Will the Euro Survive its Current Difficulties? Becker

The short answer is “yes”. Yet possibly much more serious challenges to the euro will arise in the future unless some important changes are made in the European Monetary Union (EMU).

When the euro was launched on January 1, 1999, I was skeptical about its long run viability primarily for two reasons. The members of the EMU maintain their ability to follow different government spending and taxing policies, and their economies are subject to specific shocks because they produce different products and services, and have varying levels of per capita incomes and wealth. Since no country has the power to print Euros, no country can offset these country-specific difficulties by devaluating their currencies relative to the currencies of other members of the EMU, or even by devaluing relative to countries outside the monetary union. Devaluation under these circumstances reduces the net import of capital by a devaluing country, and hence eases its foreign debt. In the past, countries like Italy or Greece that had, among other troubles, insufficient taxes relative to government spending, frequently devalued their own currencies (the lira and drachma, respectively). When the debt was issued in local currencies, devaluation also in effect “inflated away” some of the real value of any foreign debt.

A partial alternative to devaluation when a country is in economic trouble is for many of its workers to move to other countries where jobs are more plentiful and wages are higher. Such migration helps soak up the unemployment and reduces the scarcity of jobs caused by the economic difficulties. This is essentially what happens in the US, a common-currency union of 50 states. States that do poorly relative to other states experience outmigration of many of their younger workers. Yet migration is still quite limited within the EU, despite the progress that has been made.

However, the remarkable success of the euro since its launch more than a decade ago had been convincing me that I and other euro-currency skeptics had exaggerated the importance of these missing ingredients in the EMU. The euro has become of the most important international currencies. After falling sharply for a couple of years from its initial launch rate of close to $1.2 per euro to just about $0.80 per euro, it bounced back to reach over $1.5 dollars per euro. The euro is still above its initial exchange rate, with a current exchange value versus the dollar of about $1.35. In the past few years, considerable speculation developed that the euro might well supplant the dollar as the number one currency for international contracts and for assets held internationally.

These rosy euro forecasts have ended, at least for a while. Not only Greece, but also Portugal, Spain, Italy, and Ireland are in financial trouble with their international creditors, although Greece appears to be in the most immediate difficulties. They may all get out of these troubles without defaulting on their debt, but similar challenges are likely to arise in the future unless major changes are made in the architecture of the EMU. Either much more power over taxation and government spending has to be taken away from the individual member countries and given to the central authorities of the European Union in Brussels, or much more effective measures need to be introduced that would prevent government spending of different countries from greatly exceeding their tax receipts.

Since most countries within the monetary union are probably more willing to leave the union than give up sovereignty over their spending and taxation, the centralization of taxation and spending authority seems unlikely. Perhaps a system of fines and other punishments to weak-willed countries will be sufficiently strong to deter future transgressions, but that seems unlikely.

There is no simple way out of this dilemma, which is why Germany, after much initial reluctance, is warming to the idea of calling on the IMF to help Greece. One plan being discussed is for the eurozone countries to provide the funding used by the IMF. Since much of the IMF financing comes from the US, eurozone financing would avoid the EMU appearing to ask the US for assistance. Although the European Central Bank opposes this indirect route of helping Greece, the hope is that the IMF is more capable than the EMU of imposing stringent restrictions on Greece’s spending and taxation.

Some commentators have drawn analogies between the fiscal difficulties of the United States and Greece and other weak members of the EMU. As Posner shows, the US and Greece have many similarities in terms of fiscal deficits and the rate of annual turnover of its government debt. However, one crucial difference is that the US has a much more robust economy, and greater growth prospects.

The other absolutely essential difference is that the US debt is denominated in dollars, a currency that it controls, while none of the EMU countries can issue more Euros. If push came to shove, the US could consider meeting its obligations to creditors by issuing additional dollars, and partly inflating away its international debt burden. Inflation is a potential weapon for the US Treasury, almost regardless of whether its debt is in the hands of Americans or foreigners, although both groups would protest against seeing the real value of their assets greatly reduced by inflation. Greece can probably force domestic holders of its government debt to take severe haircuts, but aside from bankruptcy, it is much more impotent than the US against international creditors.

Perhaps, as Posner suggests, Greece and possibly also the other fiscally weak members of the EMU should be allowed to declare bankruptcy, although this is not without serious consequences for the future of the EMU. Still, the monetary union might well be stronger in the long run if its weaker members were forced out, or were forced into more responsible behavior by having to bear the consequences of irresponsible actions.

 

Comments

[Gordon Longhouse]

If the effects can be contained, some form of default would be salutary both for Greece and for its creditors. Both will be reminded that lending and borrowing money is a risky transaction; a fact that seems to have been lost on the debt markets lately.

Will a Greek default bring about a run on sovereign and perhaps other debt? I do not claim to know for certain but would point out that, unlike the situation with AIG and Lehman Bros, Greece's problems like those of the rest of the PIIGs has been flagged well in advance so default should not be a surprise to anyone and should not be seen as potentially a reflection of anyone else's credit risk.

Also the fact that this is a slow motion train wreck means that default can be planned and creditors offered certainty around how much money they can expect back and when. Something along the lines of the GM bankruptcy in which creditors had an idea of the result of bankruptcy before it began, is called for here.

Creditors would lose but by knowing approximately how much they will lose, they will be able to price their assets and sell them if needs be. Unlike during the GFC, the absence of uncertainty means the market would be able to operate though no doubt it would get excited.

Such a model if it were successful, could perhaps serve as a model for Spain, Portugal, Ireland and Italy should it be necessary.

[Chicago School and a Denier of MMGW]

"Still, the monetary union might well be stronger in the long run if its weaker members were forced out, or were forced into more responsible behavior by having to bear the consequences of irresponsible actions."

Can we force out California...?

We just created another entitlement program we cannot afford.

[Jim]

Might I suggest that all interested parties re-read Aristotles "Politics", in particular chapter 5 on democracy. As you probably know, he was an astute and long term observer of the constitutions of multiple city states in Greece. There are very clear analogs to our present situation.

[Jack]

Jim: Many of the classics are online now including The Wealth of Nations many like to quote but, seemingly, few have read. It would be good for a discussion here sometime as it appears to be a capitalism more humane (especially considering the era) than the devil take the hindmost thing our "own?" has become.

http://classics.mit.edu/Aristotle/politics.5.five.html

While musing over the basics, it might be good to consider the evolution of currency. Obviously a natural evolution of enabling trade but one that shortly led to the money changers in the temple, and surely has been an enabling factor for the "compensation" of today's CEO's to soar from 50 times working folk's "wages" to 500 times in just the last three decades.

Other than kingdoms who would agree to chipping in the wages of 500 for the "leadership" of one, unless the person was an owner, or one who clearly added value that DID "trickle down" and bring benefits and annual increases to the entire team?

And a (perhaps wild) speculation on banking. Since most of the money loaned against residential mortgages is our own, could direct micro-lending eventually replace the role played by bankers and WS thieves?

Consider, we put demand deposits in banks at a negative ROE which they can lend at some ten times assets for a typically very good gross return. Suppose that residential lending WAS done by the standards that served us well for a century or so. Then suppose that there were honest and competent bond rating firms that would rate portfolios of loans on behalf of the investing public.

The portfolios would then be available on the net for investors large and small. Could it be that the "invisible hand" of millions of investors would do better than did our bankers?

Well, in addition to all else that has been "curious" about home mortgages, I find it interesting that similarly cheap money was available in LA, LV, et al where the housing bubble was most evident
http://mysite.verizon.net/vzeqrguz/housingbubble/los_angeles.html with more than a doubling in less than a decade, as was the case in OK City and others where the "bubble" hardly existed and the subsequent deflation very small.

So, if mortgage products were sold to the public, like stocks, in geographic groupings or by other criteria would the wisdom of the market tend to limit the lending on McMansions in overheated markets? When, or if, we were wrong and a sizable correction occurred the ballast would be that of millions of direct investors not the filmy "assets" of go-go WS scammers.

[Chris Graves]

The problem with both Judge Posner and Professor Becker's analysis on this matter is that their analysis completely neglects the role of capital, both social and financial. First, if people in Europe were to copy the American model as Professor Becker suggests and move around relatively freely in search of employment, the necessary social capital that facilitates spontaneous cooperation would undermined. A common language including a common dialect and set of customs and habits all contribute to forming a way of life that supports the economic as well as the political/legal system. Investments in social capital involve time for social ties to develop along with a sense of place that roots a common way of life. These sociological processes serve to cultivate an informal cooperative system that the economy functions within. We can see this dynamic playing out by comparing the productivity of European workers with American workers and finding that several European countries boast higher rates of productivity over a specified time period, say per hour, than American workers.

The second problem with our duo's analysis this week is that it also overlooks the role of capital in funding long-term economic projects. The more complex, "roundabout" method of production involving the development of labor saving equipment tends to be underfunded over time if the interest rate is not allowed to follow market forces and if inflation distorts the time horizon of entrepreneurs encouraging them to divert resources to the final stage of production and neglect long-term investments. Consequently, there is a shortage of investment funds to sustain longer term projects and to develop a capital structure that sustains such projects in the future. The processes at work in Greece are presently eating away our capital structure as termites eat away the supporting structure of a house. It is no answer to those who point out the parallels between our own financial weaknesses and those of Greece to say that we are more productive and we can inflate our way out of trouble when even greater levels of inflation will only create greater imbalances between the stages of production and between savings and investment funds making greater productivity in the future less sustainable.

[Bogdan]

That's a remarkable post, kudos!
I am these days so afraid of what happens worldwide, and more because all my money are kept in Euro, in a Greek bank...I wonder if I should change the bank and currency...?

Thanks again,

With all the respect,
Bogdan

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