The Euro Crisis-Bred In The Bone

Ed Dolan, economist, euro crisisThis post is by guest blogger, Ed Dolan (you can find him on Twitter as @dolanecon). He is an economist, writer and educator who wants to make economics understandable to everyone. We continue to celebrate our 3rd anniversary of this Twitter chat as we explore the Euro Crisis, politics and the global economy this Friday, July 27th, at 5pm BST/12pm ET/9am PT on #KaizenBiz.

The slow-motion disintegration of the euro area is the least surprising economic crisis of modern times. It was bred in the bone when EU leaders ignored all that was known about the benefits and risks of currency areas in pursuit of political objectives.

Advantages of the euro…

The chief advantage of a shared currency, as economists have long known, is that it fosters increased trade by reducing costs and risks of exchanging currencies. In itself, that is all to the good. It also has the political lure, for some leaders, of appearing to be a step toward the goal of a United States of Europe.

And yet, the European Union is not the United States

The trouble is, Europe is not the United States. The US has gotten along very well with a unified currency ever since the end of the Civil War. Here are the key differences that allow the dollar to work while the euro struggles:

  • The member countries of the euro area are more structurally diverse than US states in terms of level of income, legal systems, culture, productivity trends, and exposure to external shocks.
  • European labor markets are less flexible. Countries that have independent currencies can absorb structural shocks through appreciation or depreciation of their exchange rates. Where exchange rates are fixed, wages take their place as the shockabsorber of last resort.
  • The EU has a radically different fiscal structure than the United States. In the US, the federal government accounts for 60 percent of total government spending. The central budget of the European Union accounts for about 2 percent of the total.In a crisis, there is no central EU government that is strong enough to rescue any but the smallest member countries.

The problems were foreseeable

European leaders knew about these problems from the outset. They staked their hopes on a set of rules that were supposed to keep a crisis from happening: Rules against excessive debt and deficit, declarations on harmonization of tax and labor policies, strict sanctions against those who broke the rules, and a prohibition against bailouts of the weak by the strong. They also introduced a European Central Bank that was supposed to have one and only one objective: low inflation at all costs.

Unfortunately, the rules were unenforceable from the outset. When Germany and France became the first to violate them, and suffered no consequences, they became meaningless.

Excessive structural diversity plus unworkable rules meant that failure was only a matter of time. Faced with the shock of the global financial crisis, the rules began to bend. Now they are rewritten week by week at crisis summits. The end game is underway. It is no wonder that to many, the price of holding the euro together—a generation of high unemployment and economic stagnation—no longer seems worth paying.

How would a breakup of the euro affect current members and the world economy as a whole?

Some observers point to the quick recovery of Argentina after it defaulted on its sovereign debt and abandoned its currency board link to the dollar in 2001. Individual countries like Greece, Ireland, or even Spain might experience the same good fortune, especially if they could negotiate an orderly exit.

The consequences of a breakup could be especially hard on Germany. For one thing, membership in the euro, which contains weak as well as strong members, helps hold down Germany’s exchange rate. A reissued German mark or a scaled-down “Northern euro” might appreciate rapidly and undermine competitiveness, as has happened in Switzerland. Also, German banks would be exposed to sovereign defaults.

China would both win and lose from a breakup of the euro. Germany, the world’s second largest exporter, would be a less formidable competitor, but the EU is also China’s largest market for its own exports. Devaluations in Spain, Italy, and elsewhere could mean a significant loss of markets.

The United States would be more likely to lose than gain from a euro breakup, especially a disorderly one. The US recovery is already fragile; more uncertainty could push it back into recession.

How would you describe the level of optimism shown by EU leaders given the variety of cultures and fiscal policies of each country?

If each country has its own market bubbles & fiscal concerns, how unified can the euro be over time?

Is political leadership the biggest obstacle to resolving the euro crisis? Why/Why not?

Who actually pays for the Eurozone crisis?

Where is the real growth in the global economy?

How long do you expect the global economy to remain volatile?

About the author: Ed Dolan is an economist, writer, and educator with many years of experience teaching in the United States and Europe. He is the author of Introduction to Economics from BVT Publishing.


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