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.
Nice work, P.
As your answers to Ian make clear: It is really about local control and localisation. The Euro was a pro-globalisation project. But it hadn’t been thought through properly even on its own terms, for the reasons you give.
Now we can start to push for the alternative more strongly and openly: protecting the local, locally, nationally, continent-wide and globally. _Local_ currencies, and national currencies, not international currencies, are part of this. They go with local and national government, true subsidiarity – not centralisation and corporate and business control, which has [sadly] been the EU’s main ideology to date.
Couple of points, coming late to this discussion.
The idea that interest rates control economic growth and investment: not the Japanese experience. Interest rates have been effectively zero there for some time, and people don’t borrow, don’t invest. Why is that? Traditional economic theory doesn’t give much of a clue.
The idea that Irish banks became highly leveraged because people were more indebted because of (among other things) the property bubble: a mistake in ascribing causation, I would suggest. Banks need to leverage – at least those banks which are moneymakers. Their whole raison d’etre is increased indebtedness. The form it takes is quite secondary. Indebtedness exists, and increases, because banks push it, not because people demand it. It has become the engine of the western economy. Right now, people are repaying debt, and the economy is therefore in crisis.
Currency: the point about currency is not whether it is “local”, but whether it is sovereign. If it is, then you have some control over your economy (the Greek problem is compounded by giving away control over their own currency and economy). Having one currency means having one economic policy, one political view…and the point of the euro was not to reflect that we had that, but to try to bring it about, via the back door. Predictably, it has failed. The remaining questions are about how rapidly and damagingly it will collapse, not whether it can continue.
Default: a few comments above refer to default as if it is a national issue. I think it is clearer to see default as an issue of international capital extending debt in ways which can’t be repaid and which will therefore be defaulted. Trying to allocate this to nation states is both misleading and unhelpful in understanding what’s going on here.
A couple of points. I think we differ here in our view of government. Different currencies are an unnecessary complication in the same way as different governments are. While its right that it is more difficult for people who want to move between Scotland and England to have different laws on things like smoking in public places or different choices over things like whether or not to have nuclear power, the benefits outweigh the costs.
Interest rates are, you’re right to say, not the only thing that influences the creation of asset bubbles. But they are a very important part in that equation. And interest rates are only misused by governments in the same way as any other powers are. I don’t believe, for instance, that because the Scottish government made the wrong decision about a golf course in Aberdeenshire we should take all powers for planning from it and give them to Brussels, Westminster or somewhere else in the hope that they’ll get the decisions right.
Ireland could have tried to stop the property bubble, but the speculative capital would simply have been pushed into other assets. The important thing here is the demand for a bubble, not what the bubble is in. And if you want to unnecessarily complicate things trying to regulate against asset bubbles when interest rates are inflating them will do that. As bubbles emerge in stocks, commodities etc government would have to move to regulate each. That really would make it very difficult for the economy to function.
The reality is that the “unnecessary complication” you highlight would be a very effective way to ensure local investment, just like a local currency.
The question here is really about whether we can trust governments to get decisions right. My view is that we should give governments the power and try to encourage them to use it for the right things. You appear to be saying that the best way to avoid governments making short-term decisions is to take powers away from them and give those powers to someone else very far away. And we can see that taking powers away from local governments means devastating consequences, like those for the Irish economy…
A ‘local currency’ (as in Edinburgh) does not give you control over it – it’s still simply a replacement for barter, but what it does is to reduce leakage out of the local economy, which is a good thing.
Re Ireland – to use interest rates to dictate investment is a very blunt instrument and shouldn’t be relied on for that purpose. For example, if Ireland had wanted to reduce the speculative development (which I doubt very much if it did at the time), it could have easily done so through other means.
Allowing Scotland to go it alone would exacerbate the problem whereby currency speculators exploit the weaknesses and perceived weaknesses of currencies (like when Soros made billions out of the UK coming out of the ERM). Having separate currencies is an unnecessary complication – e.g. why should I pay banks a 5% charge every time I go abroad (or for that matter buy imported goods)? This is a hidden and costly tax – except that the ‘tax’ is going to the banks and not the common good!
It’s a shame that so many people are blaming the Euro for what are essentially the faults of profligate governments with short-term aims. Essentially, if a country is running its economy badly, it will get found out eventually, no matter how hard the currency hides it. Hiding economic problems for future generations to sort out and handing money to banks and speculators are also things, I believe, that Greens should not be in favour of.
I’m not sure how the Euro could have run alongside existing currencies. It would have cost a lot to administer 12 or 13 parallel currencies. Of course, there was a period for changeover, but that had a defined end.
On your second question I’m really not sure what happens. It will be very difficult to reintroduce a range of currencies, especially if it happens to the weakest countries first. A very good reason to stay out of the Euro (or not to have gone in initially)
Thanks, but for me the most important thing here is local control of the economy. I (and many other Greens) are committed to control of the economy being at the most local level possible. That’s why we’re campaigning for a local currency in Edinburgh, and support more devolution of powers over the economy to the Scottish Parliament.
While it’s true to say that Greece had significant structural economic problems before they entered the Euro (and that surely points to the heavily politicised nature of the demand to enter the Euro), Ireland certainly didn’t have those problems.
While I disagree with the neo-liberal model which relies on unsustainable consumption and crippling inequality Ireland was a model of how to do neo-liberal economic development well from the mid-90s onwards. But entry to the Euro took an economy based on export-led growth and turned it into one gigantic asset bubble around property. Overnight interest rates went from 6% to 2%. That will always promote speculative development. That surely can’t be a good thing?
There’s a good case to suggest that Scotland would benefit from control over interest rates, and currency separation from the UK. This would alleviate the problem of hot money coming into and out of The City and artificially inflating the value of Sterling. This artificial inflation has hugely damaged our productive economy to the benefit only of city speculators and bankers. That’s not something of which any Green would be in favour.
All a bit too simplistic, Peter.
A country with structural economic problems will not be fixed by simply tinkering with its currency. By simply devaluing the Drachma, Greece would have have incurred inflation. More importantly, without addressing its deficit problems, the risk of further devaluations would mean loans would only be granted to it in hard currencies like the dollar – and those debts would increase markedly as the currency is further devalued. Unless Greece had then addressed the real problem of balancing its government spending over time, the difficulties it would face in servicing its debt would have been no different – it’s just that the extra payments would have been as much due to the value of the debt (in terms of local currency) increasing following devaluation, as well as high interest rates being charged due to a poor credit rating.
A good example is the less severe fault line which existed in the UK in the early 2000s. It was argued that interest rates were too high for the Scottish economy, their being based on a need to curtail the overheating property market in the South East of England. As a result, house prices in Scotland rose by a much lower rate than in SE England. When the property market was hit, however, Scottish house prices fell by much less than those in the SE England – showing that whatever the impact of interest rates, any underlying structural problems ultimately need to be addressed.
I always maintain that if we were to start from scratch, no-one would suggest each country had its own currency – currency is, after all, simply a way of avoiding the need to barter (my sheep for your sack of potatoes). Having floating currencies simply allows for political manipulation designed, in the main, to mask economic problems in the short term. Politicians, after all, are only interested in solutions as long term as the next election.
There is a saying in economics that if something is unsustainable, then it will not be sustained. Sustainability is the underlying philosophy of the Green movement, and it should be adhered to in economics as well as ecology.
The euro should have been rolled out alongside national currencies instead of replacing them. What kind of system is likely to replace it if it does collapse?