Too easy to swallow the euro's red herring

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.

Dr Oliver Marc Hartwich is the executive director of The New Zealand Initiative.

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Oliver dear boy, what you stumble upon is this: Few economics professors actually have any data to base their pet theories on, they have a gut feeling, and some homilies around supply and demand, most have big mouths and a lot are under size specimens.....In short, most are little men with a big voice, a niche group with a pet theme.
No data to back up what they say or feel...just a gut feeling the modern equivalent of a bigot, you can expect to be abused if you disagree.

Europe with separate currencies is a handicap. The euro made it a scratch race. The ECB is trying to reaffirm the handicap instead of declaring a winner.

The solution to the Euro Crisis is simple, but getting there will be nigh on impossible. For a common currency to work you need a common politic, common Labour Laws, common taxation etc etc.

The Euro was created to stop prevent a future German war. In retrospect having Germany simply invade and take over Europe would've perhaps been a better way to form a European nation. Of course there would've been casualties but how many lives have been destroyed already and there's no end in sight.

There you are James nome de sanc plume, as Churchill once stated, you killed the wrong pig. ;-]

Oliver, surely the key issue is 'when is the EU going to recognize that the traditional, automatic and relatively painless safety valve of individual european country exchange rate changes that has corrected market imbalances for centuries IS the market, which the common currency lunacy ignored (but like the law of gravity could not suspend)'!

Another even scarier possibility is that Europe is transitioning into a post industrial labor society wherein the ability to manufacture will be concentrated into just a few pockets of excellence all deploying high levels of automation. There will be absolutely no economic need or capability for second tier countries to acquire the 21st century skills that would enable them to participate in the manufactured goods sectors. In a world like this, a country's export options are very limited, Agriculture is always a protected sphere, and services will always remain an inwardly focused industry. What export options are left?

The reality of such a transition is that CAS countries MUST forever underwrite CAD countries. The CAS manufactures accept ever-more-worthless promises from CAD debtors because they need to maintain market share or die off themselves. It becomes the job of the banking and political sphere to paper over this chasm, so that everyone can afford to play another round.

Another interesting observation on the Euro was posted on the Mises Institute site Friday, June 22, 2012 by Jesus Huerta de Soto.
The economic problems are largely ones of political mismanagement, just as they are here.
Jesús Huerta de Soto is professor of economics at King Juan Carlos University.
this is the link to his article.

Good one Geoff,
With insufficient time to complete the order of events, the points race has now been cancelled and we move straight to the last event on the program.... the elimination race!

Oliver - you left out culture, which at least two of the commentators above have hinted upon.

Oliver left out nationalism which prevents political union which is necessary for fiscal union.

I completely disagree with your statement "It is a crisis of competitiveness – or rather of diverging competitiveness within Europe."

The problem is not a crisis of competitiveness, but one of a number of countries with weak economies (PIIGS) riding on the tails of the strong economies.

Europe coped perfectly well with different currencies, I have first hand experience as I grew up there and travelled to a number of countries before emigrating to Australia in 1969, and most Europeans were able to convert one currency to another with no problems. Even the old Pound Sterling with its weird 20 shillings to the pound and 12 cents to the shilling, presented no problem.

Another factor is national identity and culture. These are hurdles that cannot be overcome and no European of any ethnicity is willing to assimilate with a neighbour country!

Just ask the ethnic Tyrolians in South Tyrol, even after nearly 100 years of annexation to Italy, South Tyrolians still speak German and still protest against the annexation and clamour for unification with their Tyrolian brothers in Austria.

Trudi, I think your second paragraph demonstrates that competiveness (or the lack thereof) between economies actually is the fundamental underlying problem.

And it's 12 pence to the shilling, ja?

Trudi, you raise a very good point about national identity and culture within each of the EU member countries. It's something I know little about, however I believe it's one of the major hurdles (if not THE major hurdle) for any kind of fiscal union in the EU.

As for the single currency (Ie - the Euro), and correct me if I'm wrong here, put simply the whole idea behind its inception was to reduce barriers to trade within the EU and increase competitiveness throughout the EU and abroad. Eg - reduction in transaction costs for instance. Unfortunately with actions come consequences.

The euro crisis is a crisis of the EU and its incomplete and unsettled transition into a form of federation. This transition can also be seen as a crisis of the Nation State which since the 1990s, in Philip Bobbitt's theory, has been changing into the Market State. Germany seems more inclined to the form of a managerial Market State but there may be no agreement about how the transition can proceed, especially with the French. This suggests that, in the long run, the EU will be unable to exert the control over markets necessary to sustain the euro which in turn could lead to a fragmentation of the EU as well as the euro. As always, the timing of the change is the big unknown.

One could state that the german central position in europe has forged it's destiny.They are a disciplined people with a high degree of co operation within the state. After WW2 when germany reached a relative stage of wealth the german workforce religiously holidayed in the southern mediterranean club countries.They unlike germany relied on much of their income on the tourist money .Germany had re built it's smashed cities,and re tooled. The rise of germany was inevitable,and the problems that the rest of europe faces are also just as inevitable.Work,thrift and excellence in the work place are just a part of the explanations that seem to elude people.