Developments in the Eurozone threaten to plunge the continent into depression, as talk of Greece’s exit from the monetary union is gaining traction among Europe’s political elite.
In a sign of disorientation, there are conflicting messages emerging from Brussels. Last week, Karel De Gucht, the EU Trade Commissioner, revealed that contingency plans were being drawn up for Greece’s exit from from the Eurozone. This was immediately denied by his counterpart, Olli Rehn.
A Greek exit is likely to be eventful. Confidence is brittle, and economies do not work when there is doubt in its currency. The euro can and must be saved but only with fundamental changes in economic policy.
Understanding the solutions to the crisis requires an understanding of its causes. Europe is where it is by design. The pretext for currency union was not just political integration; it was believed that a common currency would create a ‘convergence machine’, raising the living standards of the poorer states to the levels enjoyed in Western Europe.The idea was that a shared currency would encourage more foreign investment and trade to flow between rich and poor states, so that the poorer states had the means with which to exploit their comparative advantages, whilst using established know-how and technology from the richer states.
In a recent report by the World Bank entitled ‘Golden Growth: Restoring the lustre of the European economic model’, we discover that the adoption of the euro in 1998 actually hinders the convergence of the states in the southern periphery – the likes of Greece, Spain, Italy and Portugal. We can see this by looking at productivity for the two groups; growth in productivity is a sign of sustainable economic growth. For the stronger economies – Germany, France, Holland, Austria and Scandinavia – productivity grew consistently, whereas it actually fell in the southern periphery.
It fell because the sheer inflow of finance from core to periphery from 1998 onwards, justified with the belief that the periphery would actually grow and repay debts, and supported by low interest rates, replaced domestic saving, encouraged unproductive investment in local, small-scale and internationally uncompetitive activities, and entrenched a culture of dependency on foreign funds, both privately and publicly.
However, simply disbanding the currency union is not an option because the euro has tied trade and debt contracts inextricably between member states. The euro must survive and policymakers will have to make unpalatable decisions.
Primarily, three things need to be done: help the periphery to compete by allowing inflation in Germany to rise, create a fiscal union in which sovereign debt is shared, and make the European Central Bank a lender-of-last-resort.
Firstly, Germany needs to stop resisting higher inflation and allow its economy to boom. At present, unions and government are essentially holding back a German boom by keeping wages down and imposing national austerity. But a German boom with higher inflation would help the peripheral states stabilise. States within the zone share the same currency, so the only way in which states can adjust their competitiveness with each other is if prices in the periphery become relatively cheaper than those in Germany.
Relatively lower Greek prices make Germans richer as they can afford more Greek holidays and feta cheese, whilst relatively higher German prices make Grecians poorer as they find BMWs and lederhosens more expensive, but this is exactly what is needed to balance trade. Companies will not significantly cut prices unless they can significantly cut their costs. This means lower wages, weaker pensions, and restraint in the public sector as firms and governments wean themselves off debt. With unions digging in and lifestyle expectations intransigent, these reforms will be fraught with resistance, but are inevitable, whatever the fate of the euro.
Secondly, European sovereign debt must be shared, which has to imply fiscal union. Joint-liability bonds could be issued for a certain portion of national debt, with any residual strictly covered by the country itself, similar to how it is in the United States with its federal and state budgets. However, this would be a huge political leap for a Europe which remains Westphalian, divided by language and cultural idiosyncrasies.
Thirdly, the ECB must be made a credible lender-of-last-resort to stop the speculative attacks on banks that may eventually set off a chain of devastating bank runs. It also needs to guarantee deposits at all European banks. If the ECB makes these steps, its actions will effectively be supported by all Eurozone taxpayers, and this is more a German concern than a periphery concern.
Austerity alone is not enough, a point majestically made by JM Keynes in the Economic Consequences of the Peace, published in 1919. In reference to punitive German reparations demanded by the Allies, he wrote: ‘If Germany is to be milked, she must first of all not be ruined’. It appears these days that the boot is on the other foot, the German foot.
