Posted by: Dirk | May 1, 2010

The decline and fall of the euro zone?

The contribution which an organised and living Europe can bring to civilisation is indispensable to the maintenance of peaceful relations. In taking upon herself for more than 20 years the role of champion of a united Europe, France has always had as her essential aim the service of peace. A united Europe was not achieved and we had war.

Europe will not be made all at once or according to a single plan. It will be built through concrete achievements which first create a de facto solidarity. The coming together of the nations of Europe requires the elimination of the age-old opposition of France and Germany. Any action which must be taken in the first place must concern these two countries.

With this aim in view, the French Government proposes that action be taken immediately on one limited but decisive point. It proposes that Franco-German production of coal and steel as a whole be placed under a common High Authority, within the framework of an organisation open to the participation of the other countries of Europe.

This is taken from the Schuman declaration of May 9th, 1950. It laid the foundation of what today is the European Union. The idea of the pan-European project had been to build institutions to further peace and prosperity for Europe. Further down the road, the common market was created to enable European nations to expand trade, which would lead to gains from trade for everybody, given some redistribution from winners to losers, of course. However, dynamically the nations would concentrate on comparative advantage and there would be less and less losers as countries adjusted to the new environment.

The euro project built up speed in the 1990s, and again an institution would be created that was thought to further European integration by making trade simpler. Without exchange rates there would be no exchange rate risk, which would anchor expectations and increase investment. Also, there would be no more transaction costs of changing monies for businesses and people. The theory of optimum currency areas provided a frame to discuss monetary integration, and two theoretical problems were pondered.

One, governments should not be able to borrow too much and then pose a danger to the euro zone’s stability. The stability and growth pact was created, limiting the possibilities for euro zone governments to increase debt. The other problem was asymmetric shocks. If one country experienced a decline in GDP and other countries did not, what to do with the interest rate? There would be only one interest rate, set by the ECB. However, the occurence of asymmetric shocks were ruled out as unlikely, and anyways, there are other means of economic policy just in case (like fiscal policy and transfers).

Nevertheless, today we have a situation in Europe where countries have seen their debt increase and now find it difficult to refinance. Only one year ago, the EU has celebrated the euro at ten (years) as a success story. What has happened?

In a monetary union, there will be people with differences in productivity. This is no problem as long people are paid according to their productivity. Let’s say that German workers are 50% more productive than Spanish workers. Given that they earn an additional 50% compared to their Spanish colleagues, firms will be willing to use labour in both countries. After all, their competitiveness is on the same level. To produce one unit of the good, both workers are paid the same wage. The Spaniard takes longer to produce the good, or more Spaniards are employed to do it, but the wage bill is the same.

In this situation we have an external equilibrium. The value of goods that Spaniards export to Germany equals the value of their imports (it is assumed here that countries – apart from varying wages and productivities – are identical). This is because workers are paid according to their marginal productivity. This is an idea which neo-classical economists use and which has been a quite realistic assumption about reality in the second half of the 20th century in Western Europe. However, things have changed in the 21st century.

While productivity of German workers has been increasing as it did in the last century, wages stagnated. I will not speculate why they did, but just point out that it was the result of economic policy. As wages fell, the price of German products relative to Spanish products was falling. Spaniards started to buy more German products. At the same time, low interest rates caused a real estate boom in Spain. Therefore, on an aggregate level, Spaniards paid the additional German imports by lending from German banks.

In short, the cycle looked something like this: German firms were more competitive than Spanish firms and exported more. The additional revenue went into profits, which were lying idle in the bank. The bank s started to look for ways to invest the money. Since in Germany demand was low because of stagnant wages, investment in Germany did not pick up. Banks looked to other places. Spanish banks were demanding money, since Spaniards wanted to buy and build houses. As every Spaniard knew, since the beginning of house price statistics these have shown a decline. Investing in real estate was a no-brainer.

Therefore, German banks lend to Spain, where the money went into real estate, pulling up the construction industry. This led to more demand in Spain, since more people were employed and demanded goods and services. This led also to a bit of inflation, so general wages were rising as well. However, productivity growth continued to be slow. This meant that Spanish companies found it harder and harder to compete with German companies. A gap in competitiveness had opened, which lead to Germany bathing in the title of Exportweltmeister and current account deficits in the periphery of Europe.

When the real estate bubble burst, problems began. Banks failed, since they could not recoup the value of the loans they made to finance real estate loans. This happened in Ireland, in Spain, in the US and other countries. The financial troubles led to governments take on much of the risk by buying up non-performing assets. That increased government debt everywhere and led to higher interest rates – or better, yields – on government debt. Since what is debt to the Spanish – or Greek – government is wealth for German savers, the problem is a tricky one.

The problem is tricky because it is actually two problems rolled into one. Why?

The debt problem is to a huge part the result of the divergence of competitiveness of euro zone countries. Current account deficits in the periphery were the counterpart to the German current account surplus. Germany cannot be Exportweltmeister without her trade partners moving into debt. This is not a theory but a fact that builds on simple BoP arithmetics. When I export more than I import, you must pay by increasing your debt towards me (or lowering mine towards you, but that’s not what happened). It is as easy as that.

The stagnating wages in Germany in conjunction with rising productivity are perhaps the major cause of today’s euro zone troubles. The gap in competitiveness is a problem in itself. That is why we have two problems:

  1. Countries in the periphery have trouble to repay their debt.
  2. Countries in the periphery are not competitive.

Problem #1 has to be fixed now, because otherwise Greece goes bankrupt, while problem #2 can be fixed later. If it is not fixed, imagine what happens. After repaying its debt, Greece finds itself in a situation like that of today. German products are cheaper than Greek products, therefore the circle is likely to start again: Greece moves into debt as German exporters are unbeatable. Finally, another financial crisis will result as it becomes clear that Greece cannot repay (all of ) its debt.

The euro zone has an adjustment problem. The external adjustment of countries was left to markets, while the internal adjustment was left to the European Central Bank. Markets were trusted to let no situations build up where adjustment occurred as a shock. However, markets have failed. They did not foresee the country risk that the periphery of Europe would built up through their loss of competitiveness. Only when it was too late did rating agencies downgrade government debt from these countries.

With flexible exchange rates, this would probably not have occurred. The German Deutschmark would have appreciated vis-a-vis the currencies of the European periphery, making German products more expensive and periphery products cheaper. This is how adjustment on the external side is supposed to work. An imbalance causes processes that push the equilibrium back towards it long-time value. These processes were exchange rate adjustments, which we badly miss today. A depreciation of currencies of net-importing nations and, at the same time, an appreciation of the German currency would have prevented these troubles.

Coming back to Robert Schuman, institutions matter. They are built with a purpose in mind. Europeans have to make up their mind. The financial market cannot be trusted when it comes to allocation of capital if trade is imbalanced. Instead of a win-win situation trade has caused the Greek prime minister to call for (more) German reparations to make up for the damage done by the Nazi invasion. Also, there will be threats to stop paying its debt, which will create unhappiness for German savers.

The current institutions of the European Union have led us astray from the consensus of the early days. Peace and prosperity were the goals back then, leading to institutions that helped to reach those goals. Today’s institutions make sure that whoever is in debt has to repay what he owes, regardless of why he ended up with that debt in the first place. They do not allow for market adjustment in the sense of bringing current account imbalances back under control. When countries in Europe are heavily indebted and arguably it is not only their fault, the political economy of trade changes. Imports will be seen as the vehicle to increase foreign debt, which they are given that current accounts are not balanced (except in the case that they are so in order to repay foreign debt).

The euro zone has been in decline since the introduction of the euro. It was not the euro itself that was bad, but the interaction of economic policies in Germany and the periphery, where a boom was allowed to take-off, with the euro zone institutions that led to that decline. Not every decline ends in a fall, however. Learning from the past is supposed to make our institutions better. The euro zone member should get together and draw the right conclusions. The euro is not lost, it can be saved. It remains to be seen whether we end up with more or less European integration.

Leave a Reply

Fill in your details below or click an icon to log in: Logo

You are commenting using your account. Log Out /  Change )

Google photo

You are commenting using your Google account. Log Out /  Change )

Twitter picture

You are commenting using your Twitter account. Log Out /  Change )

Facebook photo

You are commenting using your Facebook account. Log Out /  Change )

Connecting to %s


%d bloggers like this: