labor mobility within the euro area remains limited: young Irish workers emigrate to Australia or Canada, the Portuguese to Angola or Brazil. And with no federal budget to smooth asymmetric shocks, procyclical austerity, which exacerbates rather than ameliorates recessions, has been the policy weapon of choice during this crisis—whether imposed by the markets or by euro area politicians and central bankers. Mass unemployment in the periphery is exactly what theory would predict in such circumstances.

Indeed, since 2008 we have learned that traditional optimal currency area theory was too sanguine about European monetary union. In common with much mainstream macroeconomics, it ignored the role of financial intermediaries such as banks, which link savers and borrowers. Many of the euro area’s most intractable problems stem from the flow of capital from the core to the periphery via interbank lending. When that capital stopped flowing, or was withdrawn, the resultant bank crises strained the finances of periphery governments. That further worsened bank balance sheets and credit creation, leading in turn to worsening economic conditions and rising government deficits—a sovereign bank doom loop that kept replaying.

Political ramifications

Bank crises have had poisonous political ramifications, given their cross-border impact. Panic-driven decision making has been ad hoc and inconsistent—contrast the treatment of bank creditors in Ireland in 2010, who were largely made whole, with those in Cyprus in 2013, where they took a big hit. This will have long-term political consequences. Despite the understandable desire of European bureaucrats to regard such matters as water under the bridge, hypocrisy and bullying remain unpopular with ordinary voters. Small, vulnerable countries have had a painful lesson in European realpolitik that they will not soon forget.

Where do we go from here? Since 2010 the focus of most economists has been on how to make the currency union work better. Even those who were skeptical about the European Economic and Monetary Union (EMU) worried sufficiently about the consequences of a breakup to shy away from advocating a country’s exit. The result has been a series of suggestions regarding how to prevent a collapse of the euro in the short to medium run, and how to improve its functioning in the longer run.

In the short run, what is needed is looser monetary policy and, where possible, accommodative fiscal policy as well. If economic historians learned anything from the Great Depression, it is that adjustment based on austerity and internal devaluation (as deflation in individual euro area members is termed nowadays) is dangerous. First, nominal wages are sticky downward, which implies that deflation, if achieved at all, leads to higher real wages and more unemployment. Second, deflation increases the real value of private and public debt, raises real interest rates, and leads consumers and businesses to postpone expensive purchases in anticipation of lower prices to come. Britain ran large primary surpluses throughout the 1920s, but its debt-to-GDP ratio rose substantially thanks to the deflationary, low-growth environment of the time.

Third, fiscal multipliers are large when interest rates are near zero, so spending reductions result in hefty declines in national income. The IMF has found that in the current crisis fiscal multipliers are closer to 2 than they are to 1—as was true between the world wars. The inescapable conclusion is that the ECB must act aggressively, not just to prevent deflation, but to set an inflation target above 2 percent for a transitional period to facilitate real exchange rate adjustment and promote the solvency of its member states. More investment spending by countries with sufficient fiscal capacity, or by the European Investment Bank, would help as well.

For the longer run, there is widespread consensus—outside of Germany—that the euro area needs a banking union that promotes financial stability and that replaces ad hoc crisis decision making with a more rule-based and politically legitimate process (see “Tectonic Shifts” in this issue of F&D). This process should include common supervision for the euro area, a single resolution framework for failing banks with a euro area–wide fiscal backstop, and a common deposit insurance framework. The Euro-nomics group, made up of noted European economists, has proposed a “safe” euro area asset that national banks could hold. This would help break the sovereign bank doom loop described earlier and make it easier for national governments to restructure their debt when necessary (by reducing collateral damage to their country’s banking system). The example of the United States suggests that an element of fiscal union, beyond what is required for a meaningful banking union, would be an important stabilizing mechanism. A euro area–wide unemployment insurance system would be one small step in this direction.

Less Europe

These are all arguments for “more Europe” rather than less. I and many others have made such arguments over the past five years. But as time goes on, it becomes more difficult to do so with conviction.

First, crisis management since 2010 has been shockingly poor, which raises the question of whether it is sensible for any country, especially a small one, to place itself at the mercy of decision makers in Brussels, Frankfurt, or Berlin. It is not just a question of hard-money ideology on the part of key players, although that is destructive enough. It is a question of outright incompetence. The botched “rescue” of Cyprus was for many observers a watershed moment in this regard, though the ECB interest rate hikes of 2011 also deserve a dishonorable mention.

There are serious legal, political, and ethical questions that must be asked about how the ECB has behaved during this crisis—for example, the 2010 threat that if Dublin did not repay private creditors of private banks, the ECB would effectively blow up the Irish banking system (or, if you prefer, force Ireland out of the euro area). A frequent argument is that the ECB cannot loosen monetary policy because it would take the pressure off governments to continue structural reforms that Frankfurt believes to be desirable. Aside from the fact that there is less evidence of the desirability of these reforms than economists sometimes admit, deliberately keeping people involuntarily unemployed to advance a particular policy agenda is wrong. And it is not legitimate for an unelected central banker in Frankfurt to try to influence inherently political debates in countries like Italy or Spain, because the central banker is both unelected and in Frankfurt.

Second, it is becoming increasingly clear that a meaningful banking union, let alone a fiscal union or a safe euro area asset, is not coming anytime soon. For years economists have argued that Europe must make up its mind: move in a more federal direction, as seems required by the logic of a single currency, or move backward? It is now 2014: at what stage do we conclude that Europe has indeed made up its mind, and that a deeper union is off the table? The longer this crisis continues, the greater the anti-European political backlash will be, and understandably so: waiting will not help the federalists. We should give the new German government a few months to surprise us all, and when it doesn’t, draw the logical conclusion. With forward movement excluded, retreat from the EMU may become both inevitable and desirable.

Europe has lived through a golden age, largely as a result of European integration. This helped foster growth in the 1950s and 1960s and has given Europeans freedom to study, work, and retire abroad that is taken for granted. The EMU in its present form threatens the entire project. During the interwar period, voters flocked to political parties that promised to tame the market and make it serve the interests of ordinary people rather than the other way around. Where Democratic parties, such as Sweden’s Social Democrats, offered these policies, they reaped the electoral reward. Where Democrats allowed themselves to be constrained by golden fetters and an ideology of austerity, as in Germany, voters eventually abandoned them.

Divergent paths

Europe is now defined by the constraints it imposes on governments, not by the possibilities it affords them to improve the lives of their people. This is politically unsustainable. There are two solutions: jump forward to a federal political Europe, on whose stage left and right can compete on equal terms, or return to a European Union without a single currency and let individual countries decide for themselves. The latter option will require capital controls, default in several countries, measures to deal with the ensuing financial crisis, and agreement about how to deal with legacy debt and legacy contracts.

The demise of the euro would be a major crisis, no doubt about it. We shouldn’t wish for it. But if a crisis is inevitable then it is best to get on with it, while centrists and Europhiles are still in charge. Whichever way we jump, we have to do so democratically, and there is no sense in waiting forever. If the euro is eventually abandoned, my prediction is that historians 50 years from now will wonder how it ever came to be introduced in the first place.

Kevin Hjortshøj O’Rourke is Chichele Professor of Economic History at All Souls College, Oxford.

[admin]

Tim Taylor is in agreement

---

Will We Look Back on the Euro as a Mistake?

For the last few months, the euro situation has not been a crisis that dominates headlines. But the economic situation surrounding the euro remains grim and unresolved. Finance and Development, published by the IMF, offers four angles on Europe's road in its March 2014 issue. For example, Reza Moghadam discusses how Europe has moved toward greater integration over time, Nicolas Véron looks at plans and prospects for a European banking union, and Helge Berger and Martin Schindler consider the policy agenda for reducing unemployment and spurring growth.  But I was especially drawn to "Whither the Euro?" by Kevin Hjortshøj O’Rourke, because he finds himself driven to contemplating whether the euro will survive. He concludes:

The demise of the euro would be a major crisis, no doubt about it. We shouldn’t wish for it. But if a crisis is inevitable then it is best to get on with it, while centrists and Europhiles are still in charge. Whichever way we jump, we have to do so democratically, and there is no sense in waiting forever. If the euro is eventually abandoned, my prediction is that historians 50 years from now will wonder how it ever came to be introduced in the first place.

To understand where O'Rourke is coming from, start with some basic statistics on unemployment and growth in the euro-zone. Here's the path of unemployment in Europe through the end of 2013, with the average for all 28 countries of the European Union shown by the black line, and the average for the 17 countries using the euro shown by the blue line.

In the U.S. economy, we agonize (and rightfully so!) over how slowly the unemployment rate has fallen from its peak of 10% in October 2009 to 6.6% in January 2014. In the euro zone, unemployment across countries averaged 7.5% before the Great Recession, and has risen since then to more than 11.5%. And remember, this  average include countries with low unemployment rates: for example, Germany's unemployment rate has plummeted to 5.1%. But  Greece has unemployment of 27.8%; Spain, 25.8%; and Croatia, Cyprus, and Portugal all have unemployment rates above 15%.

Here's the quarterly growth rate of GDP for the 17 euro countries, for all 28 countries in the European Union, and with the U.S. economy for comparison. Notice that the European Union and the euro zone actually had two recessions: the Great Recession that was deeper than the U.S. recession, and the a follow-up period of negative growth from early 2011 to early 2013. As O'Rourke writes: "In December 2013 euro area GDP was still 3 percent lower than in the first quarter of 2008, in stark contrast with the United States, where GDP was 6 percent higher. GDP was 8 percent below its precrisis level in Ireland, 9 percent below in Italy, and 12 percent below in Greece."

 


For American readers, try to imagine what the U.S. political climate would be like if unemployment had been rising almost continually for the last five years, and if the rate was well into double-digits for the country as a whole. Or contemplate what the U.S. political climate would look like if instead of sluggish recovery, U.S. economic growth had actually been in reverse for most of 2011 and 2012.

O'Rourke points out that this dire outcome was actually a predictable and predicted result based on standard economic theory before the euro was  put in  place. And he points out that there is no particular reason to think that the EU is on the brink of addressing the underlying issues.

The relevant economic theory here points out that if two areas experience different patterns of productivity or growth, some adjustment will be necessary between them. One possibility, for exmaple, is that the exchange rate adjusts between the two countries. But if the countries have agreed to use a common currency, so that an exchange rate adjustment is impossible, then other adjustments are possible. For example, some workers might move from the lower-wage to the higher-wage area. Instead of a shift in exchange rates cutting the wages and prices in global markets, wages and prices themselves could fall in an "internal devaluation." A central government might redistribute some income from the higher-income to the lower-income area.

But in the euro-zone, these adjustments are either not-yet-practical or impossible. With the euro as a common currency, exchange rate changes are out. Movement of workers across national borders is not that large, which is why unemployment can be 5% in Germany and more than 25% in Spain and Greece. Wages are often "sticky downward," as economists say, meaning that it is unusual for wages to decline substantially  in nominal terms. The EU central government has a relatively small budget and no mandate to redistribute from higher-income to lower-income areas. Without any adjustment, the outcome is that certain countries have depressed economies with high unemployment and slow or negative growth, and no near-term way out.

Sure, one can propose various steps that in time might work. But for all such proposals, O'Rourke lays two unpleasantly real facts on the table.

First, crisis management since 2010 has been shockingly poor, which raises the question of whether it is sensible for any country, especially a small one, to place itself at the mercy of decision makers in Brussels, Frankfurt, or Berlin. ... Second, it is becoming increasingly clear that a meaningful banking union, let alone a fiscal union or a safe euro area asset, is not coming anytime soon.

Given the unemployment and growth situations in the depressed areas of Europe, it's no surprise that pressure for more extreme political choices is building up. For Europe, sitting in one place while certain nations experience depression-level unemployment for years while other nations experience booms, and waiting for the political pressure for extreme change to become irresistible,  is not a sensible policy. O'Rourke summarizes in this way: 

For years economists have argued that Europe must make up its mind: move in a more federal direction, as seems required by the logic of a single currency, or move backward? It is now 2014: at what stage do we conclude that Europe has indeed made up its mind, and that a deeper union is off the table? The longer this crisis continues, the greater the anti-European political backlash will be, and understandably so: waiting will not help the federalists. We should give the new German government a few months to surprise us all, and when it doesn’t, draw the logical conclusion. With forward movement excluded, retreat from the EMU may become both inevitable and desirable.

[admin]

European Commission endorses Telegraph view of the euro

By Ambrose Evans-Pritchard Economics Last updated: June 13th, 2014

232 Comments Comment on this article

Laszlo Andor (AFP)

I never thought I would live to see a serving European Commissioner suggest that it was "reckless" to launch the euro without a lender-of-last resort or fiscal union to back it up.

Or that EMU policies have led to a vicious cycle and a catastrophic double-dip recession that is entirely due to the dysfunctional character of the project.

Or that the Greek debt crisis was botched because Germany’s leaders were playing politics with the North-Rhine Westphalia elections.

Or that that the internal devaluation policies forced on the victim states are cruel and inherently self defeating.

Or that EMU's stabilisation regime has not come close to putting monetary union on a viable footing, able to command political consent over time.

But we have one today from László Andor, and it is a corker, delivered in Berlin of all places. The European Commissioner for Employment and Social Affairs is very close to outright revolt, not surprisingly since his job is to deal with the terrible consequences of these policies.

At least someone is speaking for the moderate Left in this Europe of Omerta, where the code of silence stifles criticism from those whose political values are most injured. His proposal – for starters – is a pan-EMU unemployment scheme to act as a fiscal stabiliser and to share the burden of asymmetric shocks.

He is entirely right, on one level. The pro-cyclical policies of austerity cuts (beyond the therapeutic dose) in those countries already in the most trouble – without any offsetting cushion from intra-EMU devaluation or monetary stimulus – is intellectually criminal and will be judged in the harshest fashion by historians. It sets in motion a horrible spiral of labour hysteresis, investment droughts, and technological decline.

But his romantic proposal creates a different problem, one that is equally intractable. Mr Andor does not address the issue, and I can see why, since the implication is that EMU can never be made to work, and should therefore be dismantled in the least traumatic way possible before it does any more damage.

If there is to be a fiscal union with at least 5pc to 7pc of GDP going to a central budget, this automatically alienates the budgetary powers of the Bundestag and other sovereign parliaments to a transnational EU body. It eviscerates the core power of the national legislatures: the power tax and spend, (the principle on which the English Civil War and the American Revolution were fought).

It implies a full-blown political union under a higher sovereign parliament (or an authoritarian priesthood regime), with both the substance and the machinery of a unitary state. It means that the historic nation states must abolish themselves, becoming linguistic or cultural provinces of a federal union.

None of this is remotely possible. The German Constitutional Court has ruled in crystal clear language that any such move is a violation of the Grundgesetz and will be prohibited (unless the constitution itself is changed). You can perhaps read the European elections in many ways, but to suggest that the French people – for example – are clamouring for a further erosion of sovereignty takes a heroic willingness to overlook the facts.

But let us not quibble. Here are a few extracts:

I believe it is my responsibility to share key conclusions from my four and a half years’ experience as Member of the European Commission – lessons from years of financial and economic crisis that was unprecedented in EU history and that should never be repeated.

Europe has been going through two crises and not one. The first we shared with the rest of the world, while the second one specifically originated from the inherent weaknesses of the current EMU architecture and brought us on a different path than the rest of the industrialised world.

Mr Andor said that the whole sequence of events that let sovereign debt crises spin out of control in early 2010 – followed by loan packages that merely bought time, without debt relief – has led to economic and political disaster.

Debts from financial markets were replaced by debts from official sources, which turned the euro zone into a club of debtors and creditors, set against each other.

The elected governments of Greece and Italy were replaced with technocratic administrations as the democratically elected ones were unable or unwilling to implement front-loaded fiscal consolidation.

From a fragile recovery we entered a double-dip recession in 2011. This became an existential crisis of the monetary union, and of the EU as a whole.

While Europe went into a second recession in 2011, the US economy was already steadily growing because the US had relevant instruments in place and the US Government and central bank did not hesitate to use them to generate growth and jobs.

The EU only started to emerge from the financial whirlpool when the ECB announced that it would be ready to act as a central bank in a crisis. In short, the sovereign debt crisis of the past four years has shown us that without a lender of last resort, a central budget or a co-ordination framework geared towards stimulating aggregate demand, EMU has been – at best – a structure for fair weather, but not for a financial and economic crisis.

The euro has also been a trap, because Member States can no longer adjust to economic shocks through tailor-made monetary policies and devaluation in their exchange rate, while at the same time being subject to strict rules on fiscal policy.

Mr Andor said the eurozone had failed to abide by its treaty obligation, which establishes the “objectives of balanced economic growth in a highly competitive social market economy, aiming at full employment and social progress.”

The EU has not only missed the key welfare targets agreed in 2010. It has gone backwards. The numbers at risk of “poverty nor social exclusion” has risen form 118m to 124m, with most of the damage concentrated in a handful of states.

Like others, he blames the original sin of EMU: a centralised monetary policy under the ECB without a fiscal counterpart.

This means that instruments that were historically used to limit the social impact of crises were not available any more, while there has been nothing newly introduced to replace them.

The point is that macroeconomic instability in Europe stemmed predominantly from the incomplete design of the Economic and Monetary Union: troubled countries could not unilaterally devalue, could not call upon a lender of last resort and could not count on any fiscal support from other Member States that would enable them not just to survive but to stimulate economic recovery.

The only mechanism through which troubled countries inside the EMU have been able to restore economic growth is so-called internal devaluation, i.e. cost-cutting in both the private and public sectors by shedding labour and reducing wages. Internal devaluation has resulted in high unemployment, falling household incomes and rising poverty – literally misery for tens of millions of people.

Moreover, it is a recipe that cannot be applied in many countries at the same time because it undermines overall demand. If many countries cut their wages and lay off workers, nobody wins in terms of relative competitiveness but everybody loses.

In other words, it is a Pareto Suboptimal, as this newspaper has argued from the start. EMU hurts everybody.

At a time when Europe would need to invest significantly in its human capital in order to cope with the growing demographic challenge, we have allowed a financial crisis to push millions of people out of work and into poverty. This has damaged Europe's economic potential and social cohesion for many years to come.

The dangers of an orphan currency with no fiscal union were explored as long ago as 1970 in the Werner Report. It argued that the currency would act as “a leaven for the development of political union, which in the long run it cannot do without”.

The Marjolin Report of 1975 proposed a “Community Unemployment Benefit Fund”. The MacDougall report of 1977 said monetary union would need a shared budget of 5pc or 7pc of Community GDP.

The proposal was in fact that regions with a current account surplus should contribute and deficit regions should draw down funding, as normally happens within nation states, so that social cohesion and aggregate demand could be maintained.

Did Helmut Kohl, François Mitterrand, Jacques Delors and other founding fathers of the EMU not understand that the incomplete structure they were setting up would be prone to crises? Was it not reckless for them to launch an irreversible monetary union without a proper fiscal pillar? Did they not care about the possible social consequences of macroeconomic adjustment based predominantly on internal devaluation?

In fact, political leaders in the early 1990s were far from ignorant about the importance of social cohesion, but they believed that it could be essentially achieved through legislation and social dialogue.

As the Single Market was being constructed since the mid-1980s, an important body of labour law was developed. For Jacques Delors and other leading politicians at the time, the social dimension of the Single Market and of the EMU was predominantly about preventing a race to the bottom in employment and working conditions.

This is of course exactly what EMU has become. It is a 1930s, beggar-thy-neighbour, deflationary race to the bottom.

Mr Andors calls this the Delors paradox.

On the one hand, we introduce social legislation to improve labour standards and create fair competition in the EU. On the other hand, we settle with a monetary union which deepens asymmetries and erodes the fiscal base for national welfare states.

Social legislation cannot make up for the absence of a euro zone budget or a genuine lender of last resort. Delors' idea of Social Europe is unfortunately offset by Delors' model of the EMU.

That is not to say that the EMU was fundamentally unfair at the time. To borrow a famous metaphor, EMU may have well been designed behind a veil of ignorance (Schleier des Nicthwissens). Nobody knew exactly how well the euro would work for any particular country.

However, it is quite clear today that EMU’s functioning in practice has not been fair. We know now that the EMU contains an inherent bias towards internal devaluation as the prevailing if not the only mechanism of adjustment to economic downturns. With such asymmetric allocation of costs and benefits, the EMU is not functioning well and its sustainability cannot be taken for granted.

In the history of the European Communities, two attempts at monetary cooperation have already broken down because the system was not resilient enough. The existence of a single currency in itself should not be seen as a sufficient guarantee against such a breakdown to happen again.

The EU cannot live together for too long with the risk of monetary breakdown, which also would bring with itself social and political breakdown. If our Economic and Monetary Union is meant to be irreversible, it must also be fair and it must be based on solidarity. Either we give up the dogma of ‘no fiscal transfers’ in the EMU, or we give up the European Social Model

Well put Mr Andor.

[admin]

["The only mechanism through which troubled countries inside the EMU have been able to restore economic growth is so-called internal devaluation, i.e. cost-cutting in both the private and public sectors by shedding labour and reducing wages. Internal devaluation has resulted in high unemployment, falling household incomes and rising poverty – literally misery for tens of millions of people. Moreover, it is a recipe that cannot be applied in many countries at the same time because it undermines overall demand. If many countries cut their wages and lay off workers, nobody wins in terms of relative competitiveness but everybody loses."]

In fact, it's even worse. Since the core countries also run low inflation policies, the troubled countries only recourse, internal devaluation, forces them to run highly deflationary policies which not only kills demand, it also kills nominal growth.

Even low nominal growth (let alone zero, or even negative nominal growth) automatically increases the debt burden, this is the so called denominator effect.

Debt/GDP increases where debt increases by interest payments and deficits while the austerity and internal devaluation policies keep GDP growth minimal or even negative.

This is why Italy's debt/GDP has increased from 118% of GDP to over 130% of GDP in just a couple of years, despite (or better, because of) heroic austerity measures.

The demand destruction also produces long-term negative effects to the productive capacity of the economy (the hysteresis effect):

• Low demand reduces investment in productive capacity, reducing the future production capacity of the economy
• Low  investment also slows down the adoption of new technology, reducing future productivity growth
• Low investment reduces the demand for labor, making a bigger part of labor supply economically obsolete through long-term unemployment.

We already argued this was a problem even in the US more than a year ago, but it recently turned out these effects are even bigger then we thought.