No one doubts the commitment of many in the EU to seeking a way to prevent the Euro breaking up. The Euro project is deeply embedded in the European establishment. But, are they fighting a lost cause? Are the structural problems with the single currency so severe, they would be better off pursuing an orderly break-up? Or would the break-up of the Eurozone lead to an even worse period of instability and economic crisis?

Reasons Why the Eurozone is heading for a Break-up

1. There has been no Economic Harmonisation

Harmonised competitive indicators in the EU (2011 Q1), source: ECB Stats based on unit labour costs indices for the total economy:

Since 1998, Germany (DE) has seen a reduction in labour costs of 18.5%. By contrast, Italy and Ireland have seen an increase of 6.6% and Greece of 9.7%.

The Eurozone is not an optimal currency area. There is a huge difference between northern European economies (Germany) and Southern European economies. This is not a difference in debt levels. It is a difference in productivity and relative wage costs.

In normal circumstances, this would not be a problem because the German currency would appreciate due to its hyper-competitiveness – and the exchange rate of Italy, Greece e.t.c. would devalue, but this has not happened because the Euro permanently locks in exchange rates. See also: (competitiveness in Europe) | Two Speed Europe

2. Current Account Deficit

• This divergence in labour costs, productivity and inflation is reflected in the current account statistics within the Eurozone. In particular, it shows that Germany has had a persistently large current account surplus, which is matched by a current account deficit in other Eurozone economies.
• With a fixed exchange rate, German goods have become more competitive in the Eurozone. Southern Eurozone goods have been uncompetitive. The exchange rate imbalance is a significant factor in the persistently low economic growth in Southern Europe.
• Without a mechanism for exchange rate adjustment within the Eurozone, the current account imbalances will persist.
• Furthermore, this issue rarely gets much attention. The EU and Germany frequently talk about the need for internal devaluation for countries to regain competitiveness. But, internal devaluation is causing economic misery of unemployment and falling GDP.
• Economic Imbalances in the Euro by Christian Schoder 2011

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Readers Question: How sustainable do you think that the austerity measured imposed on European countries are in economic and political terms?

This is a good question. Firstly, I feel there is a certain political appeal of austerity. See: Why is austerity politically popular?

When austerity was introduced, there was a reluctant support for austerity – because of the widely disseminated view it was necessary. However, as time passes and austerity appears to have given more pain than gain, the political support will continue to dwindle.

A politician promising to ‘get tough on debt’ has a certain political capital. A politician promising to bring in counter cyclical budget policies is  (firstly, is very rare) and also likely to get ignored or mis-understood. There is growing criticism of austerity, but it is a rare to hear a politician talking about – targeting full employment, running a bigger cyclical deficit and / or monetising debt.

There are a few issues:

Unemployment is a marginalised political issue

Eurozone Unemployment

In my opinion, unemployment is one of the greatest personal finance disasters and one of biggest economic / social problems facing society. It is not just a loss of income, but also a loss of self-esteem because you don’t have the opportunity to contribute to society. But, there never seems to be the same political urgency to tackle high unemployment. When the Coalition government was elected in 2010, the impression I got is that they were more concerned with reducing the budget deficit than tackling unemployment.

The ECB seem to live in a bubble where they define economic success as achieving an increasingly meaningless inflation target, budget deficit reductions and lower bond yields.

However, with unemployment rates in Europe continuing to increase, it may become a bigger issue amongst the electorate. If European policy makers don’t engage with the unemployment issue, there may be an increased gap between the unemployed and policy makers.

Austerity hasn’t worked

Generally, a temporary rise in unemployment and fall in GDP can be shrugged off. However, the problem with the austerity policies of the last few years, is that they have left Europe in continued difficulty. Even by a very narrow view – measuring success by debt to GDP targets, it has often failed (Austerity self-defeating). Some of the worse affected countries like Greece, Italy and UK are failing to stop the rise in debt to GDP.

EU debt

But, in the bigger picture, austerity and monetary inflexibility are contributing to a significant double dip recession. Unemployment for 6 months is one thing, but a rise in long-term unemployment is much more serious.

The problem Europe faces is that it is hard to see where strong economy recovery is going to come from. With tight monetary, tight fiscal policy and fixed exchange rates, there is an inertia – preventing economic recovery and reducing unemployment. Even countries who don’t need to pursue austerity – Germany and Netherlands have embraced the trend for cutting spending. The consequence has been to push European growth lower. There is a real danger of a lost decade; we already have lost half a decade.

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Readers Question: In response to the post on ‘printing money, imports and inflation’, why can’t the British government just print lots of money and import goods from abroad to relieve the pressure on its budget?

In theory, they could do that. But, if you print money and spend it on imports, you would see a significant depreciation in the exchange rate. The British government can print Pound Sterling, but to buy imports they have to increase supply of Sterling on the foreign exchange, leading to a lower value of Sterling.

With a big increase in import spending, there would also be a deterioration in the current account. Though the depreciation in the exchange rate would offset this because the depreciation in the exchange rate makes exports more competitive.

The problem of the depreciation in the exchange rate is that it would lead to imported inflation. The price of imports rises and this contributes to cost-push inflation leading to lower living standards. There would also be a concern that a depreciation in the exchange rate may cause exporters to have less incentives to cut costs and improve efficiency because they can rely on the ‘easy’ option of a depreciation.

Also, there would be an adverse impact on market confidence. Ff the government  printed significant amounts of money to buy imports, it would discourage foreign investors from holding UK bonds. Because foreign holders of UK bonds would see a fall in the value of their UK investment.

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