The euro as saviour from an inflationary fate?

During the current crisis, it is difficult to see the benefits of the euro. While it is increasingly seen as the cause of most countries’ malaise, its benefits are generally limited to the increased trade between European countries.

One additional benefit that requires review is that the euro currently fiscally restrains European governments, analogous to how the gold standard used to work. Eurozone governments lack the ability to directly monetize their debts. As a consequence, inflationary pressures have been subdued during the present recession. If each country controlled its own monetary future, it is difficult to say whether inflation would still be held at bay.

Sovereign countries have a natural incentive to inflate their liabilities away when finances get tight. It is for this reason that independence of the central bank is granted. By being separate from the government, the central bank’s conflict of interest is reduced, or hopefully eliminated. Southern European countries historically granted only weak independence to their central banks. This was evident over the thirty years prior to the formation of the euro as Europe’s south frequently found itself in periods of high inflation.

The European Central Bank was formed to guarantee and institutionalize this independence. No longer would a member state be able to inflate its worries away, and hence an era of stability ensued. Without fear of inflation, foreign investors found southern European countries increasingly attractive.

If the euro, and especially the ECB, did not exist today, one would expect that the current budget crises of the PIIGS would be cured with the usual medicine. Strong doses of inflation would reduce the real value of these liabilities, staving off insolvency.

While the euro is increasingly seen as a net “bad” for at least some Eurozone economics, there is at least this silver lining: it has promoted monetary responsibility.

Yet this assessment looks only at the visible effects of the recession, and not at the counterfactual of how things could have been. Let’s partake in some revisionist history.

As I have outlined previously, by joining the monetary union, member states effectively guaranteed investors lending them money that there would be no inflation risk. As a consequence, borrowing rates decreased substantially throughout the Eurozone. This effect was particularly pronounced in the previously high inflation countries of southern Europe. What this translated to was reduced borrowing costs through associated risk reductions. Credit expansion was fostered as southern European governments could raise ample funds at rates far lower than they had ever seen.

The counterfactual is what the last decade would look like without the euro. Investors lending money to southern European countries would not have had the same confidence that their investment would not be inflated away. As a consequence, borrowing rates would have been higher, and the propensity of these European countries to borrow would have been tamed.

To partake in a small amount of speculation, I hazard to guess that with this reduction in borrowing, PIIGS countries would not be in the solvency crisis now gripping them (or at least the magnitude would be diminished). If they did not find themselves in the current malaise, there would be little reason to inflate their troubles away. Or, at the very least, if the size of the problem was tempered by higher borrowing costs, there would be less of a need to inflate the problem away today.

Despite working as type of “fiat gold standard” that alleviates inflation, the euro has actually been the mechanism bringing forth the perceived need among so many European countries to pursue inflationary policies. Pursuing such policies will eliminate one of the few beneficial aspects of the common currency, and will do little to change one simple fact: the euro fostered the conditions that made such excess borrowing possible in the first place.


  • Sam Bryan says:

    This is intellectually equivalent to saying that because they will likely do stupid things in university and endure some hard knocks, children would be better off never growing up.

    If Club Med did the right thing and defaulted in their debt, believe you me you could have both a euro and an international credit market unwilling to lend to them.

    One cannot blame the euro for being too sound. That is like blaming the ruler when a man doesn’t measure up.

    (Love Cobden Centre by the way.)

  • David Howden says:

    Hi Sam:

    actually it would be equivalent to saying that if children were allowed to act but only faced the costs of adults, they would be better off never growing. Children face high cost for a reason (falling off a chair hurts a child, while it is only inconvenient for you and I). They learn from these high costs. If you took that away they would grow into adults that were, well, childlike. I think that accurately describes the growing pains of some Eurozone members — it´s a bit of a painful growth spurt for them.

    I would be the last person to ¨blame¨ the euro for being sound. But I would suggest that taking risk away from some without holding them accountable is not such a great idea either.

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