The Euro Crisis shows the importance of Economics
At any time now the Euro could collapse. The common currency which was adopted to widespread acclaim in 2000 looks like it may be on its last legs. It will take only one more economic collapse in a member state to make the currency so unstable that it might not survive. This crisis has exposed the internal contradictions of a currency designed for an era of economic stability.
The long boom led many to claim that Alan Greenspan, the Chair of the US Federal Reserve had “solved the problem of economic recessions” created a false sense of security about the Euro. If the economy kept growing the Euro would be alright. This belief turned out to be hubris.
In a world of post-credit crunch instability it has becomes ever clearer that it will be difficult for the Euro to survive. This is difficult for many supporters of the Euro. The single European currency was always presented as a political issue. If you liked foreigners then you also liked the Euro. If you wanted to keep Britain’s sovereignty and the Dunkirk spirit alive then you wanted to keep the pound. Economics got very little attention in this debate. Even those who had slightly differing opinions on why we should or shouldn’t join the Euro were silenced. How often was Tony Benn allowed onto the mainstream media to explain his reasons for wanting to stay out of the Euro?
But the Euro was always an issue of economics. I often discussed it with people who couldn’t understand why I was sceptical about the Euro. After all, I liked foreigners, I was a progressive, I certainly had no time for Dunkirk spirit style nationalism. I’m sure people put it down to a foible, or intellectual arrogance, or nit picking. For me, though, the economics never added up.
I couldn’t understand how a massive currency-bloc could function. The key to this is the way in which interest rates control economic growth. Low interest rates stimulate demand as it is cheaper to borrow. An economy that is growing quickly runs the risk of overheating. This occurs when growth leads to speculation on assets like property. As more and more profit is generated, so more is sucked into speculation which becomes a more valuable activity than manufacturing or delivering services.
Anyone familiar with the UK economy over the past 10 years will be recognise this pattern of economic development. The problem with speculative bubbles is that they will pop once the productive elements of the economy become less profitable. Speculative booms both make productive sectors less profitable and depend on their profitability. This paradox means that speculative bubbles should be avoided. High interest rates can help stop these bubbles from developing by stemming the flow of money into speculation and help to focus the economy on productive activity.
It is only possible to set one interest rate for any one currency. This is because the interest rate is set by a Central Bank. Investors could easily move their money from one country to another within the same currency area to find the best rate. In other large currency blocs, like the USA the impact of this is mitigated by massive intra-currency transfers from successful areas (like New York) to less successful areas. These transfers were never planned for the Euro. And it is the failure to implement this financial support and the inability to set local interest rates that are is crucial to the Euro’s failure. At the time the Euro was created many of the peripheral economies were booming. Ireland and Spain in particular were growing very rapidly (partly because of speculative bubbles in property). For that reason they had high interest rates. The core economies of France and Germany were growing at a much slower rate, so had lower interest rates. At monetary union the overall interest rate had to account for the bulk of economic activity being in France and Germany. It was therefore set low – around 2%.
In Ireland, Spain and Greece this meant that the insipient speculative bubbles in activity like property and construction were inflated more and more quickly. Their populations became more and more indebted as the costs of essentials like accommodation increased. Their banks became more and more leveraged to lend to people investing in property. The result was that their economies became heavily dependent on the stability of the Eurozone. They were relying on Alan Greenspan having “solved economics.”
As we all found out to our cost in the credit crunch Greenspan and the European Central Bank had not “solved economics”. In fact they’d created a massive bubble of consumer debt that was bound to pop at some point. When it did it brought the economies of the countries most exposed to consumer and housing debt to their knees. These countries included Euro members Portugal, Greece, Spain and Ireland. The group became known as “PIGS” – an acronym created from their initials.
So, we can see that the origins of the Euro crisis lie in the credit crunch. At this point the stability of the Eurozone evaporated. And once the stability went it was impossible for the Euro to carry on as successfully as it had during the long boom up to 2007. Now what was needed was a move to massive cross subsidies from the economically stable core (France and Germany) to the highly unstable periphery. But voters in Germany and France had never been told that this would be a cost of the Euro.
It is this point that is crucial. Had the voters of France and Germany been told they would be liable for any potential default by another member of the Eurozone they may well not have accepted the proposed new currency. The voters of Britain may also have rejected it for the correct reasons. There might have been an actual debate about the economics of the Euro, rather than the politics. But the requirement to focus on political (rather than economic) arguments for the Euro may be its political undoing.
By 2010 the PIGS countries all had high levels of sovereign debt (either incurred through state spending or bailing out failed banks). Such high levels of debt meant that it was difficult for them to borrow on the money markets. With high levels of debt to service and the need for new debt that lenders were unwilling to supply the PIGS countries came close to defaulting on their debt. For a country in the Euro to default on its debt would have brought the Euro to an immediate crisis point.
So the European Central Bank backed by Germany and in conjunction with the International Monetary Fund had to loan a huge sum to first Greece, then Ireland to bail them out. Portugal needed a bailout in May, with Ireland already having come back for a second bailout earlier in the year. The result has been that, while Germany is the most successful economy in Europe and probably the second most successful in the world, its government is remarkably unpopular. In Finland a right-wing anti-European party was the biggest winner in the national elections because of the repeated bail-outs. The political will to keep the Euro going is weak.
So if Portugal requires a bail out there will be real and growing tensions in the centre of the Eurozone from countries that resent bailing out countries that have failed to manage their economies properly. Or even worse, countries that have fecklessly trapped themselves in a highly indebted consumer bubbles. If the country that requires a bailout is a country as large as Spain this exacerbates the situation even more.
It is hard to see the Euro surviving a Spanish bailout. Because of the scale of the Spanish economy a bailout will be several times larger than that in Ireland. It is hard to see the political will for such a bailout coming from France or Germany. The Euro’s days may be numbered – the inability to withstand economic shocks was always going to be fatal. The failure to make the political argument for massive intra-Euro transfers and the problem of setting a single interest rate will rip the Euro asunder if any more countries need a bail out.
This also points to a wider political point. While political arguments are important, it is always vital to examine the economics behind any proposal. Had the country considered the economics of Nick Clegg’s “savage cuts”, rather than assuming that the only way to cut national debt is to cut public services, we’d be in a much stronger economic position. We’d also have a fairer society.