Opinion - The Euro Crisis: Cause and Possible Resolutions

In the last two months, a break-up of the euro has moved from a notion derided by the European elite, to an event that seems almost inevitable.  In reality, the inherent flaws of the current Eurozone system made this crisis inevitable, and there exist only two possible outcomes: (1) the 17-nation Eurozone (EZ), or some subset, moves to complete economic union, or (2) the weaker nations begin to exit the common currency.

In the current structure of the EZ, the euro represents a basket of independent economies, some of which are stronger (e.g. Germany) and others which are notably weaker (e.g. Greece).  As a result, the Euro’s value in the world market reflects that overall mixture of strong and weak economies and provides the strong countries with an undervalued currency and the weak countries with an overvalued currency.  This has worked quite well for the core northern countries like Germany, Finland, and the Netherlands which have seen their exports increase dramatically, improving productivity and generating significant trade surpluses, to their economic benefit.  According to Austan Goolsbee, professor of economics at the University of Chicago, Germany’s exports as a percent of total Gross Domestic Product (GDP) grew from 29% in 1999 to 47% in 2008, and “its net export contribution to GDP (exports minus imports as a share of the economy) rose by nearly a factor of eight.”  Much of these exports have gone to the southern countries of the EZ.  Goolsbee further notes that in three key southern countries, Spain, Italy, and Greece, the export percentages of GDP have either increased slightly or have fallen over that time period.  Essentially, this means that industry and jobs have moved from less productive regions such as Greece to more productive regions, such as Germany.

The threatened countries share some key characteristics, including restrictive labor laws and an uncompetitive workforce, over-regulation of industry and the economy, and over-taxation, the sum of which has led to economic stagnation and high unemployment.  Exacerbating these economic fundamentals are massive welfare entitlements that are unsupportable by the slow- or no-growth economies, resulting in a ballooning debt load.  The current euro crisis began when investors realized that Greece could not possibly generate the economic growth necessary to retire their current debt, much less their massive future obligations.

Separate sovereign currencies help regulate imbalances caused by disparate economies.  For instance, over the last decade Germany’s mark would have increased in value compared to the Italian lira, lowering the competitiveness of German products and slowing Germany’s growth in exports.  Italian goods would have gained competitiveness from a properly valued currency, and the current account imbalance between the two countries would likely have been much smaller.  Italy’s debt issue would not be solved, but would be partially mitigated by the devaluing currency with the concomitant inflation reducing the value of the debt.  They would be paying off debt with ever-cheaper lira.

Under the terms of the European Union bailouts, Greece, Italy, and Spain are being forced into dramatic budget cuts and tax increases, the latter of which will retard their economies even further and force more cuts and tax increases in a vicious cycle.  This counterproductive response is illustrative of the misguided Keynesian economics professed by the EU bureaucracy, which has also added to the debt crisis through its reliance on “stimulus” programs which increases sovereign debt with minimal to no effect on economic growth.

Interestingly, Nouriel Roubini, professor of economics at New York University, predicted this situation in 2006: “ . . . if Italy does not reform, an exit from [the euro] within five years is not totally unlikely.”  He continued: “Italy faces a growing competitiveness loss given an increasingly overvalued currency and the risk of falling exports and growing account deficit.  The growth slowdown will make the public deficit and debt worse and potentially unsustainable over time.  And if a devaluation cannot be used to reduce real wages, the real exchange rate overvaluation will be undone via a slow and painful process of wage and price deflation.  But such deflation will keep real rates high and exacerbate the growth and fiscal crisis.  Without necessary reforms, eventually this vicious circle of stagdeflation would force Italy to exit [the euro], return to the lira and default on its euro debts.”  Roubini summarized his prediction: “If Italy were to exit [the euro] this effective default on domestic and external – public and private – euro debt obligation would become unavoidable.  And a sovereign nation is able to follow such policies – [euro] exit, return to national currency and effective default on euro debt – regardless of any legal or formal constraints that the [EZ] treaty imposes in terms of no exit clauses.”  That means as a sovereign nation Italy still has the ability to break the EZ treaty when they realize it is in their best interest to do so.

At the formation of the euro, Milton Friedman, one of the greatest economists of the twentieth century, noted the fundamental flaw of the structure: “The exchange rates between different currencies provided a mechanism for adjusting to shocks and economic events which affected different countries differently.  In establishing the common currency area, the euro, the separate countries are essentially throwing away this adjustment mechanism.  What will substitute for it?”  He continued: “ . . . the more likely possibility is that there will be asymmetric shocks hitting the different countries.  That will mean that the only adjustment mechanism they have to meet that with is fiscal and unemployment: pressure on wages, pressure on prices.  They have no way out . . . with the euro, there is no escape mechanism [of sovereign currency devaluation].”

Thus without a substantial change in the substance of the EZ, either the weaker countries will be forced to abandon the euro or a core group of stronger countries will abandon it for their own new common currency.  The alternative is a move to complete economic union and much greater political union: a true United States of Europe.  The current proposals of “fiscal oversight” by Brussels are, of course, wholly inadequate; at some point a non-governmental, unelected bureaucracy will be unable to force a sovereign nation into certain actions.  Once that line is reached, a country’s government or its people will balk.  In the long run, nothing short of a surrender of fiscal sovereignty to the EU by all the EZ governments can save the euro.

The dollar succeeds in the United States because the states of the Union have surrendered their economic sovereignty to the federal government.  Economically, this means that the more productive states like Texas engage in a constant transfer of money to the less productive areas (think Detroit) through the federal government.  This occurs within the various European countries now: the industrial north of Italy essentially subsidizes southern Italy.  In a United States of Europe, money from Germany and the other highly productive areas would go to the less productive southern countries.  What is uncertain at this point is whether Europe’s people are ready for this massive step.  The relatively modest bailouts thus far have already created ill will among the taxpayers of Germany, and the overall price tag of fixing the EZ’s debt issues will be an order of magnitude greater.  On the other hand, the governments and bureaucracies of the European countries are totally committed to the EU and to ever-increasing bonds among the community, so this scenario is not completely impossible, particularly if the EU manages to finesse the necessary treaty modifications and avoids plebiscites. 

To summarize, the original concept of the common euro currency was flawed from its inception as was noted by non-Keynesian economists from the outset.  The removal of the mechanism of variable exchange rates without imposition of a federal European sovereign power rendered the current crisis inevitable.  Resolution will occur either through a dissolution of the common currency or a move to a significantly stronger economic union with a surrender of fiscal sovereignty by the EZ nations to a federal entity.