Wednesday, July 08, 2015

The euro question.

Greece GDP per capita nearly tripled in the fifteen years prior to it Greece adopting the euro. It has been a disaster since then. Maybe the crisis is about the idea of the euro, not just about Greece.

When Greeks went to the polls last week, did anyone really imagine that they were going to vote to accept German terms to end the current round of the Greek financial crisis? In the middle of an economic depression, would Greeks really vote to cut pensions for the poorest Greeks, along with the middle class, to further cut social services and to raise taxes across the board, for the promise that--for the moment--they can remain members of the Eurozone?

How would voters across the United States have responded back in the darkest moments of the 2008 financial crisis if our political leaders who were considering a massive bailout of our financial system had put the question to vote: Shall the US Government and Federal Reserve Bank provide a couple of trillion dollars to bail out AIG, Citibank, Goldman Sachs, and other global banks who lost their shirts on complex financial bets... Of course we would have voted no. And so did the Greeks.

Greek Prime Minister Alexis Tsipris knew this. He knew that the Greek demos--the ones who literally brought us democracy to begin with--would not vote to assuage the Germans, to prostrate themselves before the world and apologize for their profligacy and laziness. This was not going to happen, whatever the carrot might be. He wanted a no vote, and he got a no vote.

Few knew better than the Germans that this would be the outcome. After all, they too had once been a defeated people, suffering in the wake of their defeat in World War I under the cruel thumb of foreign powers. They had accepted treaty obligations under duress and built up debts that buried the German nation in a deep depression. Like the Greeks last week, the German volk did not sit back and accept responsibility for their past misdeeds and the wretchedness of their circumstances. When the opportunity came, they voted for a political party that promised relief from the Treaty of Versailles and Germany's World War I debts.

Long ago, in the wake of two world wars, there was a dream of a united Europe. It was a dream of those who believed that German power in the heart of Europe would best be restrained if it were placed in the center of an economic union. And it was a dream of the French to create a third force that would counterbalance the influence of the United States on the world scene.

Six years after the European Union was finally created in 1993, the euro was introduced as the common currency of 19 of the 28 member nations of the EU. But monetary unions created among otherwise independent nations are complicated concepts and historically almost never survive. When the global financial collapse came in 2008, the weaknesses of the Eurozone became pronounced. In the face of impending financial collapse across the continent, German Chancellor Angela Merkel made clear then as she did last week with respect to Greece: each European country is responsible for its own banks and its own debts. One nation after another bailed out their banks. There may have been a European Central Bank, but there was no European central banking system as we understand it. There was no interdependency, and--as the Greeks learned painfully last week--there is no deposit insurance.

The financial crisis of 2008 begged the question of whether the concept of a united Europe itself had failed. Neither of the two original ambitions of a united Europe had been realized. Far from being tamed, Germany emerged as the single dominant European economic power, and on foreign policy Europe failed to emerge as a unified force in political or military terms. With respect to the rationale behind the creation of the euro, the 2008 collapse rendered quaint notions of Europe decoupling from the dollar, and as continued technological change made currency markets seamless to consumers, EU nations with their own sovereign currencies have seen no disadvantage in being outside of the monetary union.

But whatever its failings, the creation of the Eurozone has been a boon for Germany. As an export-driven economy, the common currency has provided Germany with captive export markets where it can sell its goods with no fear of its currency value rising against that of nations that buy its stuff. Germany has outperformed all other countries in the Eurozone since its creation, and there are structural reasons why that go beyond traditional images of German workforce discipline and superior engineering.

In the normal world--a world of freely exchanged currencies among independent nations--an importing nation has to purchase the currency of an exporting nation to buy the stuff it wants. That demand for the currency of the exporting nation pushes up that currency's value. If the exporting nation wants to keep the value of its currency from rising--which would make its stuff more expensive and thus make the exporting nation less competitive--the exporting nation has to buy something in return from the importing nation in order to keep the trading levels of the two currencies in balance. This interrelationship is central to global trade and national economic strategies.

Asian nations that have prospered since World War II provide examples of how trade and currency flows work. Those nations--like Germany--built their economies over the past fifty years with "export-driven" strategies tied to a currency "peg." A currency peg, in this case, refers to economic policies designed to keep a given nation's currency in a stable relationship with the US dollar. In order to sustain an export-driven economic growth strategy over time, as a nation's exports to the United States grow, that nation must balance the upward pressure on its own currency by recycling those dollars back into the United States, whether by purchasing goods and services, buying US Treasury securities or other means.

In Europe, the creation of a single currency has allowed Germany to avoid the need to adopt economic policies to manage the value of its currency relative to its trading partners. Since the creation of the Eurozone, Germany has been able to sell as much stuff as it wanted to across Europe with no resulting pressure on the Deutsche Mark, for the simple reason that there no longer is a Deutsche Mark. As an export engine, Germany has been able to build its manufacturing economy at the expense of other European economies with no fear of having to address a rising currency value.

For the weaker, southern European economies in particular, being in the Eurozone has been problematic. Open trade and currency markets provide important feedback loops to participating nations that guide them toward policies that will balance currency relationships and bi-lateral capital flows over time. Stronger countries have incentives to invest in weaker countries where costs are lower, while weaker countries have incentives to improve labor productivity and adopt other policies to support economic growth. The creation of a currency union disrupts those feedback loops and distorts decision-making in each country, as has been evident in Greece.

Over its fifteen years as a Eurozone country, Greece has underperformed a wide range of regional non-euro countries, including those in and out of the European Union. The histogram below presents data from the International Monetary Fund that suggests that European countries outside of the Eurozone have fared far better than Greece over the past fifteen years. Many of those countries faced far more difficult social and economic challenges--particularly those emerging from the Soviet block--than Greece has faced, yet they adapted to the demands of international markets.

The measures that Germany has demanded that Greece implement--reduced pensions, labor market reforms, delayed retirement--mirror those that currency and capital markets would have pushed Greece to make if it was not in a currency union. A central element of the crisis in Greece has been the problem of forcing difficult decisions through a political process--as reflected in the Greek vote against capitulating to German demands--instead of making those difficult decisions in response to market forces, as did those non-euro nations illustrated in the histogram.

The Greece financial crisis has become a long-running morality tale, pitting the profligacy and obstinance of the Greeks against the fiscal rectitude of the Germans, but it is not that simple. It is true that the Greeks are profligate. They refuse to pay the taxes that they owe. They retire too early, and they have little regard for the rules and regulations of financial prudence that are innate to the Germans. All of that may be true, but is secondary to whether membership in the Eurozone has benefitted Greece relative to the status quo ante. 

The graphic below illustrates the point. It presents a comparison of the trends in industrial production in Greece and Germany before and after the adoption of the euro by Greece. Few people seem to recall Greece when it was a poor, developing country with dirt roads everywhere and few signs of affluence. Voluntary payment of taxes--what we take for granted in the United States--is the exception not the rule globally, so that alone is not a measure of economic maturity. Indeed, non-collection of taxes--translated into a low effective tax rate--should be a boon to economic growth, not a deterrent. As illustrated in this graph, Greece had experienced a long period of industrial growth prior to joining the Eurozone, as GDP per capita almost tripled over the fifteen year period from 1985 to 2001, the year Greece adopted the euro, from $4,832 to $12,419.

The underlying question raised by the Greek financial crisis has been largely ignored, which is whether Greek adoption of the euro--or even the creation of the Eurozone at all--was a bad idea to begin with, and one that will not get better with time. This is the question that Germany must fear, that Greece, and others, ultimately come to realize that it is Germany that has benefited most from the creation of the euro, and that others, particularly the weakest economies, may have paid a steep price to be members of the Eurozone club.