I remember when the European Union, and the creation of the Euro, was being discussed and formulated. I was sitting in an economics class in college.
The European Union would be the culmination of a series of efforts to unify Western Europe – starting in 1951 with the creation of the European Coal and Steel Community (ECSC) and later, the 1957 creation of the European Economic Community (EEC) – which removed many barriers of trade between member nations. Over time, the EEC added additional European nations and expanded its influence and scale. Fast forward to 1987 and the creation of the Single European Act (SEA) which strengthened both legal and foreign policy influence and concentrated the decision-making power of the EEC. It also established a timetable of 1992 for the completion of a common market. And thus, the Maastricht Treaty was signed on February 7, 1992 and formally created the European Union (EU) – it also called for a common currency – the yet to be named Euro.
On January 1, 1999, 11 countries—Austria, Belgium, Finland, France, Germany, Ireland, Italy, Luxembourg, the Netherlands, Portugal, and Spain—adopted the newly created currency. They also relinquished control over their own exchange rates. Certain criteria had been set for inclusion such as debt/GDP, inflation rates, budget deficit tests and exchange rate stability. Belgium and Italy failed to meet the debt/GDP test but were allowed to join regardless. Greece did not meet basic qualification requirements and was initially excluded but was then admitted in 2001. Denmark, Sweden, and the United Kingdom chose not to adopt the Euro as their national currency. The euro was introduced to the general public on January 1, 2002.
At the time (1988), I struggled to understand why the EU would want to create a common currency. Why would countries want to give up their Sovereign Right to print money and manage their own monetary policy? I could not see any particular benefit to the Euro’s creation other than a political one – a political goal to increase Europe’s world standing and influence. I felt the effort was doomed in the long run – and I still do. A common currency accomplishes many things – none of them particularly positive. Proponents put forth the argument of currency stabilization – and its positive influence on trade amongst union members. But this argument ignores the ability to easily hedge currency fluctuations – it also ignores negative impacts on specialization via comparative advantage. The bigger problem is the loss of national monetary policy – and the incentive for, and assumption of, risk-taking by member nations.
When a stand-alone country encounters economic headwinds it can respond by adjusting its monetary policy (interest rates, available currency) accordingly. But the European Union must adjust its monetary policy based on the average overall condition of its member countries. The EU is also forced to give a greater weight in its monetary policy to the singular economic powerhouse of Germany. This creates a situation of perpetual interest rate imbalance. Said another way, interest rates will be too low in countries where wages are rising and too high in countries where unemployment is rising.
Another related and darker problem exists. Prior to the Euro’s creation, if a country belonging to the old EEC engaged in monetary recklessness (increased debt, spending, etc) the markets would respond with higher interest rates and/or falling currency prices via exchange rates. This controlling mechanism was removed with the creation of the Euro. In practical effect, the stronger, more fiscally disciplined economies were not only subsidizing countries that chose to engage in more reckless monetary policy and actions – they essentially encouraged them to do so.
As an example, Spain was experiencing higher rates of inflation than the overall EU. Yet, the European Union was pursuing a policy of lower interest rates. This led Spanish households to increase their spending (particularly on housing) rather than reduce debt, and allowed the Spanish government to pursue an agenda of social programs. They did so because it was attractive to do so. Interest and exchange rates did not adjust for Spain’s actions – market discipline was removed. When debt markets finally took real notice of the debt/GDP growth variance within the EU member nations, they dislocated and Spain entered a period of extreme recession. Italy as well. Greece was in far worse shape and ultimately engaged in a negotiated default and partial bond write-down.
Now think about this situation from the perspective of the monetary authorities sitting in Brussels. Greece, Spain, Portugal, Italy, even France, are all facing high levels of unemployment. Yet Germany’s economy is booming and is running at or near full employment – as are several other member nations. What monetary policy do you engage in to fix the issue in one country without harming another? The hard answer is that there is no answer.
A quick aside. Some may ask about the United States – after all we are a nation of “united” states. There are some crucial differences. First, as noted by Milton Friedman “It is worthwhile for a group of independent countries to adopt a single currency when (a) the economic shocks that hit the individual countries are similar and (b) labour is highly mobile among the countries.” The United States generally meets this test. The European Union with its varying languages and cultures – and lessened labor mobility – does not. Secondly, America has its banking institutions regulated at the federal level. Each member country in the EU regulates their own financial institutions. Bank failures in California are a federal government problem as opposed to a California problem – not so in the EU. Lastly, our federal government makes up a huge bulk of our overall governmental spending. Again, not so in Europe, where the EU’s budget is dwarfed by the governmental budgets of its member nations. These differences are real and important.
So what is the answer to the European Union’s structural problem?
If you are to listen to the leaders of the European Union in Brussels the answer would be more of the same – and on an accelerated basis. Their answer would be to more deeply integrate the economies of the European Union in such a way as to make any sharp divergence in either economic activity or monetary policy among member nations impossible. To this I say good luck.
A second answer would be to do away with the Euro before the member states decide to do away with the European Union. There are many benefits to well-drafted trade agreements but there is absolutely no need for a common currency to bind them. The EU could easily maintain free-flowing trade – and all the economic benefits from free trade zones – while gaining from the fiscal disciplines that a multi-currency environment would provide. This would not be a simple solution – the extrication would be difficult but it is almost certainly better than the first option. The main problem is that it would require the giving up of political power and clout from those least inclined to do so.
Lastly, there could be a complete disintegration of the European Union – something that actually appears to be happening in a slow motion crescendo of elections, reforms and resignations. Some might argue its already too late. I’m not sure we are at that point but it’s feeling pretty close. Personally, I would prefer to take action while I could still maintain a measure of control.
Globalism is a political structure – a politically desired outcome. It is not something that is being driven by free markets – although those same markets are driving global integration – the movement and flow of goods. And like all politically driven outcomes, globalism is doomed to ultimate failure if it is not concurrently supported by free markets. At some point the political is overwhelmed by the hard realities of the economic.
Like the times we run out of other people’s money…
newer post Populism – The Road Back to Capitalism
older post Carrot not Stick – Fixing our Economy