This is the long version of a very abbreviated presentation I gave in my International Relations class last week. I had to mercilessly hack away at this to get it down to about 22 minutes (for what was supposed to be a 12-minute presentation), so I figured I’d preserve the original for posterity (such as it may be).
GDP (Gross Domestic Product) – The measure of the final value of all goods and services produced within a country’s borders in a given time period.
GDP per capita – A ratio of GDP divided by population. Often used to give a rather imperfect sense of the average per person wealth of a nation.
Deficit – The yearly operating shortfall of a nation’s budget (revenues/taxation vs. spending)
Debt – The cumulative amount of deficits as a single figure (what a nation “owes” to bondholders)
(Both deficits and debt are often compared to GDP rather than given as numbers to give a ratio rather than a figure without any further context.)
II. Optimum Currency Area
Optimum currency area is an economic framework for determining the geographical area which would offer the greatest efficiency to participants operating under a single currency. The considerations typically used to determine this are:
-Labor mobility across the region.
-Capital mobility as well as price and wage flexibility within the region.
-A system of redistribution or revenue sharing to compensate for the potential failings with respect to the first two conditions.
-Areas or nations with similar business cycles. This allows a common central bank to deal with financial downturns in a more effective manner.
By these standards, the EU does not fare terribly well as a common currency area. Point by point:
– The euro area has theoretical labor mobility but in practice language barriers and the difficulty of navigating issues of housing and schooling, as well as problems with recognizing professional and trade accreditation means that in practice, labor mobility is quite limited compared to the a currency area such as the US.
– Capital mobility is very free in the EU but price and wage flexibility is not. As we will see, these two conditions work at very cross purposes within nations suffering the most in the recent financial crisis.
– No formal system of fiscal redistribution exists in the euro area. This is in stark contrast to the US, which has redistributive payments including Social Security, Medicare/Medicaid, the Earned Income Tax Credit and Unemployment Insurance, along with block grants for education and infrastructure which operate across state lines and serve to partially equalize wealth among US states and partially compensate for asymmetrical shocks to one part of the country by moving resources there from other states/taxpayers.
– The euro area has notable divergence in business cycles among its member nations as well. This is, in significant part, due to the different policies of taxation to fund government spending. Nations like Germany, Austria, Finland and Luxembourg, who fund government spending largely through efficient revenue collection have much less risk to financial panics than nations such as Greece, Spain, Portugal and Ireland whose banks depend heavily on “wholesale funding” (bond sales on the open market). For these nations, recent market panics and increased borrowing costs has sent their national accounting deep into the red in a very short time, a condition which the ECB is not well-equipped to address.
III. The euro area system
The European Central Bank is the intergovernmental central bank created by the Maastricht Treaty. It is located in Frankfurt, Germany, and is the authorized issuer of all euro bills (nations are allowed to mint coins locally) and is also the clearing facility for holders of reserve accounts denominated in euros (electronic settlements, etc). The bank’s mandate is to maintain the purchasing power of the euro and thus price stability in the euro area (In other words, the mandate of the bank is to guard against inflation or currency devaluations. In this regard it is different from the US Federal Reserve, which has a “dual mandate” to guard against inflation and also to work towards full employment (though in practice, the latter mandate is largely a fiction in the neoliberal age). Also unlike the US Federal Reserve’s relationship with the US Treasury, there are no “European Union” bonds handled by the ECB to raise funds for shared fiscal expenditures. Individual nations must still offer their own debt in bond markets to raise funds not covered by taxation, which are denominated in euros, but which are subject to credit conditions that vary nation to nation.
The creation of the euro and the conditions for joining were laid out in the 1992 Maastricht Treaty. Protracted national debates among nations over currency union led to notable negotiated exemptions (UK, Denmark) and at least one case (Sweden) of purposefully failing repeatedly to meet the “convergence conditions” to avoid the obligation to join.
Criticisms voiced during these debates included concerns in Germany and elsewhere about the loss of “national identity” that a single currency would represent. In France, protests against economic tightening were loudly voiced in the midst of relatively high unemployment. Others pointed out that the targets set by the Stability and Growth Pact, such as annual deficit to GDP (3% or less), overall debt to GDP (60% or less) and exchange rate stability were not situations which a government could always manage in an “annual” framework and that economic swings did not fit into neat yearly time slots. Such arbitrary targets and the perceived importance of meeting them were responsible for heavy Greek manipulation of fiscal data in the lead up to joining the currency (where they were working with firms like Goldman Sachs to use complex currency swaps to hide debt), as well as fears over failure and real failures to meet the criteria by a number of nations. Eventually, numerous exemptions were offered to various nations failing to “converge” in the name of making the deadline to launch the currency.
IV. The euro, pros and cons
Positive effects for strong economies:
For nations such as Germany and France whose combined GDP makes up over 40% of the total economic activity of the euro area, the common currency serves to counteract the normal effects of having a large strong economy with very high average living standards.
So a nation such as Germany, which is highly regarded by bond markets and is considered a very stable economy, would find themselves facing the constraints of a high exchange rate with other nations (due to the desirability of German denominated debt for savers concerned with the possibility of default), making their exports relatively very expensive for other nations.
However, once Germany, through a common currency, is lumped in with 16 other countries, a number of which are NOT highly regarded by bond markets, the net result is to move the overall exchange rate of the euro down in value relative to where a German currency would be exchanged on its own. In practice, Germany is “borrowing” the appearance of being a riskier currency to invest in from its neighbors, making all sorts of German products, particularly higher cost items such as cars, appliances, industrial/medical equipment and so forth much more affordable to the rest of the world. This has allowed Germany to enjoy a level of export competitiveness more closely resembling that of a developing country such as Korea while having a standard of living among the highest of the developed economies.
For smaller economies with higher levels of historical instability, a primary effect of joining a single currency with much stronger and more stable nations is to greatly reduce the cost of issuing government debt obligations on the bond market. This is what allowed countries such as Greece and Ireland to have credit booms which were quite different but were both fueled by very low cost credit to what were both small economies which would have been considered much higher credit risks without “borrowing” part of the financial stability of countries such as Germany and France. Furthermore, the lack of exchange rate volatility of the euro was a factor in helping to lower inflation in countries such as Greece and Italy, who had inflation rates of close to 20% annually in the 80s, then 8% to 10% during the 90s but had rates of 2% to 3% per year in the first decade of the 2000s.
The newly unregulated capital flows which began in the decade before the introduction of the Euro have resulted in large flows of capital from the larger economies of Europe to countries such as Greece, Ireland, Portugal, and Spain. It is no coincidence that these are the same countries experiencing the worst of the financial crisis now. Two decades of dependence on low interest rates and large deficits made these countries especially vulnerable to the “asymmetrical shocks” mentioned earlier, one of the indicators of unsuitability for a common currency area.
Ireland, which has had the lowest corporate tax rate (12.5%) in Europe since the 1956, suddenly looked a whole lot more attractive when you could move your headquarters to Ireland and do business in euros with more than a dozen nations. At least Google, Pfizer, Microsoft, Hewlett Packard and others thought so. Foreign direct investment surged in Ireland in the first 5 years after the introduction of the euro with these massive capital inflows.
This corporate expansion included a huge bank sector expansions in Ireland, which eventually began driving a housing and property boom that saw bank lending to “non-financial firms” (mostly made up of lending to individuals and property developers) go from 60% of GDP in 1997 to 210% of GDP in 2008. During this same period average home prices went from just over 4 times the average annual wage to over 12 times the average annual wage and no collateral loans fueled most of this buying.
A different case, Greece has a long history of poor tax / revenue collection and a very large informal / gray market economy. While its level of government spending is right at the EU average, its level of revenue collection was much lower versus its neighbors resulting in fairly persistent annual deficits. 20 years of inexpensive credit thanks to the low “borrowed” rates of the euro area as a whole made the country especially vulnerable when credit markets seized up in 2008.
Following the emergence of the US financial crisis in September of 2008, Ireland shocked the EU, even perhaps the world, with its blanket guarantee of depositors and bondholders. This seemingly off the cuff announcement put the Irish taxpayer on the hook for over €100bn. Meant to assure investors, the announcement simply transferred investor fears to the ability of the relatively small Irish govt to guarantee such a massive amount of debt in the midst of global recession. This led over the next few months to a doubling in the price of borrowing by the Irish government (a situation which has deteriorated to much worse bond yields in the last 6 months) and began to make clear the sharp limitations experienced by nations which issue debt but do not issue the currency that backs it.
This same issue emerged as the major problem for Greece the following year with the newly-elected Socialist government’s announcement of a doubling of the deficits previously reported by their predecessors (another move meant to calm markets). This news sent their cost of borrowing on a trajectory that would triple from 4% to over 12% within a year and a half.
Both of these countries are now engaging in savage programs of austerity, with massive public sector job, health care, education and retirement cuts as well as a huge privatization program in Greece, prescriptions straight from the “Washington consensus” of the 1990s. This is in exchange for a combined bailout from rich EU nations and the IMF.
Perversely, the fact that such massive cuts will shrink these economies and reduce further their ability to collect revenue, reducing spending and demand and leading to further job cuts and economic contraction is generally acknowledged by economists, financial analysts and even politicians, yet this same medicine seems to be the only thing that European politicians can come together on.
Debt deflation has historically been avoided by nations suffering asymmetrical shocks by devaluing their currencies relative to their economic partners. This allows a nation to lower the cost of its exports to offset increased costs of making debt payments and can cushion the blow of economic downturns to the standard of living of its citizens. However, this option is removed when in a common currency area and was explicitly proscribed by the Stability and Growth Pact as we saw earlier. Thus the only way the offending nation can reduce its deficit is by drastically cutting public spending and shrinking the entire economy until some equilibrium is reached and it can gradually begin to repay its creditors.
And just who are these creditors? Generally, the sovereign debt (bonds) of these countries in crisis are held by the largest banks in the richest countries of the EU, particularly Germany and France (and the UK, the largest EU economy outside the euro area. See this AMAZING graphic to get a sense of this relationship). From this vantage point, the sense of urgency over bailing out these countries for amounts in the hundreds of billions of euros becomes understandable. Nations such as Germany and France realize that they are keeping the wolves from their own doors by preventing the bond defaults of these nations. This type of “shadow bailout” essentially serves as a giant transfer of wealth from the governments of the rich nations to their own endangered financial institutions.
This all amounts to kicking the can down the road. Civil unrest, general strikes and the rise of the “Do Not Pay” movement in Greece and the likely downfall of Ireland’s Fianna Fail government (which has ruled the country for ¾ of the last 80 years) over their extension of the bank guarantee should be sufficient warnings that a more permanent solution is required, but so far the message seems not to have sunk in.
Serious proposals for a long-term solution to the sovereign debt problem usually involve forcing bondholders to take a partial loss (a “haircut”) in exchange for a payment schedule which will not cripple the ability of these distressed countries to continue to grow at a rate making repayment likely (in fact, interest rates on debt are supposed to reflect the possibility of default, yet to date not a single default has occurred. This begs the question of why interest rates are skyrocketing for these nations as the euro seems to be a de facto “backstopped” currency thus far). A more radical proposal (at least in the context of today’s climate) would involve the European Council and the Parliament approving a large distribution of cash to EU nations based on population. This would effectively be a devaluation of the entire area’s currency, but due to the fact that most EU trade is to other EU nations, it has the political appeal of being a large free cash handout to the more fiscally solvent nations and a “do over” for the nations in crisis, which would allow them to avoid severe self-induced recessions. Of course, the final possibility is for countries to exit the euro but the issues involved are daunting on logistical, fiscal and psychological levels.
In conclusion, the crisis of the last 3 years has revealed most of the serious weaknesses of the unique euro currency area and in all likelihood, the incredible difficulty a nation would encounter moving back to a sovereign currency is probably the only factor keeping the currency union whole at this time. The clock is ticking on the euro and in the end, it will take serious work by EU policymakers to come up with a solution to keep the euro viable with its current membership, let alone a continued expansion.
Partial sources (beyond included links):
GDP, deficit, debt and interest rate statistics:
The Treaty of Rome and the Maastricht Treaty:
The ‘Sense and Nonsense of Maastricht’ revisited:
What have we learnt about stabilization in EMU?
Willem H. Buiter*
Professor of European Political Economy
European Institute, London School of Economics and Political Science,
Universiteit van Amsterdam, CEPR and NBER
Manipulation of fiscal figures
Long-term solution to the financial crisis: