Friday, November 21, 2014

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%.

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.

  • Contact us to secure rights


  • Hide Comments Hide Comments Read Comments (12)

    Please login or register to post a comment

    1. CommentedJason Gower

      Why would Germany choose to go back to the D-Mark? There are no arguments here that tell me why Germany would do this? So easy to write these Euro breakup stories but do the authors ever consider the enormous benefits to trade of a single currency? Yes some are feeling the pain and the system is rigid without fiscal/political/banking union but what would Germany's exports have been from 2007 to 2012 with the D-Mark? Amazing how we focus so much on pieces of paper and so little on the needed reforms and the cultures that make economies uncompetitive in the first place. If Germany saw vibrant, growing economies reforming themselves to become more competitive (forward looking with their demographic challenges etc.) then perhaps it would say the E word...and the "crisis" would be over in a matter of minutes. However, under current conditions there is no chance that Germany will accept Eurobonds with the moral hazard that exists due to this monetary system without the other pieces. So perhaps you can write a story about the cultural differences that exist across the EZ, nationalism, etc., etc., as the true reason why the Euro may one day die instead of these crazy stories of Germany choosing to leave the Euro on its own free will.

    2. CommentedTomas Kurian

      Yes, it would be wise but as Germany benefits enormously from it I am afraid we will have to go to the bitter end.
      Only when France will be ruined to the extent of Spain, only then they will abandon Euro and EU, and it will not be an organized exit but one run by extreme parties.

      Insanity of internal devaluation as a means to achieve competitiveness

    3. CommentedHeiner Hartmann

      @ Jose

      First, austerity isn't necessarily about reducing debt but about to get your budget to a managable level. Second, the state of debt before the crisis isn't the most relevant indicator. If you have e.g. high consumer debts, problems in your banking sector or high unemployment that all might get your public debt to soar. Just look at the UK's public debt before and after the financial crisis. So there might be "hidden" debt or risks in your system.

      "the problem we had was the raise in the default probability associated with ECB not being the lender of last resort." To be clear about this, if you have had your own central bank you basicly would just have printed money to ease the market pressure. You are right this is a mayor function of national central banks. Maybe a good measure in the long run, but bad for your consumers in the long run (and they know it that is why they all want to keep the Euro). However Draghi more or less did that with his anouncement to buy bonds if necessary.

      "Lira, Peseta, Escudo, Dracma, Irish Pound, existed during many years, and we showed we could control our currencies."
      Yes i remember very well how popular these currencies were on the international markets... and also very popular for people that earn their living by speculating with currencies. Even for the sake of repeating myself... is there a sizable movement in one of the "Crisis" states that really wants these times back? I don't think so.

      "Germans have to realize that the colonization years are over, and that your dream of building colonies to dispose your products and get cheap resourced ended badly twice in one century…"

      And here is where you lost me and whatever was your argumentation... But to give with the same coin, you as a portuguese probably know much more about colonial endeavours... People in Angola or Mozambique surely all have fond memories.

      I remember best Willy Brandt and what he did to aid Portugal. Though i concede that it is more difficult for the Portuguese and Irish as they unlike the Greeks can't blame german occupation for all their economic problems.

        CommentedAlexandros Aslanidis

        @Heiner Hartmann

        "Austerity isn't necessarily about reducing debt but about to get your budget to a managable level."

        Austerity is about getting your budget to a manageable level only if you don't control your currency (i.e. in the case of the euro) and thus are vulnerable to attacks by the market.

        "Maybe a good measure in the long run, but bad for your consumers in the long run (and they know it that is why they all want to keep the Euro)."

        I seriously doubt consumers want to keep the euro, seeing how consumption has been hit in the South. If somebody wants to keep the euro, then that is people that own assets, that would rather have them denominated in a hard currency. However, they too will wake up to the reality that their illiquid assets aren't gonna be worth much once internal devaluation takes hold, while their liquid assets will become the victim of fiscal consolidation.

        CommentedJose araujo


        Now, the case for austerity, which you were advocating, was that public debt levels (the famous RR 90%) were the main responsible for high interest rates and reduced growth, hence the importance of public debt. Also austerity was aimed at slowing the growth of public debt via the reduction of the deficit. Now what happened is that public debt growth accelerated with austerity, so not even that we accomplished, although that’s not what Government PR and the Media tell us.

        Regarding the functions of ECB, and the lender of last resort function, It has nothing to do with printing money, but with the option to print money, and to the notion of sovereign debt being the risk free rate in a specific country. It’s clear that I’m against the Euro and one the reasons is because a country losses flexibility and control. If Portugal had a central bank and a currency, the level of in balances of our economy would never happen, first because our currency would depreciate preventing that and our interest rates would grow.
        You seem to have a problem with currencies, which is absurd. Economies always had their own currencies, and appreciation and depreciation of currencies is a normal event. Just think of currencies like a price formed in a market, so when demand grows currencies appreciate, but when demand shrinks, currencies depreciate.
        Portugal had a currency, long before Germany even existed, we has a country had our ups and downs like any other country, many of our crisis, like in Germany were caused by this view of fixed exchange rates, and by having leader that were ignorant. We thought we had improved with our entrance in the EU, but it turned out that ignorant leaders isn’t a Portuguese monopoly.
        Regarding the Mozambique and other comments, you are talking to the wrong person, since I always was against any form of colonization mentality, and especially against any view of racial superiority, which I despise. Unfortunately history tends to repeat, since we don’t learn from it, and we now are seeing the surge of this colonization, racial and moral superiority mentalities, which in my opinion you are a clear representative and that is translated to the current European policies.

    4. CommentedJose araujo

      Very nice article. They are hard to find, but there are some Europeans that actually realize in what a mess we are,and what to do to get out of it.

      Now, I think that we could study a less radical step, that wouldn't require the dismanteling of that aberration we call the Euro, maybe 3 steps back would help.

      First step, raising VAT on imported goods. There is no sense on taxing the value your economy adds at the same rate of imports, and it wopuld make Germany less competitive within Europe.

      Second Step, implement capital controls and track capital movements across Europe and create the option of limiting this movements.

      Third, the principal on sovereign Debt the ECB purchases should be immediatly cut to the acquisition value once the ECB buys sovereign debt.In alternative The ECB wouldn't purchase directly the bonds, but do it through local central banks.

    5. CommentedHeiner Hartmann

      This is actually true. However there were some major crisis during this time and i doubt that we will see anything one the scale of the "Made in the USA" Global financial crisis in the next 5-10 years.

    6. CommentedHeiner Hartmann

      This really is your solution? I don't even want to imagine a crisis so deep that could make this politicaly possible. Even the past and current crisis wasn't able to achieve that and i don't think a future crisis will convince a majority of voters/ politicians in any of these two countries to pursue that...

      It might or might not make economic sense to do this, but politicaly this is a culdesac as the french would say. In Germany i don't see any other party apart from the AfD (Alternative für Deutschland) asking for this and they didn't even make it into the national parliament.

    7. CommentedHeiner Hartmann

      "Under pressure from Germany, they have pursued the latter option." What do you mean by that?

      Because Germany declined a collectivization of debts there weren't many options left. Countries with a struggling economy didn't get fresh capital from the markets anymore and that is hardly Germany's fault. These countries do have three options:

      1. Getting the other countries of the Eurozone to vouch for their old/ new debts. For obvious reasons politicaly unpopular... But of course the easiest way out for those countries under pressure.

      2. Staying in the Eurozone and introducing austerity measures. The only choice you have if you can't make new debts and don't want to leave the Eurozone.

      3. Leaving the Eurozone. A policy that didn't find a majority in any struggling eurozone country. If this solution is so obvious, did anyone actually bother to ask why there are no big political parties in any Euro country asking for this?

      As far as i know there is not a single Eurozone country where a majority is in favor of such a move and obviously politicians that want to attract a majority of the voters are also not in favor (at least not openly). Only fringe movements are openly in favor of this policy option and even they don't talk to loudly about "breaking up the Euro", because surprise the electorate doesn't like it.

      Mainly anglo-saxons and as i said some fringe movements are talking about this. The former do so because they don't understand what the EU/ Euro is meaning for many Europeans or because they have some vested interest (people like Soros who want to enrich themselve with currency speculation). The latter because they only think in short term economic categories.

      I don't think that the average e.g. italian wants to go back to the lira where their politicians could use devaluate away their economic mistakes.

        CommentedJose araujo

        @Heinar, You couldn't be wronger in several points...

        First austerity didn't make the debt reduce, quite the contrary. Before austerity Portugal didn't have a debt problem (public debt was well behind EU average) and in 4 austerity years our debt doubled.

        Second the problem we had was the raise in the default probability associated with ECB not being the lender of last resort. So this wasn't a collectivization of debt that was required but for the ECB to perform regular functions of a Central Bank.

        Lira, Peseta, Escudo, Dracma, Irish Pound, existed during many years, and we showed we could control our currencies. Individual currencies for a country is not the exception, the exception is having several countries with the same currency, actually that’s not an exception that’s an aberration.

        Germans have to realize that the colonization years are over, and that your dream of building colonies to dispose your products and get cheap resourced ended badly twice in one century…

    8. CommentedGerry Hofman

      While the idea of abandoning the single currency and return to the money of old is advocated by many from different corners, it has so far been ignored by those in power. The reason being that the resulting chaos and confusion resulting from such a move would make an outcome extremely difficult to predict with any degree of certainty. The costs however would be large and most likely outweigh any supposed benefits. Countries like France have yet to address their economic problems with any sincerety, having mostly just raised their taxes and not much else. The real solution will have to come from somewhere else and will depend on a lot more creative and innovative thinking then what is presented here.

    9. CommentedFernando Ferreira

      An eccentric solution to EU. But who will push Germany out of the euro? since Germany benefits from a undervalued currency