The Euro: Help or Hindrance?
April 7, 2014
There’s No Turning Back
Marina Whitman is Professor of Business Administration and Public Policy in both the Ford School and the Ross School. She has been a member of the President’s Council of Economic Advisers and a vice-president of General Motors, as well as a director of several multinational corporations.
Is the Euro a help or a hindrance for what? For founder Jean Monnet’s dream of a federation of Europe that would bind France and Germany in a compact to make a third European-based world war impossible? Or for a barrier-free economic union that would enable the nations of that continent to overcome “Eurosclerosis” and compete against an economically-dominant United States?
The first step toward Monnet’s vision was the formation of the European Coal and Steel Community (ECSC) in 1951. This internationalization of the Ruhr valley, the industrial core of Germany’s strength during both world wars, encompassed the six countries that signed the Treaty of Rome to establish the European Economic Community (EEC): France, Germany, Italy and the three small Benelux countries. The immediate effect was to create a customs
union that abolished tariff barriers among the six and created a common tariff wall against the outside world. The ultimate goal though, was a common market characterized by the free movement of goods, capital, services and people.
A major next step was the Single European Act of 1986, which laid out processes and a deadline for the completion of the common market and its “four freedoms.” Then, in 1992, the Maastricht Treaty created the European Union (EU) and laid plans for a common currency; the elimination of national currencies and the full circulation of the euro were achieved in 2002. By 2013, the EU included a total of 28 countries, 18 of which share the common currency.
Among the economic benefits is a decrease in the costs of transactions across national boundaries. The Eurozone also eliminates exchange risks that can have severe financial implications for exporters, importers, foreign investors, or international businesses. The primary cost is the loss of autonomy of a participating country in conducting its monetary and fiscal policy, as well as the ability to increase its global competitiveness via devaluation.
What determines whether the benefits of moving to a common currency will outweigh the costs? Economists generally agree on the need for substantial mobility of capital and labor among the members, as well as flexibility of prices and wages. Also essential is an automatic fiscal transfer mechanism that redistributes money from members that are prospering to those that are being left behind. As plans for creating a common currency were underway, several prominent American economists raised danger flags, pointing out that the potential members were far from constituting an optimum currency area (OCA). The EU nations confronted language and cultural barriers to labor relocation, wage rigidity, and the absence of any mechanism for automatic fiscal transfers.
The global financial disaster of 2007-08 created a crisis that threatened the demise, or at least serious retreat, of the euro. The enormous gap between the economic positions of the strong “northern” members and the weak “southern” member countries underpinned sharp divergences in interest rates, unemployment rates, and progress toward recovery from recession. The likely inability of the weak countries to make painful adjustments without being able to employ monetary or fiscal stimulus or currency devaluation , combined with the unwillingness of the strong countries to finance substantial “bailouts”, produced widespread speculation on which member states were likely to drop out.
In the ensuing years, the weaker countries have managed to make greater adjustments than had been thought possible and the stronger members have, somewhat grudgingly, allowed mechanisms to ease the strains. Efforts to bring about convergence of banking regulation and to move toward risk- sharing through zone-wide deposit insurance are underway. But the Eurozone countries remain stuck in the awkward position the American sceptics predicted, still a long way from forming the sort of federal system that would constitute an OCA.
But there can be no turning back. If Greece, the weakest of the group, was to abandon the euro and return to the much-devalued drachma, it would find itself with an insuperable burden of euro- denominated debt and without access to financial markets. More broadly, it is likely that the prospect of even one country leaving the Eurozone would cause widespread financial panic. Today, unlike several years ago, most of Europe’s political leaders appear determined to avoid such an outcome. Whether the creation of the euro some 15 years ago was a wise idea or not, the Eurozone must hang together and complete the additional moves required to insure its survival.
The Euro Splits Europe
Christian is a PhD student in Economics with focus on International Economics. His current research looks at the transmission of business cycles across countries. He holds a master’s degree from the University of Tuebingen in Germany.
Introducing the Euro in 1999 could never be justified on economic as well as a political decision. As the former Spanish Prime Minister Felipe Gonzales said: “We need this united Europe… We must never forget that the euro is an instrument for this project.” In the following years, the euro became a part of Europe’s identity whose convenience is taken for granted by travelers. Naysayers had a hard time making their argument as Europe underwent years of growth, especially in the weaker countries like Portugal, Ireland and Greece. But six years after the onset of the great recession the reality looks different: People in many countries are poorer than they were in 2007, and the dream of a united Europe is further away than ever. So why did the single currency idea backfire?
Initially, everything worked as intended: capital flowed from the richer countries in the EU core to the poorer countries in the periphery to finance their catching-up process, but those flows were not driven by strong productivity growth in the periphery. In fact, productivity stalled. It was the single currency that reduced the risk for lenders and made it attractive to invest in the periphery. Lured by low interest rates, households and firms took on large debt burdens. In this period of foreign-financed growth, trade unions pushed through higher wages. This quickly undermined the countries’ competitiveness and led to even stronger imbalances in international markets. Those believing in the euro only saw how the periphery countries grew and that progress wiped away any concerns about how those countries would repay their debt.
How vulnerable the situation actually was became obvious in 2008 when the Great Recession hit the US and spilled over to Europe. Suddenly, banks in the EU core became nervous about their investments and called back their loans. Facing tight credit markets and a falling demand, firms had to either cut wages or fire employees. Many either didn’t want or couldn’t cut wages, and countries experienced strong increases in unemployment. For instance, in Spain the unemployment rate had reached levels above 25%. Again, this harsh adjustment is due to the euro. If Spain had continued to use the peso, its currency would have devalued. A weaker peso would act as a valve to take off the pressure from high wages, making Spanish products cheaper on world markets and spurring demand for them, so that firms could refrain from firing workers. The euro renders this external adjustment impossible, and countries try to slowly adjust internally by cutting social spending and deregulating labor markets. However, this process takes time and is painful.
It is hard to quantify the costs of the euro. Spain has dubbed its unemployed and disillusioned youth the ‘lost generation’ because its employment opportunities are permanently diminished, even once the economy has recovered. The only country that seems to economically benefit from this crisis is Germany. After a strong but short-lived recession in 2008, it recovered and has experienced strong GDP growth since in 2010. But this boom is fueled by a weak euro and large exports alone. If Germany had its own currency, the Deutschmark would become stronger and increase Germans’ purchasing power. In fact, Switzerland has experienced improved living standards in recent years due to their strong currency, a fate that Germany could have shared if it had kept the Deutschmark. Instead, investment in Germany has reached record lows and many workers have barely seen any increase in wages over the last 15 years.
The costs are not only economic in nature. Instead of unifying Europe, the euro splits the continent into two camps: debtors and creditors. Fearing non-repayment creditor countries, Germany, for example, pushes for austerity measures in debtor countries, and only recently, politicians have realized that such policies exacerbate the crisis. Worse, they undermine the concept of democracy. Political populism is on the rise in almost all countries, especially where unemployment rates are high. Even countries on the other side of the cleavage, such as the Netherlands, see right-wing parties that bash the EU for costly rescue packages leading the polls. This is particularly concerning in light of the European Parliament elections this spring.
Taking stock, the euro has not only caused considerable economic damage, but has also poisoned the political and social climate in Europe. The former Italian Prime Minister Mario Monti stresses that much is at stake: “If the euro becomes a factor promoting Europe’s drifting apart, then the foundation of the European project is destroyed.”