English text of Novo article

In: Uncategorized

22 Feb 2012

There follows the English language text of my article on the eurozone published German in Novo online on Monday.

Much of the discussion of the eurozone crisis bears as much resemblance to reality as a Brothers Grimm fairy tale. It recounts a moralistic battle of good versus evil rather than attempting a reasoned examination of Europe’s economic plight.

The mainstream narrative will be wearily familiar to those who follow the news. In the bad corner are the Greeks and other southern Europeans who are supposedly lazy and have no compunction about living beyond their means. In the good corner are the hard working and prudent Germans. Once again, so the story goes, sensible Germans are having to bail out the irresponsible citizens of southern Europe.

Trouble is these stereotypes are untrue. According to figures from the Organisation for Economic Cooperation and Development (OECD) the average Greek worker did 2,109 hours of work in 2010 compared with 1,419 hours for the average German. In other words the average Greek worker did almost three hours of work for every two hours put in by the average German.

Similarly it is a myth that Greeks generally retire much earlier than Germans. There is little difference between Germany and Greece in this respect. The average effective retirement age for Greek men – the age at which they actually tend to retire – was 61.9 years for Greek men in 2010 compared with 61.8 years for German men. On average the effective retirement age of German women was 60.5 years; slightly more than Greek women at 59.6 years.

Nor is Germany the model of fiscal rectitude that its leaders often like to pretend. Germany breached the EU rule limiting its fiscal deficit to 3% of GDP – a rule Germany itself had insisted upon – as far back as 2002 and 2003. Although Greece also often exceeded this fiscal limit too many eurozone members that subsequently got into trouble did not. As Martin Wolf, the chief economics commentators of the Financial Times, has argued:

“Focusing on this [3% fiscal deficit] criterion would have missed all today’s crisis-hit members, except Greece. Moreover, the four worst exemplars, after Greece, were Italy and then France, Germany and Austria. Meanwhile, Ireland, Estonia, Spain and Belgium had good performances over these years.”

Fiscal problems for most countries in the eurozone only emerged after the onset of the crisis. Blaming fiscal laxity for the region’s economic plight gets things upside down.

To find the real reason for the eurozone’s plight it is necessary to look elsewhere. It lies in the attempt to create a monetary union by lumping together countries with great variations in productivity levels. These discrepancies are clear from the OECD figures for labour productivity as measured by GDP per hour worked in 2010. If America’s level is set at 100 the German level was 90.9, Spain 80.1, Italy 74.4 and Greece 57.0. The main reasons for these discrepancies is the productive level of the economy, the amount of technology employed in production, rather than the physical effort of workers.

To understand why this arrangement was always inherently unstable take a simplified model of how the eurozone operated. Assume it just consisted of Greece and Germany. Although both countries benefited from the arrangement in the short-term in the longer term it was just a way of evading their economic weaknesses.

For Greece, at least until the emergence of the crisis in 2009, the eurozone helped provide it with a source of cheap credit. Since it shared the same currency its debt was considered almost as good. It could borrow money in the international markets at about the same rate as Germany. This arrangement provided a pleasant boost to Greek consumers in the short-term but in the longer term led to the emergence of a financial bubble.

Once the challenges facing the country became apparent its membership of the eurozone deprived it of the standard mechanisms for short-term adjustment. It could not devalue its currency because it had adopted the euro in place of the drachma. Nor could it adjust its interest rates as they were set for the eurozone as a whole by the European Central Bank in Frankfurt.

It is easy to forget that Germany too received an artificial boost from the existence of the eurozone. It meant that German exports were significantly cheaper than they would have been if it had retained the mighty Deutschemark. Taking this factor into account it is clear that Germany’s economic performance in recent years is much less impressive than often assumed. It has relied on the combination of an artificially weak currency to promote exports with the suppression of wages at home.

The eurozone can therefore be seen as a vehicle for economic evasion. It allowed Germany to sidestep the need for restructuring and new rounds of investment. It also evaded the challenge of developing Greece into a more modern and productive economy. Ironically it ended up widening the gap between the two economies despite tying them together in a monetary union. What is remarkable about the eurozone is not that it eventually went wrong but that it ran smoothly for about a decade.

To make the picture more complete it is necessary to examine one more important element. Banks were the main conduit for the flow of funds from the core eurozone countries to the periphery. In our simple model this would mean German banks lending to Greece. In reality it involved banks from many European countries, including non-eurozone states such as Britain and Switzerland, increasing lending to countries of the European periphery.

There was a surge in regional lending in Europe in the years running up to the emergence of the crisis in 2009. Cross-border, euro-denominated liabilities of eurozone banks shot up from about €2 trillion with the advent of the eurozone in 1999 to about €10 trillion in 2008, according to the Bank for International Settlements, the central bank for central bankers.

Once the crisis emerged it meant that the integrity of the banking system quickly came under threat. The banks ended up holding a lot of bad debt among other difficulties they faced. Although the eurozone turmoil is often discussed in terms of the troubles facing countries, particularly on the southern periphery, it is also a threat to the region’s banks. The motivation for “bailing out” countries such as Greece has much more to do with shoring up banks from core eurozone countries than helping Greek people.

In this context it should be remembered that although bank lending was regional the banks themselves remained largely national. For instance, it was French, German and banks based in other countries that were lending to Greece. A truly pan-European banking system did not emerge.

Hyun Song Shin, an economics professor at Princeton, has pointed out that although bank liabilities in the eurozone are relatively free flowing the assets are less mobile:

“Compared to other dimensions of economic integration within the Eurozone, cross-border mergers in the European banking sector remained the exception rather than the rule. Herein lies one of the paradoxes of Eurozone integration. The introduction of the euro meant that “money” (that is, bank liabilities) was free-flowing across borders, but the asset side remained stubbornly local and immobile. As bubbles were local but money was fluid, the European banking system was vulnerable to massive runs once banks started deleveraging.” (“Global savings glut or global banking glut?”, Voxeu, December 20, 2011).

From this sketch it should be clear that the problems that have emerged in the eurozone are not incidental. Nor should they be blamed on the moral failings of its citizens.

The eurozone is a technocratic institution that was flawed from the start. It ties together fundamentally different types of economies into a rigid structure. It also attempted to evade dealing with the challenges facing the region’s economies rather than facing up to them.

The best first step towards tackling Europe’s economic weaknesses would be to dismantle the eurozone. That would remove the institution’s inherent imbalances and put pressure on countries to tackle their fundamental problems.

A genuinely united Europe would be welcome but it would need to be a democratic initiative that faced up to economic challenges rather than evading them. It can only be achieved if the institutions of the eurozone and the European Union are abolished.