Deconstructing the Euro

PARIS – In January, Chris Williamson, Chief Economist at the economics research firm Markit, called France “the new sick man of Europe.” With near-zero GDP growth, rising unemployment, and mounting public debt – not to mention counter-productive austerity policies – it is difficult to argue otherwise. Given France’s profound importance to Europe’s economic and political stability, this poses a major threat to the entire European project.

Recent developments confirm Williamson’s diagnosis. French business activity sank to a seven-month low in December. While tax revenues increased by €32 billion ($44 billion) last year, the government deficit fell by a mere €8 billion and public debt increased from 89% of GDP to more than 93%. Meanwhile, unemployment rose from 9.5% to 10.5%.

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The obvious conclusion is that austerity is not the answer. Indeed, France must abandon its current policies, for its own – and the rest of Europe’s – sake.

France’s problems, like those of the eurozone’s other troubled economies, stem from the fact that the euro’s exchange rate does not align with member countries’ economic positions. As a result, these countries’ virtual exchange rates vis-à-vis Germany are critically overvalued, inasmuch as wages in these countries have risen more quickly, and labor productivity more slowly, than in Germany. Given that the implicit nominal exchange rates are fixed “forever” within the euro, these countries have accumulated major deficits relative to Germany.

Likewise, the deficit countries’ exchange rates are overvalued relative to third countries like the United States and Japan, while Germany’s currency is undervalued, because the euro’s exchange rate is determined by the balance of payments of the eurozone as a whole, which Germany’s massive surplus distorts. In short, the euro exchange rate is too weak for equilibrium in Germany and too strong for equilibrium in France and the other less competitive eurozone economies.

The eurozone’s weaker economies thus face a dilemma: either expand in line with productive potential, thereby incurring external deficits, or enforce austerity, eliminating external deficits by squeezing imports. Under pressure from Germany, they have so far pursued the latter option.

The current “competitive austerity” trend is irrational, first and foremost, because, by undermining domestic demand, it directly controverts the currency union’s fundamental principle that a large domestic market should act as a buffer against external demand shocks. This is causing everyone to suffer – even Germany. Indeed, from 2007 to 2012, Germany’s exports to other eurozone countries declined by 9%, from €432 billion to €393 billion.

But this is not the only threat that austerity poses to Germany’s hard-won prosperity. The euro has also caused Germany’s business cycle to diverge from those of the less competitive economies, while prohibiting customized monetary policies. And the common monetary policy that all are being forced to pursue is intensifying deflationary pressures in the weaker countries, while increasing inflationary pressures in Germany.

Furthermore, populations in the eurozone’s stagnant economies are increasingly demanding that Germany change its policies, increasing wages and implementing measures aimed at boosting consumption and discouraging savings. While responding to such demands would help to ease political tensions across the eurozone, they would face strong opposition within Germany.

Similarly, resolving the crises that will inevitably emerge from the current rigid exchange-rate system will ultimately require Germany to agree either to debt write-offs or to large-scale government-bond purchases by the European Central Bank, which would flood the eurozone with liquidity. Either outcome would run contrary to Germany’s interests and preferences, making it as unfair an approach as austerity.

What the eurozone needs is a solution that does not force any one country or group of countries to bear the brunt of the adjustment – and that means a controlled segmentation of the currency union. Contrary to popular belief, this could be done in a way that reinvigorates the European ideal, rather than reviving the parochial nationalism of the past. The key is to ensure that it arises from the European Union’s economic and political core.

Specifically, Germany, Europe’s greatest economic power, and France, the intellectual progenitor of European unification, should announce their simultaneous exit from the euro and re-adoption of the Deutsche Mark and the franc. This would trigger the immediate revaluation of the Deutsche Mark – and possibly of the franc – relative to the euro.

For their part, other EU member countries would have to decide whether to retain the euro in its truncated form or revert to their own national currencies, possibly pegging them to the revived Deutsche Mark or franc. Regardless of their decision, the price competitiveness of the eurozone’s weaker economies would improve considerably.

Of course, France and Germany would need to implement interim arrangements to safeguard their banking systems’ stability. Moreover, they would have to negotiate with the ECB and other European governments a plan for managing euro-denominated debts.

A period of monetary uncertainty, as European economies adjusted to the new environment, would be unavoidable. But that would be far better than the economic and political impasse in which the eurozone is now trapped.