The Flaws of Common Currency

The latest episode of political turmoil in Italy should not come by as a surprise. In a country which has had 64 governments since World World 2, instability and chaos are very much the norm. But Italy’s recent political crisis was more than just the next chapter of national political drama. Far from it, the crisis was a microcosm of deep divisions within Europe about the EU’s role, its power and its future. The elections in March shocked the European establishment, producing huge wins for the anti-establishment Five Star Movement and the Far-right Lega Norde. The parties share a common distaste for the Euro, Germany’s imposed austerity, and immigration. As was the case with Greece, Brexit and the Eurozone crisis as a whole, European elites have been quick to blame the forces of populism for the bloc’s instability; But perhaps the time is right for Europe’s leaders to think introspectively. Rather than point fingers continuously, European elites, not least Germany, should recognize their own flawed policies, responsibility and lack of ambition which has contributed to rising Euroscepticism across the continent..

Criticism of the Euro featured heavily in Italy’s electoral campaign, and not without reason. Adopting a common currency for a set of nations with vastly different cultural, political and economic preconditions was always going to prove problematic. While the debt crisis which engulfed Europe involved a complex variety of factors including sluggish productivity in the South, cheap money and excessive capital flows leading to market bubbles, many economists originally foresaw the fundamental design flaws in having a common currency without a fiscal union. After all, taxation and spending in Europe are not centralized like in the United States, where federal money constantly flows to poorer, struggling states through institutions like Social Security and Medicaid. Europe is, however, a monetary union. The trouble is that by centralizing monetary policy to the European Central Bank, member states joining the Eurozone lost their ability to influence interest rates, a crucial instrument to deal with economic and financial risks. As financial surpluses created in rich, Northern countries like the Netherlands and Germany helped finance accumulating debt in Europe’s periphery: Ireland, Spain, Portugal, Italy, and Greece received huge sums of money to finance property bubbles. Under normal circumstances, the states would have been able to raise their interest rates prior to the crisis in the hope of discouraging excessive borrowing, ensuring the economy does not overheat. Another possibility would have been to devalue their respective currencies in an economic downturn, thus expanding their external competitiveness and boosting exports. But countries in the Eurozone lost that ability when joining the single currency. As Stiglitz puts it, the struggling economies in Europe borrowed in a currency they could not control.

While the blame for the crisis is often put on the shoulders of irresponsible, poorer European States, Germany’s self-centered approach is a case in point. In the years leading up to the market collapses of 2007, rising consumer demand fuelled by capital flows from Europe’s core contributed to increasing wages and inflation in Europe’s southern countries. While consumer demand and inflation in Southern Europe significantly outpaced that of Germany, the end result was decreased competitiveness of Spain, Greece, Italy, and Portugal’s manufacturing sectors vis-a-vis Berlin. In other words, Germany’s goods became too cheap in relative terms for the struggling peripheral economies to compete with. Meanwhile, despite low unemployment and a strong economy, domestic demand for Eurozone imports in Germany remains low. Weak demand in Germany coupled with the competitiveness problem translates to low imports from struggling economies. Economists such as Simon Wren-Lewis, Joseph Stiglitz, and Paul Krugman view this situation as unsustainable in the context of severe economic recessions in Europe’s South. At a time of record low interest rates, they argue that Germany should take steps to trigger domestic demand and increase inflation vis-a-vis the Eurozone. This would not only alleviate the competitiveness problem outlined above, but would also reduce debt in real terms, since inflation translates to a decreased value of money over time. So why not try this solution? Well, for historical reasons mostly, Germans have a deeply rooted fear of inflation. The hyperinflation of the 1920s which contributed to Hitler’s rise continues to have major implications on German economic and political culture. The European Central Bank’s central mandate reflects German interests: Unlike the US Federal Reserve which also aims at tackling unemployment, the ECB’s central task is to maintain price stability.

Mind you, inflation isn’t the only fear of German society. Perhaps unsurprisingly, debt is another. Only 36% of Germans aged over 15 possess a credit card, compared to 62% in the US. Similarly, despite being the EU’s strongest economy, Germany ranks last in Europe for home ownership, reflecting a reluctance to take mortgages. This aversion to debt and insistence on financial discipline has been evident in EU institutional arrangements as well as Germany’s policy response to the debt-struck countries of the Eurozone in the years following the crisis. Heavy borrowing and spending governments such as Greece have been labelled as irresponsible and profligate, while the Troika-imposed austerity is deemed as a necessity to restore fiscal discipline and repay debts. You got yourselves in this mess, and you must now cut spending to get out of it, goes the narrative from Berlin. Germany sees’ financial crises as a function of the excessive use of cheap credits, which crucially may only be cured by cuts in spending. Although there is much evidence to support the claim that Greece’s government acted in fiscally irresponsible, even reckless ways, this narrative misses the larger picture of why the crisis happened in the first place. Take Ireland and Spain, for example; both ran a budget surplus before the crash of Lehman brothers sent the entire global economy into oblivion. Spain’s debt to GDP ratio in 2007 was a mere 35.6%, nearly 30 percentage points lower than Germany’s at the time. Similarly, fiscal irresponsibility cannot explain why Finland, a technologically advanced country with low levels of government debt, a highly educated workforce plunged into 8% GDP contraction after the crisis.

These arguments have not altered Germany’s stubborn approach to the crisis. Bail-out institutions (of which Germany became the main contributor) including the Troika insisted on severe cuts in public spending, ‘structural reforms’ and higher taxes as a precondition to handing out loans. Austerity in Europe was sold as a necessary medicine which wouldn’t taste good, but would ultimately lead to economic recovery. The idea behind austerity is simple: When governments cut spending in a display of financial prudence, deficits fall and markets and investors are reassured. As a result, bond yields and interest rates remain low, encouraging business to spend and invest, leading to recovery. In other words, private sector confidence resulting from fiscal discipline becomes the engine of economic revival. Critics refer to this narrative as The confidence fairy. The results of such policies have in fact been quite different. In the UK, when George Osborne announced his government’s budget cuts of 81 billion in 2010, consumer confidence plunged to record lows in 2012. The numbers also tell a similar story for investment: Italian capital investment as a percentage of GDP has fallen from a level around 22% pre-crisis to 17% in 2017. Portugal, meanwhile, experienced a decline from 24% in 2007 to mild fluctuations around 15% since 2012. Unsurprisingly, these countries suffer from persistently high unemployment, coupled with low aggregate demand and investment. Austerity critics thus argue that in recessionary situations, the government should spend more, in order to offset the decline in private investment. Proponents often point to Canada’s austerity success story of the 1990s; But Canada’s economic upturn was strongly linked to its currency devaluation and strong exports to the United States, economic tools which countries ‘trapped’ in the common currency and struggling with competitiveness cannot resort to. As a result of austerity, economists like Paul Krugman have called the period since the financial crisis a “lost decade” of permanent economic damage. On the optimistic front, the crisis has opened discussions about possible reform of the European financial system, including the introduction of eurobonds to share financial risks, as well as setting up a European-wide budget resembling a fiscal union. But Angela Merkel has dashed those hopes repeatedly, not least in a recent interview for Frankfurter Allgemeine Sonntagszeitung.

Meanwhile, disillusionment with the EU is very much on the rise. Economic woes linked to a flawed common currency architecture and the doctrine of austerity have done little to quell the rise of Euroscepticism across the continent. These problems have only served to strengthen populist and far-right narratives that European institutions act in the service Europe’s economic superpower Germany at the expense of poorer states. Unsurprisingly, Matteo Salvini, Italy’s interior minister and leader of the far right Lega party, has recently described the Euro as “A German currency”. On the face of it, who can blame Germany for defending its own economic interests? After all, for all the idealistic talk, Europe is not a national community but a collection of nation states with their own priorities and interests. Thus some argue that expecting Germany to embrace a progressive vision of debt mutualisation or fiscal union at the expense of German taxpayers is naive at best, and deluded at worst. However, one must not forget that no country has benefited more from Europe than Germany. Hence, a stable, crisis-free Europe is in fact in Germany’s interests, while the status quo has proved incompatible with stability. Italy’s recent election is the latest example of rising anti-European sentiment across the globe. The 5STAR movement, Italy’s largest parliamentary party benefited from an electorate concentrated in Italy’s southern regions, those hit hardest by austerity and unemployment. Young Italians, of which a third are jobless, also came out in numbers to support the anti-establishment party. They view European elites as responsible for the budget cuts of successive Italian governments which have depressed their economic needs and ambitions. It should also worry European elites that parties like Italy’s Lega or France’s Front National calling for their own versions of Brexit are no longer considered the political fringe in Europe. And it isn’t just the far-right. Jean Luc Melenchon far-left France Insoumise, for example, runs on a platform of withdrawing from European treaties. Melenchon himself performed much better than expected in France’s presidential election last year.

The shift of anti-EU sentiment towards the political mainstream is wake-up call for European elites to embrace bold visions of much-needed reform. At a time where external threats such as migration and an increasingly isolationist United States further compound Europe’s problems, the solution is to strengthen from within and reform. A refusal to accept this reality could potentially lead to the implosion of the world’s most ambitious political project.