Euro crisis no surprise to economists

They were warned. In the late 1990s, eminent economists queued up to explain the flaws in the euro project. Chief among them was Nobel Prize winner Milton Friedman, who in 1999 – the year the euro was born – predicted that “sooner or later, when the global economy hits a real bump, Europe’s internal contradictions will tear it apart”.

But the fatal conceit of EU policymakers triumphed. The euro was a key plank of their long-term programme to centralise power at supranational level. Given this agenda, it is unsurprising that the EU’s response to the current crisis has been to further emasculate member states. Following the bailouts, the fiscal policies of Greece and Ireland are severely constrained. In the longer term, a similar approach may be rolled out across the Union.

The Stability and Growth Pact was supposed to prevent governments getting into too much debt. Budget deficits were to be under 3 per cent of GDP, while national debts were supposed to be under 60 per cent of GDP. But the pact proved impossible to enforce. Several countries – including Germany – broke the agreement, with no sanctions. Others only satisfied the criteria through creative accounting.

Stricter EU controls on government borrowing – for example a new Stability and Growth Pact with real teeth – clearly have the potential to reduce the economic problems associated with government debt. But policymakers are deluding themselves if they think this approach will solve the fundamental problems of the eurozone.

Applying a one-size-fits-all monetary policy to a huge geographical area with different cultures of saving and debt, different banking systems and different economic conditions, will inevitably blow up inflationary bubbles where interest rates are inappropriately low. The effect is exacerbated by the implicit bailout guarantee given by eurozone membership, which reduces the risk premium demanded by lenders.

In Ireland and southern Europe, a fake boom based on credit rather than productivity growth led to a huge misallocation of resources – particularly into property markets. Wages rose rapidly, especially in the construction sector.

Once the supply of credit dried up, this house of cards collapsed. And the countries that experienced inflationary booms now face a very painful adjustment process. Bad investments must be liquidated and wage rates will have to fall by around 25 per cent to become competitive with the core nations of the eurozone. This is horrendous. It suggests countries such as Greece and Portugal face a fall in living standards comparable to that suffered in the United States during the Great Depression.

Worse still, high levels of employment regulation in southern Europe are a huge obstacle to the necessary correction in wage rates. The likely result is mass unemployment. Southern Europe is also cursed with traditions of social unrest and hostility to economic liberalism. Moreover, rapidly ageing populations will put extra pressure on public finances, while environmental policies threaten to undermine vitally important tourist industries by dramatically increasing the cost of air travel.

Yet recovery is still possible and the EU could do a great deal to help southern European countries bounce back. In particular, it could undertake a systematic programme of deregulation, rescinding directive after directive to lower dramatically the costs of doing business. The EU can also encourage member states themselves to reform, for example by liberalising labour markets. But so far the response to the economic crisis has involved more regulation, not less. For example, many more restrictions have been placed on financial markets, which are crucial to the investment that drives recovery.

The absence of a deregulation agenda raises the question of whether the eurozone should be broken up, with some countries re-adopting national currencies – though perhaps still allowing the euro to be used as legal tender. The new currencies could fall in value, allowing wage rates to fall without overt cuts in pay. However, the devaluation option – which happened repeatedly in many countries before the euro – arguably encourages reckless tax and spend policies.

A break-up could also lead to mass defaults on euro-denominated government debt in those countries that left the zone. Much of this debt is held by banks across Europe. Default could trigger their collapse and demands for yet more bailouts. Break-up of the euro would also be deeply humiliating for politicians and bureaucrats who have staked so much on the project and a European centralisation agenda that appears to have no reverse gear.

There are large political incentives to maintain the status quo. Struggling countries will continue to be propped up by subsidies and the fundamental flaws in the euro will remain. The EU may increasingly become a transfer union which redistributes resources from more successful countries to failing ones. Necessary adjustments will be delayed and eventually the economies of the stronger nations may be undermined.

For the last twenty years, Western Europe has suffered from slow growth and rapid relative decline. The euro crisis threatens to speed up the region’s descent into economic irrelevance.

23 March 2011, PSE