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Saving Europe from the Euro

2011-12-09

For ten years, I have predicted the demise of the euro on structural grounds. My argument is simple: a currency union requires economic amalgamation within a political union, which, in turn, requires linguistic, cultural and institutional cohesion.

The current attempt to save the euro through greater political centralization and control is folly. Even if a European political union were achieved through military force (as was attempted from 1939-1945 and again from 1945-1989) with a fiscal union imposed from above, the problem remains: linguistic, cultural and institutional heterogeneity. At best, a fiscal union would transfer money from productive members to unproductive members. It cannot reallocate economic resources.

One must face reality. Italy is dysfunctional. Greece, Spain and Portugal will never become disciplined, efficient, nose-to-the-grindstone Germanys. Nor will they suddenly convert their agricultural economies into global centers of advanced engineering. The problem is one of apples and oranges.

How, then, do Texas and Idaho coexist within a political union? Because after 200 years and a civil war, both accept the overarching authority of the Constitution, the Federal Government and the Federal Reserve System. People in Texas and Idaho speak the same language, share a similar culture and operate within a common institutional framework (laws and social norms). It is relatively easy for John to move his family and business from Texas to Idaho. It is almost impossible for Jean to move his family and business from Belgium to Spain.

A Federal Europe will not work, even if it is attempted with all the wisdom of the Framers of the US Constitution. It is for this reason that the euro should never have been created in the first place. It is why European leaders should be striving now to unwind the euro and reestablish independent national currencies. Put simply, race cars and pedestrians cannot use the same road, especially if the cars drive fast on the right, the pedestrians walk slowly on the left and the signs are all in Greek.

Regarding the current debt crisis: normally, a country can grow out of its debt through entrepreneurship, technological innovation and increased productivity. These are infeasible for the Club Med countries (Greece, Italy, Spain, Portugal) because they lack the necessary political-economic infrastructure:

  • a robust, transparent and efficient private property-rights structure
  • widely distributed human capital (literacy, numeracy, knowledge, expertise)
  • low transaction costs (information, search, negotiation and enforcement costs)
  • a culture of enterprise and entrepreneurship (optimism, courage, competition)
  • a flexible labor market
  • sophisticated capital markets

Even with liberal and intelligent leadership, organizational and institutional change is a slow and painful process. The only short-term solution is currency devaluation and lower interest rates. The alternative, to force austerity rapidly on a population accustom to artificially high living standards in order to repay foreign debt is to risk social and political instability. Do we really want another Mussolini, Franco or Papadopoulos? Dissolving the euro would rejuvenate the European economy by enabling member states to achieve equilibrium within the global economic system, assuaging rather than exacerbating nationalist sentiments.

The benefits to Club Med countries leaving the euro are enormous:

  • default and devaluation would:
    • eliminate the national debt (eliminate interest payments)
    • boost exports (strengthen domestic industries)
    • encourage direct foreign investment (create new industries)
  • regaining independent monetary policy would:
    • enable lower short-term interest rates
    • enable Quantitative Easing

The costs are significant, but not insurmountable:

  • medium-term inability to borrow on the global financial markets
  • imported inflation due to higher import prices
  • lower real incomes due to higher inflation
  • lower consumption due to lower real incomes

Yet higher import prices depend upon where one is importing from. The Club Med countries would not suffer high import prices for goods and services imported from each other. While Greece, Spain and Portugal are mainly agricultural countries, Italy does have an industrial base. The more countries that leave the euro, the broader the Club Med market of goods and services at equivalent prices. Moreover, there is an entire world beyond Europe with which to trade.

Viewed in this light, the pernicious nature of the euro becomes apparent. The Club Med countries are currently forced to compete with Germany in terms of productivity, they must accept German interest rates and adopt German fiscal constraints. Political union is not a recipe for salvation. Chained to the euro, the Club Med countries face economic stagnation.

The tragedy is that monetary union was never a necessary step for a common Europeanmarket. The European Union can function perfectly well without the euro. Economic convergence would likely be faster without a single currency. It is ironic, therefore, that the euro now threatens to undermine the whole European project.

The nettle must be grasped. The Club Med countries should default, leave the euro and establish independent currencies. They should, in other words, declare bankruptcy and begin anew with currencies that reflect economic fundamentals. Ultimately, this means a dissolution of the euro as a pan-European currency.

The question is how to unwind the euro with minimal disruption to the global financial system. The problem is that sovereign debt (government debt) is held by private banks. A full Club Med default would wipe out the European banking system.

Therefore, it is essential to prepare an across-the-board, preemptive recapitalization of European banks as was done by the US Treasury for American banks during the 2008 financial crisis. Potential sources of this funding are the ECB, the EFSF, the IMF and sovereign wealth funds. However it is accomplished legally, the end result must be a pool of one trillion dollars (or its equivalent) of capital to be injected into the banks. This could be managed by the IMF, who would take the equity position.

Following the dissolution of the euro and the reestablishment of national currencies, the banks would be free to repurchase their equity from the IMF. Also, national governments would be free to issue new debt domestically to cover their deficits (no longer burdened by high interest payments). Once the Club Med countries are restored to economic health, their governments could again borrow on the international financial markets. Importantly, the incentive for economic and political reform would come not from Brussels and Berlin through treaties and diktats (which have been notoriously ineffective in the past) but from the world at large.

That the euro was politically motivated is now patently obvious. Equally obvious is the mounting threat to the international financial system from a post-war generation who doggedly refuse to abandon the dream of a United States of Europe. Yet only by sacrificing the fantasy of that political dream can the reality of European economic integration be accomplished. Seeking to force political union now is to risk generating the very conditions of the 1930s that the European Union was designed to prevent: depression, political instability, social unrest, demagoguery, autarky and war.

ETA:

2011-12-22 What really caused the eurozone crisis?

2012-01-29 Did Germany sow the seeds of the eurozone debt crisis?

2012-04-07 Currency disunion: why Europe’s leaders should think the unthinkable

2012-06-09 100bn-euro capital injections for Spanish banks

2012-11-06 Greek chaos

2014-05-21 The euro crisis: democracy v economic efficiency?

2016-02-27 Even farther union