When the idea of a common currency was floated, it was politically impossible to reject. Principles of Economics 101 were abandoned and the Euro was introduced in 1999. This was of course an economic policy blunder …writes Vatsal Srivastava
A great economic experiment began in 1951 with the formation of the European Coal and Steel Community. It was an attempt to make war within Europe impossible by establishing free trade in coal and steel, eliminating all tariffs and restrictions on cross border economic shipments.
Ideally, it would ensure that French steel mills relied on German coal and vice versa so that any future differences between the two nations would be extremely destructive economically thereby reducing the possibility of war.
In 1957, the European Economic Community was formed as a customs union with free trade among its six founding members — Belgium, France, Italy, Netherlands, Luxembourg and West Germany. By the mid 1980s, Britain, Ireland, Denmark, Spain, Portugal and Greece had joined this group. Free trade from closer integration undoubtedly led to economic gains not witnessed for many decades. But this was more about political integration and European unity.
The idea that a previously war torn continent can be economically integrated and be a beacon of democracy was impossible to ignore. European political leaders were so enthralled by the idea of a “strong and united Europe” that all warnings of future asymmetric shocks and the problems addressing them within a single currency union were ignored.
When the idea of a common currency was floated, it was politically impossible to reject. Principles of Economics 101 were abandoned and the Euro was introduced in 1999. This was of course an economic policy blunder.
Consider what happened after the global housing bubble collapsed starting with the US and eventually led to housing busts in southern Europe. The housing boom in Spain was financed by huge inflows of capital from “core Europe” — most notably Germany. This boom which eventually turned out to be a great bubble led to inflation and thus wage increases in Spain.
Wages rose about 30 percent in Spain compared to only 9 percent in Germany. After the bubble collapsed, Spain needed to turn its economy away from construction towards services and manufacturing. But at this point, Spain had lost its competitive advantage due to the wide wage differential with Germany and other neighbours.
Enter the problem of a common currency! With the Euro the only way Spain could restore competitive advantage was by cutting wages. But it is almost always impossible to negotiate lower wages and workers will always refuse wage cuts and a lower standard of living. But if Spain had its own currency, this problem would have been solved overnight.
The Spanish central bank could have simply intervened in the foreign exchange markets and devalued its currency versus its competitors in order to regain competitiveness. The same logic can be extended to explain the problems faced by Portugal, Italy, Greece and the other “non-core” European nations.
The Euro also fails to meet one of the key requisites of an “optimum currency area” — that of labour mobility. Labour does not move freely within the Eurozone. Even though Europeans can legally take up work anywhere in the European Union, linguistic and cultural divides are are large enough to put a cap on migration.
How else would one explain 50 percent youth unemployment in Greece, mass unemployment in Spain and Portugal and historically low levels of unemployment in Germany? Such stark contrasts are proof that the disadvantages of a common currency far outweigh the benefits that have come Europe’s way by adopting the Euro.
Right now it’s Greece’s problem. But as we saw at the peak of the debt crisis (2010-11), it doesn’t take time for much larger economies such as Spain, Portugal and Italy to be considered close to junk status. The markets have remained calm during this “crisis” as they believe the ECB can limit the contagion from spreading to other peripheral nations.
But in the long run, the debate won’t be about the prowess (or the lack) of the IMF’s economic forecasting models, or the austerity versus fiscal stimulus, of for that matter the ability of the ECB to do “whatever it takes” or whether the bigger threat to the Eurozone is inflation or deflation.
European policymakers will soon need to answer the more fundamental question which is at the heart of Europe’s problems: How long can the Euro survive? “If the Euro fails, Europe will fail”, said Angela Merkel in Berlin on Monday. A Grexit, or a Greek withdrawal, can be easily absorbed by the financial system. The great crisis we should prepare for is the likelihood of a “Euroexit”.