The Eurozone Crisis: Monetary Union and Fiscal Disunion, Part 1

Alejandro Reuss

Alejandro Reuss is co-editor of Triple Crisis blog and Dollars & Sense magazine. He is a historian and economist. This is the first part of a two-part series. His article “An Historical Perspective on Brexit: Capitalist Internationalism, Reactionary Nationalism, and Socialist Internationalism” is available here.

In 2007–8, after the real estate bubble burst, the entire U.S. economy plunged into a deep recession, the worst since the 1930s. But the downturn hit some parts of the country harder than others. Overall, real gross domestic product shrank by just over 4% between the pre-recession peak and the trough. Meanwhile, Florida, for example, saw its state GDP decline by over 11%—so, more than 2½ times as much. The official unemployment rate for the United States as a whole more than doubled from a pre-recession low of 4.4% (May 2007) to a peak of 10.0% (October 2009). In Florida, it more than tripled, from 3.1% (March–April 2006) to 11.2% (November 2009–January 2010). Florida’s state and local tax revenues declined from nearly $37.5 billion in fiscal year 2006 to about $28.8 billion in fiscal year 2010.

Do you remember, then, how officials from Florida had to engage in protracted negotiations with the federal government—the Department of the Treasury, the Federal Reserve, etc.—to get federal assistance in dealing with the crisis? Do you remember the recriminations from the governors and legislators of other, less severely affected states, decrying Floridians for their profligate spending and lazy work habits? Federal authorities’ insistence on state tax hikes and deep spending cuts, as Florida’s just penance for a crisis of its own making? The mass marches in the streets of Miami, Tampa, and Tallahassee as Floridians resisted this painful austerity?

Me neither.

The United States, like Europe, experienced what economists call an “asymmetric crisis”—affecting some regions more severely than others. We may only now be seeing some of the political repercussions of economic problems—both acute and chronic—in the United States. Yet the kind of turmoil that happened in Greece and other countries of the European “periphery”—the negotiations, recriminations, austerity measures, and massive street protests—did not happen in the especially hard-hit parts of the United States. One reason was that large-scale fiscal transfers between one part of the union and another happen quite automatically, and with relatively little contention, in the United States. Economist Paul Krugman, who has used Florida as an example of what was missing in Europe in response to the Great Recession, put it this way in a 2012 blog post: “Florida received what amounted to an annual transfer from Washington of $31 billion plus, or more than 4% of state GDP. That’s a transfer, not a loan. … Aid on this scale is inconceivable in Europe as currently constituted.”

Krugman’s analysis points to one of the structural problems with the eurozone—monetary union without fiscal union. Monetary union, the adoption of a single currency throughout the eurozone, deprived member countries of policy tools which they otherwise might have used in response to the sharp downturn. (Not all of those, mind you, would have been painless or desirable.) Meanwhile, the absence of fiscal union, that is, the lack of unification of taxation and spending at the federal level, ruled out large “automatic” transfers from less-affected to harder-hit countries.

Too United?

In one diagnosis, the severity of the European crisis—especially for the “peripheral” countries of Ireland, Italy, Portugal, Spain, and (most of all) Greece—can be thought of as a result of Europe taking economic unification too far. Key elements of Europe’s economic unification—in terms of finance, trade, and monetary union—played some role in setting off the crisis. Financial liberalization helped enormous financial flows pour from Europe’s higher-income “core” countries to its lower-income “periphery,” helping to fuel large housing bubbles in countries like Ireland, Italy, and Spain. Trade liberalization exposed domestic industry in Europe’s periphery to withering import competition from Europe’s core. The bubble-fueled boom, in addition, drove up domestic prices relative to import prices, helping push up trade deficits in the peripheral countries. The adoption of a single currency, the euro, by 19 of the 28 EU member states, however, merits special attention. Monetary union deprived member countries of two important policy instruments that they might have deployed as the crisis developed.

First, a eurozone member could not devalue its currency against those of other members. Greece’s current account deficit soared from the mid-1990s on, peaking at nearly 15% of GDP in 2008. (The current account balance is a standard international-accounts concept that includes the trade balance.) A country with its own currency might have “devalued” its currency; that is, Greece might have allowed the drachma (if there were still a drachma) to decline in value relative to, say, the deutschmark (if there were still a deutschmark). Here’s the standard argument: Devaluation would have made imports of goods from Germany more expensive to Greeks, and so tended to reduce imports. Meanwhile, it would have made Greek exports less expensive to Germans, and so tended to increase exports. Together, these effects would have tended to reduce Greece’s trade deficit. How fast or strong the effects would have been is debatable, considering how much Greek industries had been weakened over the years by punishing international competition. (To be clear, currency devaluation is not a rosy or painless option. Devaluations drive up the prices of imports and, by reducing import competition, the prices of domestically produced goods as well. The result is an erosion of real incomes, often hitting lower-income people especially hard. The country may be producing more goods and services, but because it is exporting more, its people—especially ordinary people—may be consuming less.)

In the absence of the policy option of a currency devaluation, Greek policymakers engaged in what economists call an “internal devaluation”—pushing down domestic wages in order to make Greek goods cheaper and more internationally competitive. One might say that, rather than devaluing its currency relative to other currencies, it devalued Greek workers relative to the workers of other eurozone countries. How can government economic policy bring about a reduction in wages across an entire national economy? Massive unemployment can do the trick—and it did so in Greece, to the tune of a 20% total decline in real wages between 2009 and 2013. Unemployment, of course, exacts an enormous cost in lost production and human suffering (see Evita Nolka, “The Human Toll of Greek Austerity,” Dollars & Sense, March/April 2016).

Second, no eurozone country could unilaterally increase the money supply to pull down interest rates or increase the inflation rate. Both lower interest rates and higher inflation, arguably, could have been good for Greece. Lower interest rates would have made it cheaper for Greek households and businesses to borrow, stimulating spending and boosting output. This is why “expansionary” monetary policy—increasing the money supply and lowering interest rates—is a common central-bank response to an economic downturn. Higher inflation, meanwhile, would have reduced real debt burdens. Debts are usually specified, at some point in the past, as a specific quantity of money. Inflation means that a certain number of dollars or euros (or whatever monetary unit) becomes easier to come by for anyone getting paid in the new, higher prices. This makes debts easier to pay off. A hard-hit country, then, might have quite sensibly adopted a highly expansionary monetary policy.

Monetary policy in the eurozone, however, is made not by individual countries but by the European Central Bank (ECB). The ECB’s mandate, as economist Gerald Epstein points out, is strictly about maintaining price stability (that is, low inflation). Contrast this to the U.S. Federal Reserve’s so-called “dual mandate” to maintain both low inflation and low unemployment. One might think that, in the midst of depression conditions and massive unemployment, the singular focus on low inflation would go out the window. Under a different balance of political power, it might have. But for much of the crisis, the most powerful country in Europe, Germany, successfully opposed a more aggressively expansionary monetary policy.

Germany was not hit very hard by the crisis, thanks in no small measure to its large trade surpluses with the rest of the eurozone and the world. (These large surpluses have developed since the creation of the eurozone, which D&S columnist JohnMiller argues “has functioned for Germany as a built-in currency manipulation system” (see Miller, “German Wage Repression: Getting to the Roots of the Eurozone Crisis,” September/October 2015).) Germany’s unemployment rate, declining dramatically before the crisis, turned upward briefly (to about 8% in 2009) before continuing its decline. So the urgency of stimulating spending, for German policymakers, was relatively low. In addition, German policymakers are notoriously inflation-averse. Some point to the scarring historical experience of hyperinflation in the 1920s, but the main reasons are probably more prosaic. As Frankfurter Allgemeine Zeitung economic correspondent Winand von Petersdoff remarked in a 2011 article, the real issue is not a historical “trauma” but the simple fact that “inflation is a major redistribution,” with debtors among the winners and creditors among the losers.

The structure of the European Union, it should be pointed out, also limited member countries’ fiscal policy space in two major ways (both constraints, though, were closely related to the logic of monetary union).

First, the 1997 Treaty on European Union, better known as the Maastricht Treaty, placed limits on government deficits and debt. (The 1998 Stability and Growth Pact (SGP) added mechanisms for monitoring and enforcing these limits.) As the website of the European Commission puts it, “The [Maastricht] treaty limits government deficits to 3% of GDP and public debt levels to 60%, so as to enable countries to share a single currency.” The logic of monetary union—and the fear, especially on the part of German policymakers, that deficit spending could fuel inflation—explicitly drove the imposition of “fiscal discipline” on the member states. (As it turned out, Germany and France, mired in recession in the early 2000s, both repeatedly breached the deficit limits without punishment.) The European Commission states that, since the limits imposed by the Maastricht Treaty and SGP are based on the structural deficit (the portion of the overall deficit that is not driven by the business cycle), they “take into consideration business cycle swings.” However, critics argue that the Maastricht/SGP limits have nonetheless been a major driver of austerity policies. As Sebastian Dulien, a researcher at the European Council on Foreign Relations, put it in 2012, “The severe [fiscal] adjustment programmes in Spain and Italy are all part of the normal working of these legislative acts.”

Second, when a government borrows by selling bonds in a currency it controls, it has the option of paying back the creditors by creating more money (known as “monetizing the debt”). This means that such a country really never has to default on its debts, and the creditors who have loaned it money need not fear that they will not get paid back. (As former Federal Reserve chair Alan Greenspan put it in 2011, “The United States can pay any debt it has because we can always print money to do that. So there is zero probability of default.”) Lenders charge higher interest to compensate for higher risk of not getting repaid. So if creditors do not fear default, they will lend at lower interest rates than they would otherwise. Even if a country’s public debt becomes large, so long as it controls the currency in which it has borrowed, its creditors will have little reason to panic, cut off further credit, demand immediate repayment, and thereby trigger a crisis (the equivalent, at the national level, of a “run on the bank”).

The European countries that got deep into debt, in contrast to the United States or the U.K. (which, for now at least, is a member of the EU, but has never been a member of the eurozone), owed their debts in a currency they did not control (the euro), and did not have the option of creating more money to pay it back. “When investors lost confidence in these countries, they … [pushed] interest rates to unsustainably high levels,” explains economist Paul De Grauwe of the London School of Economics, “making it impossible for the governments of these countries to fund the rollover of their debt at reasonable interest rate.” What does this have to do with fiscal policy? Unable to borrow further, these countries “had to scramble for cash and were forced into instantaneous austerity programs.”

This article was originally published in the July/August 2016 issue of Dollars & Sense magazine. Part 2 will be published next week.

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One Response to “The Eurozone Crisis: Monetary Union and Fiscal Disunion, Part 1”

  1. David Pearl says:

    Thank you for a clearly written article that seems to have much common sense. An intriguing question is: given the contradictions in the EU, should UK have Brexited? An insight voiced by Matthew Parris before the vote was that if the EU was to collapse, it would be best that we (UK) were not blamed and we should let that happen while we remained members. The hard line Brexiteers were unimpressed, of course. However, there is no doubt in sensible circles that the consequence of the vote will be a sharp readjustment and probably recession. In many ways, it’s worse than that because our financial Londoncentric base will be badly affected by most likely outcomes. This might have long term structural consequences, especially as the replacement of our invisibles by tractors etc is a fantasy. So, what else? Well, the political consequences are destabilising for many reasons, but one is the boost this has given to the wrecking voices on the left of politics. Even more ‘moderate’ policies, like exchange controls or large hikes in taxation, can’t be met convincingly with a counter-argument that stresses the financial downside. Brexiteers have cheerfully accepted such a downside in aid of their cherished aims of sovereignty and freedom from what they call interference. They can hardly now complain if at some later date the left tries the same trick. The rest of us will, however, do so and I regret the instability this presages.