The Eurozone – being ‘trapped in a dysfunctional monetary system’

On November 6, 2000, the Financial Times correspondent Wolfgang Münchau wrote in his article ‘Weak euro reflects uncertainty of euro-zone’ that “structural reforms alone will not determine whether the Emu is viable … The Europeans have no system of transfer payments and the EU budget is too small for this purpose … the euro-zone countries cannot remain as they are: they must move towards full economic union”. He also observed that the “current is clearly flowing in the opposite direction: EU governments increasingly emphasise inter-governmental co-operation as opposed to a wider role for supra-national institution”. I examined that ‘current’ extensively in my current book – Eurozone Dystopia: Groupthink and Denial on a Grand Scale (published May 2015) – as it was (and is) a major reason the monetary union has failed. And, further, the cultural and national barriers which prevented the creation of a system-wide fiscal union are still insurmountable. Münchau is one of several journalists and commentators who have shifted their positions on the desirability of the common currency yet remains wedded to the idea of retaining it – as if returning to national currency sovereignty would be a disaster. I opposed the Maastricht proposal when it was made public and remain opposed. Restoring national currencies, while initially disruptive will not in the long-term prove to be worse than what Münchau admits is a state where nations are “trapped in a dysfunctional monetary system”.

In the same 2000 FT article, Wolfgang Münchau wrote that:

It would be unwise to predict that Emu will fail: the euro may yet survive for a very long time. But the odds on its premature demise are shortening.

He had changed his tune somewhat by 2008.

On November 4, 2008, a conference was held in London to generate discussion that was “intended to help place the case for Britain joining the Euro back upon the political agenda”. A host of commentators from the academy and the media participated and a publication – 10 years of the Euro: New Perspectives for Britain – ensued.

Wolfgang Münchau was one of the participants and he contributed a chapter to the volume – ‘The benefits of Euro area membership from a purely economic perspective’.

He predicted that Denmark and Iceland would join the Eurozone along with all of the Eastern EU within 10 years. Such a move would isolate Britain in his view, which would then experience costs associated with being an “independent currency at the fringes of the Euro area”.

His reasoning was suspect though. He claimed that:

… entering the Euro does not make you any more solvent, but investors are crucially facing a different risk. If you default all on your own, like Argentina or Iceland, the result is a total bloodbath, possibly threatening the survival of the state. If you were to default as a member of a large currency zone, the process would be far more orderly.

First, entering the Euro changes the solvency potential of a formerly currency-issuing nation dramatically. The British government can never become insolvent and can always honour its liabilities denominated in pounds.

Once a nation surrenders its currency sovereignty and enters the Eurozone it immediately adopts a foreign currency (the euro) and is exposed to default risk as a consequence.

Second, I would not call what happened to Argentina or, more recently, Iceland, a bloodbath. The governments did not become insolvent in their own currencies and growth returned very quickly once the governments decided to concentrate on stimulating domestic demand and allowing their exchange rates to float.

Third, I don’t see anything “orderly” about the way Greece has been treated or the options it has faced. That case of adjustment has been brutal and will damage that nation for generations to come.

The unemployment rate in Iceland peaked around 9.2 per cent in 2011 but by September 2015 was back down to 4 per cent with the employment to population ratio rising. Compare that to Greece, which remains around 25 per cent after peaking at 27.9 per cent. It has hovered around 25 to 26 per cent for the last 3 years and there is no end in sight.

The difference is that Iceland issues its own currency, determines its own monetary policy and floats the currency on international markets. Its decision to allow its private banks to go broke stands in stark contrast to the way the Eurozone nations have behaved. The results are obvious.

But in 2008, despite his reservations about the Eurozone, Wolfgang Münchau still thought that for Britain “the benefits of staying out … will completely disappear” and that “public opinion” will drive the nation into the Eurozone.

But times change and his latest offerings indicate that he is not so confident of the Eurozone.

On October 18, 2015, his Financial Times article – Better no fiscal union than a flawed one – bemoaned the decision of the European Council to effectively ditch “the completion of the banking union” based on the German signal that “it would veto any proposals for a joint insurance of bank deposits, without which union is destined to remain an empty shell.”

The European Commission President made the creation of the so-called “third pillar” of the European banking union one of his agenda items to define his presidency.

The other pillars that have been agreed upon already are that the ECB will act as a common supervisory authority of the 200 largest banks and have power of the small banks when required and that there will be a common resolution funds and process – the Single Resolution Mechanism (SRM) – when banks fail.

The detail of these pillars is still in dispute. For example, Germany wants the single bank supervisor to be separate from the ECB.

The third pillar – the common deposit-insurance scheme – which was proposed as a means to prevent bank runs remains outstanding and arguably is the most important part of the banking union plan.

I will write a separate blog another day about why the proposed banking union falls short of what is required.

But the weaknesses are rather moot given that Germany will never support a system-wide guarantee of bank deposits – it considers that an “unfair pooling of risk”.

The European Council met on October 15, 2015 in Luxembourg. The focus of the agenda was the issue of migration which resulted in no solution – as is common in this forum.

A less reported discussion was about the so-called Five President’s report on completing the EMU. The motherhood statements emanating from the Council were that (Source):

The European Council took stock of the discussions on the Presidents’ report on completing Europe’s Economic and Monetary Union. The European Council reiterates that the process of completing the Economic and Monetary Union must be taken forward in full respect of the single market and in an open and transparent manner.

The next Council meeting is on December 17-18, 2015.

But these words make it clear that there is no agreement and the issue is just shunted to a further talkfest at which no coherent outcome will emerge.

Wolfgang Münchau said that it meant that the “leaders have nothing to say and do not agree”.

He argues that Europe is now at an impasse on a multitude of issues:

The Germans are blocking the deposit insurance, to the fury of the French. The east Europeans are blocking a share-out of refugees, to the anger of the Germans.

He refers to the Five President’s report that just skims across the surface of what is required without providing any clear leadership or commitment to fundamentally reform the EMU and so:

But the original design of a monetary union without a joint fiscal capacity is going to persist. The eurozone is, and will remain, a modern gold-standard type, fixed-exchange rate system.

I considered the Five President’s Report in this blog – The five presidents of the Eurozone remain firmly in denial.

The Five Presidents’ Report is the latest in several publications put out by the EU which outline how they will complete “Europe’s economic and monetary union”. The three-stage plan doesn’t come to fruition until 2025.

It abandoned any reference to establishing “an appropriate fiscal capacity, for the euro area” which was a feature of the previous Four President’s Report published in December 2012.

That Report emphasised that “A euro area fiscal capacity could indeed offer an appropriate basis for common debt issuance without resorting to the mutualisation of sovereign debt.”

No progress was been made on any of those recommendations and in the latest Five Presidents’ Report all mention of the possible establishment of a federal fiscal capacity disappeared. Any notion that there might be “common debt issuance” was deleted.

Instead, they extolled the virtues of the “‘Six-Pack’, the ‘Two-Pack’ and the Treaty on Stability, Coordination and Governance” (the fiscal compact), which they claimed had “brought significant improvements to the framework for fiscal policies in the EMU”.

They claimed that:

This new governance framework already provides for ample ex ante coordination of annual budgets of euro area Member States and enhances the surveillance of those experiencing financial difficulties.

The only concession is that they said “the current governance framework should be strengthened through the creation of an advisory European Fiscal Board.

Wolfgang Münchau wrote that any specific moves towards further economic and political integration that have been introduced or mooted (such as the European Stability Mechanism and the joint bank supervisory function) are:

… of the wrong kind, and thus deserves to be rejected. It is not the Keynesian fiscal union, preferred in France in particular, but the German variety. When the Germans talk about fiscal union, they mean rule enforcement, not macro¬economic stabilisation, eurobonds, deposit insurance or fiscal backstops. I would agree with his overall conclusion – that if this is the kind of integration on offer, it is better simply to say no and stick with the present system.

He cites the current case in Italy where the European Commission is interpreting the Excessive Deficit Mechanism rules “more flexibly than before” which “allows Italy to accompany its relative weak economic recovery with moderate fiscal expansion, which seems more or less appropriate”.

Whether the reality is that Italy’s current fiscal plans are expansionary is another question (I am researching that issue at present), but it is clear that if “a German-style fiscal union regime” was in place then Italy would have had to implement harsh austerity given its current position.

A few weeks later (November 1, 2015) Wolfgang Münchau’s article – Enlargement and the euro are two big mistakes that ruined Europe – now argues that the “single currency is a trap and eastern expansion forced the EU to take its eye off the ball”.

He says that the successive crises that seem to hit the EU are the result of:

… two catastrophic errors committed during the 1990s and at the beginning of this millennium. The first was the introduction of the euro; the second, the EU’s enlargement to 28 members from 15 a couple of decades ago. You might agree with one or other of these statements, or with neither of them. But few people will agree with both.

I am among those who agree with both of these statements, although Wolfgang Münchau himself previously did not run this line of argument.

He admits that he:

… was among those who supported monetary union at the time of its introduction.

But even though he now admits that the creation of the monetary union was a mistake he still supports retaining it:

The admission that the euro was a mistake should not be confused with a desire to dissolve it. That would be even more catastrophic. It is merely a recognition that we are trapped in a dysfunctional monetary system.

I do not agree with that statement. An orderly dissolution would be possible and would minimise the losses that such a move would have.

Continuing to operate within a “dysfunctional monetary system” is inflicting massive losses on many Member States which will resonate for generations to come.

I doubt that Wolfgang Münchau has really done a coherent intertemporal analysis to justify his position. The analysis I presented in my current book – Eurozone Dystopia: Groupthink and Denial on a Grand Scale (published May 2015) – suggests that while there would be costs in dissolution, the ability to return to growth almost immediately for nations mired in depression would deliver benefits that would not be forthcoming under the current system.

While Wolfgang Münchau also previously predicted and supported enlargement he now claims that:

Enlargement affected Europe’s ability to respond to the shocks of subsequent years in two ways. First, it forced the EU to take its eye off the ball at a critical time when it should have focused on building the institutions needed to make the euro work. Second, enlargement meant that EU countries that were not in the eurozone suddenly found themselves in the majority. That shift naturally shaped the EU’s own agenda. I recall the obsession during those years with competitiveness, a typical small-country economic issue. Debates on the reform of Europe’s treaties during those years focused on voting rights and the protection of minorities. It was the overwhelming view of European officials and members of the European Parliament that the eurozone itself did not need to be fixed.

Think about the Baltic nations that have now entered the Eurozone formally. They were content to lose a substantial portion of their populations through out-migration (including their young educated and skilled workforce) and impose harsh costs on those that stayed to meet the demands of Brussels.

Then, with their economies ravaged, they had the audacity to lecture Greece on its obligations to the rules, thus diverting the debate away from whether austerity was sensible, desirable or required to one where austerity was taken as given and the more the merrier!

The creation of the Eurozone has meant that European economies are now considerably more unstable than they were in the pre-euro period.

Wolfgang Münchau notes, correctly, that:

While the economic shocks, such as the oil and inflation crises of the 1970s, were no less severe than today, EU members had the ability to absorb them through flexible exchange rates.

And, they had their own currencies which they could use to advantage to target domestic demand and reduce the rise in unemployment.

The bond markets also knew that ultimately, these currency-issuing nations could break free of their dependence on bond-finance and float their exchange rates.

On reflection, Wolfgang Münchau seems to have changed his views from those expressed in 2008. He now thinks that there will be a “greater willingness to explore opt-outs” and while the risk of “formal break-up” is low the “real danger is that the EU is simply going to wither away and turn into a ghost”.

Conclusion

Ghosts are dead. The Eurozone died when Germany and France broke the rules back in 2002-03 and forced the system to relax the standards because they were unworkable even in the face of relatively small recession.

The GFC demonstrated clearly that the monetary union as structured is incapable of delivering reasonable outcomes to the citizens of the Member States who surrendered their currencies and adopted the euro.

Yes, there is a problem that the flexibility within the fiscal rules is not even explored – so nations target surpluses rather than on-going deficits of 3 per cent.

And that problem is due to the overlap of neo-liberal economics onto the monetary union structure. The latter was really driven by the former when the Delors Report in 1989 adopted the Monetarist antagonisms towards fiscal policy, which led tot he decision not to create a functional federal fiscal capacity.

But even if there was a relaxation in the obsessive mainstream economics approach to government spending etc, the flaws in the currency arrangements, the inability of single nations to defend their national financial systems and the one-size-fits-all monetary policy would remain and are, in themselves, terminal.

That is enough for today!

(c) Copyright 2015 William Mitchell. All Rights Reserved.