Euro Is a Common Liability (Part I of III)

By Henri Erti. Originally published on 2012/12/06

“Euro Is a Common Liability” is a 3-part series response to Aleksander Thomas’ EST article “ The Euro Is Our Common Fate“. For part II, refer here.

The Euro-zone has entered an expected consecutive recession, which has resulted in diminishing public confidence in EMU policy-making. With negative growth prognosis in the Euro-zone, issues have been multiplied and solutions simplified. As a result such a  detrimental status quo exacerbates the inconvenient truth about the common currency.

IMF Knows Best

The general global feeling of uncertainty has increased as the Euro-zone has been declared as the most probable source of future economic instability. Such scenario is not what the the founders of the Euro envisioned upon its establishment. Even when the annual IMF Global Financial Stability Report painted a grim picture for the followers of the EMU, potential actions have been procrastinated for the sake of political credibility.  Therefore, we must ask why hasn’t the Euro performed the way we would like it to do during the crisis. The answer is quite simple: The idea of the Euro was rushed and forced in order to create a new political balance of power not based on basic economic principles.

Irreversible Cycle

The awkward combination of the dangerous debts at the peripheries and healthy stability at the core has in fact created a tacit disequilibrium. The reason why the European economy has survived has been mostly due the German fiscal prudence and inherited monetary discipline of the Bundesbank to the ECB. It is detrimental to assume that the economic performance of the core economies will lift the Euro from its path. The reason why, for example, the German economy has sustained its relative strength is a direct consequence of the pernicious cycle between the ECB, distressed peripheries and Germany.

As the Bundesbank lent money to banks at the peripheries due to their positive economic growth prior to the crisis, these banks invested the money in their internal projects. As the overheating of these economies materialized, the Bundesbank withdrew its loans. However, these economies became dependent on external financing of their public goods/services, hence the ECB substituted the loans through its funds. We must note that the ECB funds to loans are financed to a great proportion from the core states’ investments to the ECB, hence the cycle is a self-fulfilling dilemma. In other words, the healthy core economies, mostly Germany, are collecting the profits of their central bank investments, which are transferred from the ECB funds to the peripheries through high interest rate loans.

Paradox of One Monetary Policy

The issues faced today are not new developments of the economic instability on the peripheries. The issues are located on the fundamental level. Setting one monetary policy for all in Europe is detrimental given such policy implementations are incomprehensive due to differences in economies of scale and heterogeneity. Mandating one exchange and interest rate to countries with vast differences in output is frankly impossible. If one economy suffers from an imbalance of payments, it would have the freedom to depreciate its currency to boost exports without directly jeopardizing other economies. Furthermore, adjusting interest rates to tackle inflation through domestic wages and prices would be decided within a country, not in Frankfurt. Speaking of Frankfurt and ECB, we can suggest that the ECB is de facto the Bundesbank. given its abhorrent fear of inflation, which has been a dominant German policy even before the Euro. As a matter of fact the raison d’etre of the ECB is to control interest rates and inflation from rising to unsustainable levels. However, the interest rates at the peripheries today suggest that the ECB has not even managed to follow its own purpose.

We Know the Solution, But…

In theory the Euro-zone instabilities could be solved by freezing inflation at the peripheries and increasing inflation at the core. However, as we remember from history, the Bundesbank has had a stern attitude towards inflation, hence ECB policy has been parallel to its most influential partner. Admittedly, the ECB’s decision to update the ESM and establishing the OMT in order to finance bond purchases in the peripheries, is a significant step. However, purchasing toxic assets, by using the finance from wealthier European economies, is a short-term solution. By injecting further liquidity without regard for growing inflation, the current problems are pushed to the future. Furthermore, improving liquidity pushes the value of the Euro up, making exports outside Europe less competitive, thus only exacerbating the fiscal instability. Advocating for the banking-union is perhaps the most credible solution, but even if the proposal is accepted, this would become reality in 2020. Not sure whether the Euro can wait another 7 years.

This Is Ugly Reality

Attacking the Euro without any empirical data or credible logic would be severe populism. However, we must be fair by taking a step back and observe the situation as it is. Yes, abolishing the Euro would be extremely expensive in the short-run. But at the same time we must realize that the increasing costs of maintaining it, will soon be more than the potential costs of not having the Euro in some countries. In all honesty, the Euro zone is currently the most volatile and fragile area and the offered solutions will only accumulate the costs to unsustainable levels. And we, the next generation, must bear the costs.