EUROPEAN stock markets are in retreat, bond yields are rising in the Eurozone periphery, and political crisis stalks Portugal. It’s a return to familiar territory, despite the best efforts of European leaders to declare the crisis over. Why are we here again? The Eurozone may be the most unsuitable combination of nations ever assembled into a monetary union.
The Eurozone embodies two divergent cultures. Club Med nations place family and quality of life foremost, worrying little about paying bills. They traditionally borrow until they can no longer do so on acceptable terms, then devalue their currencies and/or default on their debts. This behaviour is incomprehensible and unacceptable to the northern hard currency nations. They emphasise efficiency, productivity and saving. The euro could be a strong and functional currency only if the Club Med nations adopt northern European culture. But such a drastic change could never occur in a short period of time, so the euro was doomed from the start.
Before entering the Eurozone, Club Med nations had experienced much higher inflation than northern Europe, which forced them to pay much higher interest rates. Entering the euro lowered the interest rates they paid because the central bank in a currency union, the European Central Bank, imposes a uniform policy interest rate on all nations.
As a result, entering the euro reduced nominal interest rates on Club Med borrowing to levels close to those the northern nations were paying. Higher inflation in the Club Med reduced real interest rates to minimal levels, so borrowing exploded.
All would still have been well had borrowing been used to expand productive facilities that could earn the money to pay the interest on the debt, and then repay the principal by producing goods and services. But Club Med borrowing mainly funded housing and government spending. As a result, the goods and services the borrowed money could have enabled were imported. No new income was generated to pay the ever-increasing debt interest, and the principal was never repaid.
Worse, imports soared in Club Med nations, but exports remained relatively static so current account deficits rose rapidly. The northern nations supplied the bulk of the imports, but did not import more themselves, so their current account surpluses rose as Club Med deficits rose. Northern European nations could accumulate surpluses forever, but Club Med nations could not pay rising interest charges on their increasing debts forever. Financial markets soon refused to lend to several Club Med nations on acceptable terms. The time-honoured way to correct current account imbalances is for the deficit nations to devalue their currencies, and the surplus nations to revalue upwards. That is, of course, impossible in the euro.
To get around this, nations that couldn’t borrow on acceptable terms were “bailed out”. These so-called bailouts merely added more debt to the existing debt piles markets had already declared too much. The bailouts solved nothing, so the deficit nations had to devalue internally – to reduce domestic income and spending, thereby lowering imports and raising exports.
Not only did this occur when other nations were trying to do exactly the same thing, but the surplus nations also refused to increase spending to help reduce the imbalances. As a result, the economies of some Club Med countries fell into recession and unemployment soared. Unsurprisingly, imposing austerity worsened the recessions. Youth unemployment soared to over 50 per cent in Greece and Spain. In Portugal, it has reached 42 per cent. Within the confines of the euro, no Club Med nation will ever be able to raise exports to the level required to escape their current depressed state.
Monetary unions exist to promote the growth of all their members. The euro has failed miserably. Club Med is mired in depression, with Ireland and Slovenia not much better off. Not even the core nations have prospered relative to similar countries outside the euro. Sweden and Switzerland have grown significantly faster than the Netherlands, for example.
Moreover, sovereign interest rates span a relatively narrow range in a properly functioning monetary union. By contrast, market interest rates on sovereign bonds in the euro have ranged widely. The euro is dysfunctional because one-size-fits-all nominal interest rates have created current account imbalances that are uncorrectable. It is dysfunctional because it has failed to promote the growth of its members, relative to their peers outside the Eurozone.
Current account imbalances have wrecked every currency union that was not also a political union. But the divergent cultures in the euro will make changing it into a lasting political union impossible. All nations in the euro would be better off outside.
Leigh Skene is an associate at Lombard Street Research and co-author of Surviving the Debt Storm: Getting Capitalism Back on Track (Profile books).