The Euro: Where to Next?

From where did Europe’s recession come? To listen to some commentators one would think that it came from nowhere. Indeed, the idea that a contagion is engulfing Europe – that one insolvent member state could cause innocent bystanders to fall – is so pervasive that its mere mention seems redundant. It is unfortunate that such a belief is prevalent as it ignores not only common usage of the English language, but also some very simple and relevant economic facts.

Like many economic phenomena, the important aspect is not what is seen and readily apparent. As Frédéric Bastiat was able to so cogently stress over 160 years ago, the crucial role for the economist is to discern the unseen economic effects.

While it is all too easy to focus on European member states’ burgeoning public debts, widening credit default spreads, dwindling tax bases and climbing ranks of dissatisfied unemployed citizens, the hidden causes are what are needed to be assessed to correctly foresee a prosperous future. While it is increasingly becoming accepted that European governments spent more money than they had, and that the ECB held interest rates too low for far too long, the specific reasons why these events manifested remain largely shrouded in mystery.

Philipp Bagus has just written the first coherent book explaining the origins, functions and consequences of the European Central Bank. An understanding of how this institution functions is essential to anyone – from the general population to the pundit to the politician – to grasp how a seemingly beneficial institution could reap such detriment.

In particular, I would like to focus on two of the most important consequences of the formation of the common currency area.

First, let us turn our attention to the now well-recognized fact that the ECB held interest rates too low for too long. Accession to the Eurozone meant that a member state would become subordinate to a common interest rate policy set in Frankfurt. While one base nominal interest rate pervaded throughout Europe, divergent inflation rates quickly created distinct real rates. In the high inflation periphery countries – the PIIGS of today – real interest rates dropped to levels lower than most of their citizens had ever witnessed. The result was an expansion in interest-rate sensitive projects. Investment in housing, for example, flourished.

The Spanish economy illustrates the worst of these excesses. In 2006 Spaniards constructed over 700,000 new homes – more than Germany, France and the United Kingdom combined could tally. That 2006 was also the midst of a housing boom in the United Kingdom should more than allude to the severity of this problem. Today more than 1 million Spanish housing units stand empty – more than the whole of the United States.

This common interest rate policy was heralded throughout the 2000s as allowing the periphery countries access to cheap credit markets. This would allow, in turn, for quick and easy development of infrastructure to enable their rise to power. If a housing bubble qualifies as a positive buildup of infrastructure, mission accomplished.

Next let us turn our attention to the common exchange rate imposed throughout the Eurozone as a consequence of the shared currency. During the convergence to the common currency throughout the 1990s the member states of the future Eurozone saw their respective currencies more or less equalize in value. In retrospect the situation was like two sides of the same coin. In Northern Europe, especially Germany (but also Netherlands, Austria and to a lesser extent, Belgium) the once powerful Deutschmark declined in value to meet the future euro’s shared value. In contrast, along the Eurozone’s periphery a sharp increase in currency values coincided with the eventual appearance of the euro. As the common currency replaced the individual member states’ currencies a single foreign exchange rate was imposed throughout the whole of the monetary union.

The consequences are all too painfully obvious today. Italians, Spaniards and Greeks – countries and people accustomed to less valuable currency units – were able to buy foreign goods at much lower prices than was possible just a short period earlier. A spending boom developed which saw the demand for imports grow at a fevered pitch.

At the same time the uncompetitiveness of producers in these countries against foreigners was becoming apparent. Indeed, as Bagus explains on page 43 of his book, unit labor costs of the PIIGS countries soared anywhere from 10 to 35 percent over the decade from 1999 to 2009. The consequence was a drastic decrease in exports coupled with an increasing demand for cheap imports. Severe trade imbalances developed, as savings from these periphery countries flooded overseas markets in exchange for cheap goods.

Not surprisingly, the situation was the opposite in the economically stronger Northern European countries. German unit labor costs declined about 10 percent from 1999 to 2009, largely because of its newly devalued currency shared with its Southern European neighbors. The large trade surplus that Germany enjoys today and which is largely viewed as a positive glimmer of light from the otherwise dismal continent is caused by the same phenomenon that plagues the peripheral countries: a shared currency with a shared foreign exchange rate, the value of which is the average of the implicit currencies of its component countries. Unfortunately, very few individual data points comprise an average. A consequence in the Eurozone is that no one country has a currency valued at a sustainable level.

Europe’s unsustainable state of affairs did not come into existence from nothing. Nor is the current threat of “contagion” founded on any application of the real phenomenon. The same malady affects all Eurozone economies the same as every other one. More striking is that this disease has continued unnoticed for over a decade… until now.

The effects of the common currency are now apparent. While knowledge of how a car’s engine is of secondary importance when it is in good repair, as soon as it breaks down such knowledge is essential to make it roadworthy again. The Eurozone is an analogous case. Understanding how the euro functions, and how regional politics play a role in forming the common monetary policy is essential to understanding where the current recession came from and how we will get out of it.

Philipp Bagus’ new book “The Tragedy of the Euro” is essential reading to everyone who wants to gain a better understanding of both these points.