Illustration by Golden Cosmos
Euro Was Flawed at Birth and Should Break Apart Now
Since the launch of the euro in January 1999, Germany and the Netherlands have experienced a growth slowdown and loss of wealth for their citizens that would not have happened had they never joined the euro.
We know this to be true, because we can compare the progress of these two Northern European economies with that of Sweden and Switzerland, which kept their freely floating currencies in 1999 and continued to grow as before. Indeed, over the period of the euro’s existence, the German and Dutch economies have grown significantly more slowly than those of the U.S. and the U.K., despite the debt crisis now engulfing the “Anglo-Saxons.”
Sweden and Switzerland grew as fast or faster in 2001-11 as they did in 1991-2001. The German and Dutch economies, by contrast, not only slowed down in 2001-2011 (to 1.25 percent from 3 percent in the case of the Netherlands), they also suppressed wage growth to adjust for the effects of the euro. As a result, real consumer-spending growth fell to a feeble one quarter of a percent a year in these countries. A recent report on the Netherlands’ experience in the euro calculated that if growth and consumer spending had followed the pattern of Sweden’s and Switzerland’s in the decade from 2001, Dutch consumers would have been 45 billion euros ($60 billion) a year better off.
Angry, of Course
No wonder the Germans and Dutch are angry. But their anger should be directed at the governments that took them into the euro, not at the hapless citizens of Mediterranean Europe, who now are also suffering the effects of the common currency.
Sweden and Switzerland didn’t have to make any such sacrifice of ordinary people’s prosperity, while at the same time they enjoyed stronger employment as well as budget and current-account balances. That leads to only one conclusion: The euro was a mistake from the outset. It should be abandoned in unison and soon. Nobody should be surprised by the persistence of divergent cost and price inflation that has occurred among the 17 countries that have adopted the euro. That divergence produced major discrepancies in competitiveness that continued to grow over the euro’s 13-year existence. Italy’s relative unit-labor costs, for example, are now 37 percent higher than in 1998, before the euro’s introduction, while Germany’s are 11 percent lower.
At the same time, wide disparities in the sustainable growth rates of the common currency’s economies have created a natural source of imbalances. These include a buildup of excessive private-sector debt that has crippled nations with fast-growth potential, such as Spain and Ireland, since the financial crisis. Contributing to this imbalance, the European Central Bank’s “one size fits none” short-term interest rate, though nominally the same for all member countries, has varied widely and counterproductively in real terms. Real interest rates in low-inflation, slow-growth Germany were higher, further inhibiting its economy. In high-inflation, fast-growth Spain, real rates were lower, encouraging the excessive accumulation of private debt.
The blithe assumption that such imbalances would be evened out by the ready mobility of labor was always flawed: In the absence of a common language, tax structure and social-security entitlements, workers were never likely to cross borders to take up job opportunities in sufficient numbers. The policy focus on keeping the budget deficits of euro members to common targets was irrelevant to these problems, and in any case was ignored even by the policy’s main proponent: Germany.
So 13 years later, where are we? Greece, if you look at the government’s monthly cash figures rather than the massaged numbers of the troika, now has a budget deficit of more than 11 percent of gross domestic product, a 4 percent to 5 percent primary deficit (excluding interest), and total debt of 135 percent of GDP net, 168 percent gross. The austerity program the Greeks are following -- their only option, given that without control of their own currency they cannot devalue -- has made both the deficit and debt ratios greater. Austerity has caused deflation of nominal spending and incomes, which have fallen by more than 5 percent, cutting tax revenue. Government debt will surge under any scenario within the euro: If Greece stays in, the correct “haircut” for its debt is 100 percent. But it could well be forced to leave later this year.
On current prospects, Italian net government debt, which is now 100 percent of GDP, according to the Organization for Economic Cooperation and Development, will be 110 percent by the end of 2013. There is no prospect of improvement, owing to Italy’s negligible growth trend within the euro. Other euro-area economies are in worse shape.
Portugal’s government-debt ratio is close to Italy’s, but business debt is, on average, 16 times net cash flow. That means the vast majority of Portuguese corporate debt is now junk, given that junk classification occurs at 10 times annual pretax- and-interest cash flow. A recession could sharply shrink business cash flow and cause a banking crash, meaning that Portugal will probably have to leave the euro shortly after Greece.
Spain’s business sector is also in the junk zone, because Spanish corporate debt stands at 12 times net cash flow. Real- estate and other asset prices, meanwhile, are heavily overvalued. Spain’s recession may slash asset values and wither cash flow, leading again to a banking crisis and soaring government debt. Spain, Portugal and Ireland have much greater total debt, once the private sector is included, than Italy or Greece -- and austerity programs are drying up the cash flow needed to return to solvency. Austerity can only work for these countries -- with the exception of Ireland -- if they leave the euro.
All these symptoms of the euro’s poor design are linked. Wage suppression in Germany and the Netherlands has created artificial cost competitiveness, boosting exports to, and exacerbating inflation in, Mediterranean Europe. Lower wages in Northern Europe, meanwhile, have ensured weak demand for imports from the South. The resulting trade surpluses enjoyed by Germany and the Netherlands were, and will be, wastefully invested in such assets as U.S. subprime-mortgage paper and Greek government bonds.
In the future, the euro can survive only if these surpluses are given away as unrequited transfers -- more or less what is happening now, in the form of bailouts. With 2012-13 prospects for global growth much weaker than in 2010-11, dependence on the German “export machine” will blight the whole European economy, heightening the malignant effects of the euro.
To prevent a meltdown, the ECB has engaged in unprecedented and dubious practices to expand the euro system’s central-bank balance sheet, accepting junk collateral against the provision of banking liquidity. The risks are increasingly confined to the central bank of the host country, which may make future exits from the euro easier. But liquidity provision will not stop fiscal tightening from deepening recessions in Mediterranean Europe, widening deficits and debt ratios, and threatening banking crises.
Most support for deficit countries so far has been indirect, coming via the ECB, the European Financial Stability Facility and the International Monetary Fund, but it’s likely to become more explicit in the future. And the totals are large. Taking care of the virtually worthless debts of Greece and Portugal, and the budget deficits of Italy and Spain over the next four years could amount to a total of 1.25 trillion euros. If Italy and Spain additionally have to be helped to refinance maturing bonds issued in the past, this cost may double. That would threaten the financial position of some of the core euro- area countries -- including downgrades of their credit ratings.
Sequential disorderly exits from the euro need to be avoided because of the huge and extended financial turbulence they would cause. Yet it is likely that the politicians running euro-area economies will be driven to make the fundamental reforms required for a return to long-term growth only if some countries do leave the currency. As a result, the simultaneous return to freely floating national currencies offers both the best economic outlook for the member states, and the least damaging euro-decommissioning process.
This would be challenging, of course, but it could be done. All domestic deposits, transactions and obligations (including home mortgages) would be converted 1-to-1 into each new home currency. The ECB would become the guardian of a legacy “European Transition Currency” into which cross-border euro contracts would be converted at the 1:1 ratio, but without money-creating powers. The ECB would have to be recapitalized by euro members that are financially strong. Major transition loans to deficit countries would be needed to permit them to re- establish national currencies that would then float freely.
And leaving the euro area is likely to be cheaper than staying in it. A recent report on the Netherlands and the euro estimated the net initial cost to that country of leaving would be 51 billion euros, an amount the economy would more than recoup within two years, by not having to continue contributing to euro-area bailouts.
The need for radical action is urgent. Spain, for example, already has an unemployment rate of 23 percent -- and 49 percent among youth -- and yet within the euro, it is engaged in a savage further fiscal deflation that is bound to raise joblessness much higher. The politics of Mediterranean Europe could soon be seriously destabilized. It is less than 40 years since the dictatorships of Franco in Spain, Salazar and Caetano in Portugal, and Papadopoulos in Greece ended. Their equivalents may not be about to return yet, but the risk of turmoil is increasing rapidly.
(Charles Dumas is chairman of Lombard Street Research, a London-based independent consulting firm committed to monetarist economics. The opinions expressed are his own.)
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