Voices to ditch the euro are getting louder. Not only in the really depressed economies of the eurozone periphery, like Spain and Italy, but now also in core countries like Germany. We're pretty sure that had people known what would happen, the euro would never have been introduced.
It's interesting at this juncture to review the different supposed advantages for the euro, as it will turn out that on pure economic grounds, the case for the euro is pretty weak, and always has been.
Completing the Single Market
The Single Market project aim is to remove barriers to trade between EU member countries. That entails quite a lot, it's not just tariffs and quotas, it's mostly differences of regulation that prevent European economies from merging into a seamless market. There is still quite a lot to be done here (trade in services, for instance), but having a single currency was seen as a logical extension.
Indeed, having different currencies can be seen as just another trade barrier, not only because of the transaction costs involved, but the uncertainty they create for cross border trade and investment. This is true, but the transaction costs were never really that significant, and it is possible to hedge against currency movements.
There is a good deal of empirical work on the impact of having different currencies on cross border trade and investment flows, and these studies usually show some effect, but really not all that big. After all, Europe trades quite a lot with the U.S., and these have different currencies which tend to move quite a bit.
The upshot is that it is definitely an advantage to have a single currency though, but this advantage isn't all that big.
Expressing cross-border prices in the same currency supposedly increases transparency, and hence competition. Increased competition leads to increased static and dynamic efficiency, increased specialization and lower inflation. Again, an advantage, but as far as we know, almost certainly a very small one.
Sound monetary footing
These days, it's almost impossible to comprehend, but the biggest advantage of the euro was supposedly the sound monetary footing that it would bring to erstwhile monetarily-irresponsible peripheral countries. All of a sudden, their monetary policy and institutions would enjoy Bundesbank-like credibility, and in fact they did.
If ever the saying "careful what you wish for, you may get it" is appropriate, it is here, because this is exactly what these countries got. Almost overnight, the often big risk premium melted from their bond yields and interest rates, as their currencies could no longer devalue and they would be subject to rigorous Teutonic monetary conditions.
Actually, the first trumped the latter. The low interest rates set off a borrowing spree and asset bubbles in countries like Ireland and Spain. That rigorous Teutonic monetary discipline turned out to be not all that disciplining, in fact, one could argue the exact opposite. The German economy went through a rough patch itself, and since the newly created European Central Bank (ECB) had to set interest rates for all of the eurozone, a one size fits nobody problem ensued.
The result was that monetary conditions were way too loose for much of the periphery, together with the disappearing risk premium from yields, this led to a bit of a credit boom (apart from Italy, but even there the falling bond yields produced a semblance of improving public finances).
This credit infused boom not only swelled asset prices (setting them up for a collapse), equally importantly, it led to the accumulation of inflation differentials that are very hard to undo. Just as Germany was getting its unit labor cost under control, much of the rest of the eurozone experienced a various degree of wage inflation that accumulated steadily over time and led to large losses in competitiveness for numerous countries.
Normally, the way to deal with that is to hike interest rates to cool off the economy and/or devalue the currency to restore competitiveness, but neither option is open under Monetary Union. So the "sound monetary footing" that membership of the European Monetary Union (EMU) was supposed to bring to the inflation-prone, devaluation-prone Southern peripheral countries has been a distinctly mixed blessing.
Having its monetary conditions dictated by Frankfurt, rather than its own central bank, did infuse credibility and the inability to devalue boosted that further. But ironically enough, these are the same forces that produced way too lax monetary conditions, leading to inflation and a loss of competitiveness, and the fact that these countries are no masters of their own currency nor their own monetary conditions make this situation extraordinarily difficult and costly to deal with.
So one wonders, how "sound" has this monetary footing really been?
Peripheral control of the Bundesbank
Another advantage, touted especially in the Southern peripheral countries at the time, was that EMU would liberate these countries from the dictates of the Bundesbank. Under the previous fixed but adjustable exchange rate mechanism, the ERM, member countries had their currency effectively tied to the D-Mark, which compelled them to follow Bundesbank interest rates or experience pressures in the forex markets.
At the Dutch Central Bank, the joke was that we experienced about 45 minutes of monetary independence. This was ok for a small country like the Netherlands, for which Germany is the biggest trading partner and sharing the German monetary philosophy, but it was unacceptable longer-term for countries like Italy and France. They were tired of having their monetary policy dictated by Frankfurt.
The solution to that was the flight forward into monetary union. At least they would have a seat at the board of the ECB. Well, they have that seat, but all is not well here. There are significant risks if the Southern countries engineer a majority and force the ECB to do things like unconditional bond market interventions that really goes against the core of the German monetary doctrine. This could all end rather unceremoniously.
We're getting on more shaky grounds discussing the supposed political advantages of EMU. Some say that "ever closer union" will cement the EU nations together in a prosperous peaceful unity. That was the rationale of the 1957 founding Treaty of Rome (or earlier, with the European Coal and Steel Community).
But one can make a rather convincing case that EMU is a bridge too far. To function well (rather than the half-baked institutional set up it has today), EMU requires iron clad rules and/or deep surrender of national sovereignty over some of the most basic fields for democratic decision making, like the national budget.
Those who argued that a monetary union couldn't last without a political union turned out to have been right. The question is whether the EU is ready for a political union, and we fear the answer of that is a rather resounding no. And instead of helping, the euro, and the chaos and economic depression it has produced is making things more difficult, much more difficult.
So we actually see that the supposed advantages are rather insignificant, and what's more, not all what they're supposed to be. But EMU has substantial disadvantages..
One size fits nobody monetary policy
Interest rates are set with respect to the eurozone as a whole, which almost invariably means conditions are too loose for some countries and too strict for others. Rather than producing convergence, this could very well produce divergence, as we have seen already above.
Few adjustment mechanisms
The divergence that countries experience, either from the wrong kind of monetary conditions (see above) or as a result of some country specific shock (wage inflation, asset price bubble, loss of competitiveness etc.) needs adjustment to deal with these, otherwise the divergence will continue. But, with EMU membership, countries have given up two of the most important adjustment mechanisms, independent monetary policy and the ability to change the external value of the currency.
There are remaining adjustment mechanisms, like:
- Wage and price adjustments
Automatic and/or discretionary budgetary transfers
None of these adjustment mechanisms is currently sufficient to deal with a country specific shock. Compare Germany to Spain. Spain experienced a credit bubble (due to EMU membership setting interest rates too low for Spain), leading to inflation and a loss of competitiveness, a housing bubble, leading to a crash, a banking crash and an economic crash.
Normally, the inflation would have been either stopped in its tracks or compensated by a devaluation of the Spanish peseta. The asset bubble might very well not have formed if Spain wouldn't have joined EMU, lending would almost certainly have been a lot less exuberant.
Not only did a lack of adjustment mechanisms allow these problems from rising, they've made it that much harder to deal with them. Yes, competitiveness can be restored through "internal devaluation," that is, wage and price adjustment. But this is a very arduous and painful process requiring wage cuts of 30% or so.
Alternatively, unemployed Spanish people could move elsewhere in the eurozone, but this isn't a solution for 50+% youth unemployment or 26% unemployment either. Labor mobility in EMU is rather low, due to existing language, cultural, and institutional barriers.
In the U.S., with a large federal budget, automatic redistribution happens between booming states and states experiencing economic problems, but the EU budget is way too small for this to be meaningful in this regard, and discretionary redistribution (aka bailout programs) are no permanent solution either due to diminishing political support. The German voter simply didn't sign up to the dreaded transfer union, and sooner or later will exert that preference, probably in a rather unpleasant way.
Even fiscal policy cannot be used to revive the economy of a struggling EMU member economy, as members have signed up to limits on public deficits.
Membership of EMU can produce a self-reinforcing capital flight that tightens monetary conditions further. Investors in Spanish assets can sell, receive euros, and invest these euros elsewhere in the euro area without incurring any exchange rate risk. That is, the selling of Spanish assets (bonds, stocks, bank deposits, etc.) can easily trigger an outflow of capital and thereby a further tightening of monetary conditions against which the country cannot defend itself.
To understand this better, compare it to what happens when investors sell assets of a country that isn't an EMU member and issues its own currency, for instance, the U.K. The sellers receive pounds, which they either:
- Re-invest in other U.K. assets
Sell on the foreign currency markets
In the first case, the money stays in the U.K., not causing any contraction of monetary conditions. But also in the second case, as the sellers of pounds will meet buyers of pounds, who will buy U.K. assets (bank deposits, stocks, bonds, etc.) and this probably triggers a fall in the pound, producing a monetary expansion that mitigates any economic crisis.
So while a sell-off in Spanish assets causes monetary conditions to contract further, as money leaves the country, it would likely lead to the opposite result in a country that issues its own currency. How tight the credit conditions in the periphery are:
Lending to firms dropped by 2.5% in the euro area but that overall figure masks a wide dispersion. Whereas lending rose by 0.9% in Germany, it fell by 3.2% in Italy, by 6.6% in Portugal and by 11.4% in Spain. [The Economist]
No lender of last resort
Countries that have their own currency cannot really go bankrupt if their public debt is denominated in that currency (which for most developed countries is the case). They can always print more money, so there isn't really much of a default risk. This changes dramatically under EMU, as member countries effectively borrow in a foreign currency over which they have no control.
Not so with EMU members, they are subject to a clear default risk, and that's very visible in the bond yields
You first see the bond yields converging as EMU was increasingly being a reality in the late 1990s and member countries enjoyed the disappearance of devaluation risk, but after the financial crisis you see the re-emergence of diverging bond yields as default risk asserts itself in many EMU peripheral countries.
Unlike countries that have their own currency, the ensuing flight from peripheral sovereign bonds sets off the contracting monetary conditions explained above and rising bond yields that make the sustainability of public finances ever more problematic leading to more capital flight, creating a vicious cycle.
In countries with a weak banking system is supercharged as losses on bond portfolios makes the banks even more vulnerable and liable for a bail-out, further pressuring them.
Political centrifugal forces
In Italy, Beppe Grillo who won more than 25% of the vote in recent elections, making it the single biggest party in the parliament, argues that Italy may soon have to pull out of the euro and calls for a referendum on euro membership. Even in Germany, which has done very well under the euro, there are notable voices in favor of leaving:
A new party led by economists, jurists, and Christian Democrat rebels will kick off this week, calling for the break-up of monetary union before it can do any more damage. [Telegraph]
Large parts of the populations in many EMU countries are waking up to the fact that, rather than bringing prosperity and economic stability, the euro has brought quite the opposite. This could easily turn nasty quite quickly if Italy changes course and revolts against the austerity imposed by Brussels and Frankfurt.
The ECB will then have to confront a truly awkward dilemma, buy Italian bonds when yields start spiraling out of control again without the quid-pro-quo of austerity measures and alienating the Germans, Dutch, Finns, Austrians?
The one benefit that does matter
Many of the peripheral economies have been sclerotic for decades, and are in urgent need of substantial, market friendly reforms of the type that Germany imposed successfully under Gerhard Schröder a decade ago. This implies going against well-organized, established interests, something which they haven't been able to pull off. Only a very large crisis, like the present one, could make things fluid enough for these type of reforms to have some chance. Spain, for instance, has made some notable progress in this respect.
This is basically why we want to get rid of the euro, but not just yet, as the need for reform will dissipate, as leaving the euro will be seen as a quick fix and substitute for real reforms.
The benefits of the euro are surprisingly modest and the cost can be very large, as we are witnessing daily. To some extent, these costs are a function of design errors, but to remedy these, countries will have to give up large amounts of sovereignty. While steps towards that are being made, it is almost certain a large part of the eurozone electorate isn't supporting that and won't for quite some time to come
So a cool cost-benefit analysis can only arrive at the conclusion that the euro serves little purpose, the costs far outweigh the benefits.
Perhaps the most important benefit is that it exerts pressure to structural reform, making economies more resistant, flexible and dynamic. For that reason alone, we would like to keep the euro around for a while, as many countries weren't able to embark on such reforms without sufficient pressure.
Unscrambling the omelet of the euro is costly and fraught with risks, but these are one-time costs and it can be done.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.