Eurozone Has Become an Infeasible Monetary Framework

May 4, 2012
Category: General
Posted by: admin

Guest Editorial in Helsingin Sanomat

Helsingin Sanomat is the widest circulation daily in Finland.
(Translated from Finnish)

Key political leaders and decision makers in different Eurozone countries have argued for the founding of and joining in the EMU largely on infeasible arguments

Urho Lempinen

The author is a financial risk management consultant and the Managing Director of CD Financial Technology.

Historical facts suggest that the Eurozone will fragment unless the EMU member countries proceed to form a federal state.  All monetary unions in history so far have endured only a few decades unless they have lead to the founding of federal states or have been based on them.

The EMU was founded as a union of independent nations in which all member countries were to manage their economic policies under the constraints of the Maastricht Treaty. The structure of the Eurozone is ambitious: independent nations are trying to reap the imaginary benefits of a monetary union. There were no major weaknesses in the Maastricht Treaty itself, weaknesses were only in its implementation.

The main problems in a monetary union are due to differences in competiveness between countries and subsequent developments in it. When different countries operate in a common currency, competition transfers production and wealth to the most competitive countries. Differences in competitiveness arise in two ways. Some countries joined the common countries at a low and some others at a high exchange rate. The former countries obtained a competitive edge and the latter a handicap.

Relative competitiveness between countries changes due to adjustments in efficiency, productivity and cost levels over time. Germany, the Netherlands, Ireland and Finland have been the competitive Eurozone countries. On the other hand, Greece, Italy, Spain, Portugal and France have been the non-competitive countries most of the time. A competitive country becomes non-competitive over time if it is not able improve its efficiency along with Germany. Finland seems to be experiencing such a development, albeit gradually.

Imports of weak EZ countries from competitive countries have been relatively cheap at a fixed exchange rate. When supply of funding became cheap and easy, weak countries financed incremental consumption and imports by increasing their national debt.

In all countries national borrowing is increased by ‘deficit bias’. The reason for this is that while they are in opposition political parties tend to seek victory in the next elections by proposing expenditure, the financing of which they do not necessarily specify. At the same time governing parties are feeling pressure to increase spending in order to prevail in elections.

When the excessive spending and borrowing process continues long enough, only two alternatives are left: extreme contractionary policy in weak countries or direct wealth transfer from strong to weak countries. Neither alternative is easy in the long term. Contractionary policy brings about recession to the whole of Eurozone, and wealth transfer creates incentives to spend excessively at other countries expense.

The federal state would seemingly eliminate the problems; in reality it would transform them into another form. The European Commission would collect all taxes from all countries and would decide on borrowing and public expenditure in the whole region. Spending would be decided on regional grounds. Brussels would decide on the amount of spending in Greece and in Lapland. The Eurozone is hardly ready for this to be approved by the citizens.

Before inception the main economic justifications for the monetary union were increasing financial stability, faster growth, and the growth and competitive edge brought about by large inner markets.

Interest rates in the Eurozone have been historically low and relatively stable. Growth has been also stable but slow. Member countries have fallen deep in debt. These phenomena have mainly been due to the general and long standing global financial crisis, which has been extended and deepened by the debt problems of the Eurozone, but which otherwise is not directly linked with it. An economy is ill if its level of interest rates is too low for many years.

Exchange rate fluctuations have remained more or less unchanged after the launch of the euro. Therefore, exchange rate risks have been rather low. An open  exchange rate risk is much the same as the risk of a 5-10 year fixed rate bond, i.e. it is one of the lower investment risks. Furthermore, exchange rate risks are in general relatively easy to hedge. (compare: UK real estate index; why are central bankers so risk averse? Smart stupids? Complexity of issues? Alchemy?)

The cross exchange rate risks between the Eurozone countries have been replaced by severe counterparty credit risks, which are due to market concerns about the ability of member states and financial institutions to service their liabilities, and which are being continuously sorted out.

Large inner markets have slightly increased the growth rate of the Eurozone GDP, but this is mainly due to the increased borrowing of member countries. There is a slight flavor of protectionism implicit in the goal of trying to realize the benefits of inner markets. Does the ageing and weakening Eurozone need the inner markets in order to protect itself against competition? Protectionism is known to lead, in the end, to welfare losses.

It is not possible that the adoption of euro would have accelerated or that giving up euro as a separate decision would slow down economic growth of the Eurozone in the long term. The real economy is independent of the monetary economy over a period of several decades. Who does not believe in this should process through a thought experiment in which the European Central Bank donates every month 1000 euro to the bank accounts of all 332 million citizens of the Eurozone.

The economic justifications presented for the EMU have therefore not been realized. An aggregate loss may be forthcoming due to growth and welfare losses caused by implicit protectionism. The Eurozone is a wealth redistribution scheme and not a wealth growth scheme. A redistribution scheme will fall when facing disputes about the amounts to share, the principles of distribution and biased incentives. For instance the German support to the scheme would be likely to stop, if the costs of financial crisis management were to be assigned on the basis of competitiveness of member countries. (what would the cost shares be based on competitiveness; incentive problems due to punishing the austere countries)

The Eurozone crisis is in a temporarily calm before storm sentiment: what happens next? The time could also be feasible for addressing the fundamental question: is common currency to the good or to the bad of the member countries? The question is hard for the very reason that such central figures in different countries have been pushing ahead the founding of the EMU and the joining in it on grounds that are largely unfounded. (Why are we here? Political arguments for euro and their validity)

Politicians and sometimes also well known economists present the idea of Common Good as a main benefit brought about by the Eurozone. If such a concept exists, someone should write a consistent description of it so that the significance of the concept could be carefully assessed. Few would dare to accept the task?