Exiting the Euro?

In past blogs I have indicated that nations were mad entering the EMU and surrendering their fiscal sovereignty. This is especially so for the so-called peripheral nations (Spain, Portugal, Greece, Ireland, to some extent Italy) who have become basket cases in a system that prevents individual member’s from using fiscal policy to improve the circumstances of their citizens. Indeed it is a system that forces aggregate policy to act in a pro-cyclical manner for nations that are undergoing crisis – that is, the politicians have somehow managed to convince their populations that it is a credible position for them to use their policy power to make things worse rather than better. So policy which should reduce poverty and empower the youth of a nation with education and employment opportunities is now doing exactly the opposite. As I noted last week, one statistic is enough to tell you the EMU system is a failure – 53 per cent of Spanish youth are now unemployed! So can a nation exit the EMU? What would happen if it did? I had some thoughts on this today.

As an aside, it is interesting that in most research papers considering the “costs” of the EMU at the time that nation’s were debating whether to enter or not, the loss of policy sovereignty was constructed in terms of monetary policy with fiscal policy hardly mentioned. This was consistent with the neo-liberal obsession with debasing the use of fiscal policy and promoting monetary policy as the primary counter-stabilising policy tool. Further, counter-stabilisation was also narrowed to mean inflation and unemploynment became a policy tool rather than a policy target to be used in the “inflation-first” approach to macroeconomic policy.

I would recommend you read the following blogs – One hell of a juxtaposition – Euro zone’s self-imposed meltdown – A Greek tragedy – España se está muriendo – as background material to the discussion in this blog.

Recently Paul Krugman’s recent article – – says that while at time when:

… the single currency was being contemplated, the fundamental concern of many economists on this side of the Atlantic was, how will Europe adjust to asymmetric shocks? Suppose that some members of the euro zone are hit much harder by a downturn than others, so that they have much higher-than-average unemployment; how will they adjust?”

I have covered this issue in detail in the blogs referred to above. The point is obvious. Australia, for example, is a common monetary system across a number of states and territories. The states have separate fiscal operations but accept a common monetary policy (and currency). However, when our state economy’s are in trouble (which means our nation as a whole is in trouble), our federal government is able to use its own fiscal capacity (backed by its currency-issuing monopoly) to ensure that no communities are more disadvantaged than others although politics does get in the way.

We also have a common health care and pension system and common infrastructure (telecommunications etc). A similar argument can be made for the United States which leads Krugman to say that “shocks are cushioned by the existence of a federal government: the Social Security and Medicare checks keep being sent to Florida, even after the bubble bursts. And we adjust to a large degree with labor mobility: workers move in large numbers from depressed states to those that are doing better.”

The claim that the EMU would be a beneficial arrangement for member countries was based on the concept of the Optimum Currency Area (OCA) which requires that there across the monetary union there has to be flexible labour markets (wages and/or labour mobility); highly integrated trade dependence; and exposure to similar shocks.

It is clear that the EMU countries have never comprised an OCA which renders most of the mainstream “economic theory” arguments in its favour null and void. For some interesting empirical analysis you might like to read the various reports prepared by the British Treasury at the time they were contemplating entering the monetary union.

Apart from the lack of labour mobility, the major flaw in the design of the EMU system, however, relates to the absence of a fiscal adjustment mechanism. This is particularly evident in the current crisis, which is the first major cyclical downturn the system has had to react to since its inception.

It is clear that the capacity of the EMU to deal with so-called asymmetric shocks (in this case, demand shocks that impact differentially across the member coutnries) is extremely impeded by the inability of the system to provide compensating income transfers to member nations that are in deeper recession than other nations.

But the designers of the system were not happy with their nonsensical decision not to create an EMU fiscal capacity (which reflected both sovereign concerns and also the neo-liberal antipathy to fiscal policy in general). They wanted more. So the EMU ideologues who designed the system went one step further into absurdity.

They invented the “mother” of all constraints – a pro-cyclical fiscal arrangement and had the audacity to call it the Stability and Growth Pact. Its design provided neither stability nor growth. So member nations with budget deficits arising from recession are forced to contract their stimulus support to their local economies in line with the rules first set out in the Maastricht agreement).

These rules had no basis in economic theory – they were purely ideological constructs imposed on nations by mainstream economists who were blind to the way modern monetary economies actually operate.

In my book with Joan Muysken (published 2008) – Full Employment abandoned and another book we published together with Tom van Veen in 2006 – Growth And Cohesion In The European Union – we cover these issues in some detail.

So not a very sound basis at all for dragging quite disparate economies together into a monetary union. But if you don’t like it can you leave? That is a question I have been examining lately. For example, the Greek, Spanish and Irish governments should in my opinion show some leadership – which I define as being looking out for your own citizens – and exit the EMU.

But what is involved in that?

Krugman, doesn’t agree with me:

Was the euro a mistake? There were benefits – but the costs are proving much higher than the optimists claimed. On balance, I still consider it the wrong move, but in a way that’s irrelevant: it happened, it’s not reversible, so Europe now has to find a way to make it work.

I disagree – it is reversible and countries should explore the ways that they can minimise the exit costs and start using their fiscal capacities to advance public purpose in their own nations.

Krugman’s opinion is also held by Willem Buiter who told the Irish Independent on January 11, 2010 that it “would be “suicidal” for a “weaker country” to exit the euro region as they would also have to leave the European Union”. He said that there was no “chance of Ireland defaulting … because they have taken the right measures” and claimed that “Greece isn’t there yet.”

His assessment of current risks to the EMU:

… is not from our weaker brothers and sisters — it’s the stronger countries, Germany, saying, ‘I am fed up having to face the risk of bailing out the weaker’

So according to Buiter the system will remain intact as long as member countries, who are facing 53 per cent teenage unemployment rates like Spain and other social pathologies including serious spikes in poverty rates, scorch their own economies so that the mandarins in Bonn are happy.

That is a totally self-imposed and ridiculous economic system when other nations enjoy the fiscal sovereignty which enables them to reduce the consequences of recession.

How do we assess Buiter’s claim that exiting the Euro would be equivalent to leaving the European Union (EU)? Is this rhetoric only given that the EU comprises 27 member states whereas the EMU (those nations that have adopted the common currency) comprises 16 member states?

There was nothing explicitly said in the setting up of the EMU about the right to exiting. It was considered that including such a clause would encourage withdrawals and undermine the basis of the system. However, it seems that the EU nations that did sign up would be forced to leave the EU if they exited the EMU.

A recent ECB paper – Withdrawal and expulsion from the EU and EMU: some reflections (published December, 2009) has considered this issue. It says:

… the exit clause’s silence is problematic because it leaves room for speculation on the extent to which there is also a right of withdrawal from EMU and whether such withdrawal would necessarily be linked to a Member State’s withdrawal from the EU or could be independent from it.

The ECB paper considers the “two alternative approaches to the absence of any guidance in the exit clause on the existence of a separate right of withdrawal from EMU” -that leaving one requires a state leaves both (Buiter’s claim) and that leaving both is impossible per se – as being “so unsatisfactory that it would be unwise to attempt to choose between them on the basis of deductionsbeing legally questionable.”

The paper concludes that:

Member States could not, pre-Lisbon Treaty, withdraw unilaterally either from the EU or, a fortiori, from EMU, and that the only way for them to do so legally would be by means of a negotiated agreement with their fellow Member States.

So it looks like those who signed up are legally obligated to exit both the EU and the EMU.

But that is not impossible – remember that in 1985, Greenland left the European Economic Community (EEC) after strong domestic opposition that arose once they achieved self-rule from Denmark. Nothing obviously bad has happened to them as a consequence.

In an article in the Irish Sunday Post – Should we divorce the euro? (January 10, 2010) – David McWilliams likens the Irish decision to enter the EMU as the “economic equivalent of a marriage”:

If a country decides to give up its currency and get into bed with another currency, it would seem ludicrous to entertain this move without being sure that the union was suitable. As we all know, there is a difference between fancying someone and making the thing last … In general, for a currency union to work, there should also be a single fiscal policy … This is how the currency unions in the US, Canada and Australia work … Guess what? None of these attributes was in place when Ireland joined the EU economic and monetary union (EMU) and the euro. So it is clear that we didn’t join for economic reasons. So why did we join? It seems that we were too insecure to behave logically and this national insecurity – particularly among our senior mandarins – prevented us from having a debate.

He concludes that the “euro has been a disaster for Ireland, and will ensure our slump lasts considerably longer than it has to” and concludes that:

Are we expected to remain in this loveless marriage? As we saw in the past decades, divorces are now part of life. Ireland is, today, in a bad marriage – with no divorce. Like those Catholic fundamentalists who suggested that divorce would threaten the fabric of our society, the euro fundamentalists who run policy in Ireland suggest that, to leave the euro, would undermine the fabric of our economy. Like all fundamentalists, the thing they hate most is a sceptic. Lets hear it for the sceptics.

What would be entailed if a nation did exit?

From a monetary perspective, to exit the EMU a nation and regain currency sovereignty, the following changes would occur (see also ECB paper):

• The nation would have to introduce a new/old currency unit under monopoly issue. Within this currency the national government could purchase anything that was for sale in that currency including domestic unemployed labour.
• The central bank of the nation would receive a refund of the capital it contributed to the ECB.
• The central bank would also get all the foreign currency reserves that it moved over into the EMU system.
• The nation’s central bank would then regain control of monetary policy which means it could set the interest rates along the yield curve and also add to bank reserves if needed.

What about the existing sovereign debt that is in Euros? Clearly this is a (short-term) problem because the nation that wanted to exit would have to deal with a foreign currency debt burden. It is unclear how the transfers back into the central banking system from the ECB noted above would serve to offset the “euro exposure” upon exit.

But ultimately as part of a painful adjustment process it might require the nation to default which could manifest as a negotiated settlement where the creditors accepted the local currency (or nothing).

Some argue that the financial markets would make it difficult for a nation to exit. Thus, the dreaded ratings agencies would mark the nation down in the event of a “default” and force higher spreads on local debt. My reply is that they are doing that anyway to some of the existing EMU nations so what else is new!

Further, if the exiting nation gets its economy back on track using its renewed fiscal capacity; reforms its banking system to reduce the danger of speculative bubbles; and ensures there is no major cost explosion, then the local economy will remain attractive to international capital – after some ruction (tantrum) to be sure.

If the nation abandons the voluntary constraint that it issues public debt $-for-$ to match its net spending then all the issues relating to public debt disappear.

So from a modern monetary theory (MMT) perspective, many of the problems that financial markets might give to an exiting government are associated with the issuance of sovereign debt – the so-called (erroneous) “sovereign funding” problem.

Well there is no problem if the government understands how its currency system actually operates. They don’t have to “fund” their expenditure. What they have to ensure is that their expenditure promotes employment and real output growth. That is not an inconsiderable challenge but it is quite a different problem than that raised by the misguided deficit terrorists.

So a major problem with most of the extant economic analysis of this issue is that it conducted within a mainstream macroeconomic paradigm which assumes erroneously that under a fiat currency system the national currency issuing government is financially constrained.

The reality is that countries such as Spain, Greece and Ireland could revert back to currency sovereignty notwithstanding the adjustment costs and use the fiscal capacity that they would re-acquire to advance their domestic economies.

This would change the policy dynamics substantially in favour of the local government.

An interesting paper by Eichengreen concludes (page 35) that:

How formidable are the obstacles to withdrawing? Economically, it is not clear which way the arguments cut. A country contemplating exit in order to obtain the kind of real depreciation needed to address problems of chronic slow growth and high unemployment would be deterred if it thought that its efforts to engineer a real depreciation would be frustrated by the inflationary response of domestic wages and prices, or if it thought that leaving the monetary union would significantly raise its debt servicing costs. But if the defector at the same time strengthens the independence of its central bank and the efficiency of its fiscal institutions, then it is at least conceivable that these negative economic effects would not obtain …

Eichengreen is operating within a mainstream macroeconomics paradigm. But I agree with him that domestic policy should never see government net spending as a free for all.

Quite clearly currency sovereignty does not provide carte blanche for the national government. The pursuit of public purpose requires that the government spend in ways that will promote employment (including, at the very least, jobs in a public sector job creation scheme for those who are currently unemployed) and generate real output growth.

But I reject Eichengreen’s mainstream view that increasing “the efficiency of its fiscal institutions” is equivalent to imposing fiscal austerity on the citizens.

Governments should use its fiscal capacity to advance public purpose and not waste public spending on unproductive pursuits. In that sense, major handouts to financial institutions (like banks) and other companies (particularly those who are multinational and owned elsewhere) would be wasteful and to be discouraged.

This raises the issue of the current “real depreciation strategy” being used by the Irish government which is scorching its economy. It also introduces the issue of trade integration and foreign ownership. Some argue that given the increasing trade integration within the EMU, there would be significant resistance by major companies against a nation leaving the system.

In the case of Ireland, Peter Neary wrote in Celtic tiger on EMU trail that the firms that are mostly responsible for “the growth in Ireland’s exports to continental Europe, many of them in high-technology sectors such as chemicals and computers, are disproportionately foreign-owned, high-margin and capital-intensive.”

The fact is that Irish-owned firms do not export very much to the EMU zone. FinFacts says that “Ireland has not a strong exporting tradition and the UK market remains the dominant one for Irish-owned firms while the 16-country Eurozone market”.

In a detailed analysis of the Irish challenge to recover by developing export markets on the back of a massive real depreciation, FinFacts says:

… creating 160,000 net new jobs in the Irish economy is a daunting challenge but starry aspirations and pious hopes about exports from armchair “experts,” are a far from adequate response … There are no simple panaceas and after fifteen years of the Celtic Tiger, when primacy was given to property investment, it would be foolish to expect anything but a hard slog.

What about practical issues?

Clearly there would be practical issues that is involved in changing any accounting unit. Computer code and the like would have to be changed. But in Australia we voluntarily went from a sterling-based currency system to a decimal currency system in 1966 (it took three years to make the transition). The skies didn’t fall in.

I also liken the computer code issue to that which was faced by the Y2K bug – a lot of work had to be done to ensure that did not cause a meltdown.

What about the political problems?

Eichengreen (pages 35-36) concludes that:

… the political domain is where the most serious obstacles to withdrawing reside. A country that withdrew from Europe?s monetary union would be seen as unilaterally disregarding its commitments to other euro area members. Such a country would not be welcomed in the meetings where the future architecture of the European Union is discussed and policy priorities are decided. Insofar as member states value their participation in these political discussions, they would incur significant costs.

I cannot comment on the political issues that might arise in a particular country. My only observation is that politicians (witness Iceland) are usually diverted from serving the public purpose by dominant ideologies. Mainstream economics holds such a sway at present that the shifts in policy that would be required to make an exit a good decision in the medium- to longer-term would be very strongly resisted.

What will be required is a citizen’s revolt such as seems to be happening in Iceland. The existing polity has to be systematically stopped in its tracks and forced to adopt new approaches to economic policy.

Like most ideas that are difficult to embrace the response will be that “Pigs might fly” or in Spain (they have flying cows) – “cuando las vacas vuelen”.

The current macroeconomic orthodoxy has not always been! It is actually only been dominant for about 35 years. So positions that assume that paradigms never change ignore history.

A major popular reaction against the Euro is possible if the dire situation facing the poorer EMU nations is protracted. The future is bleak for these nations. As a spokesperson for Deutsche Bank claims:

The euro area will have to learn to live with a lasting drag from the adjusting peripherals.

This was in the context of the need for the “peripheral” nations to make harsh budget cuts and deregulate their labour markets. As if DB represents public purpose. But the point is that that sort of arrogance will help spur a public backlash.

Moreover, for all those who argue that that leaving the Euro system is inconceivable the questions that they have to answer are as follows (see also the McWilliams article):

1. How high does unemployment have to go and for how long does it have to remain at those levels for the wages and price levels to fall by the estimated 30-40 per cent to ensure a real deprecation occurs and competitiveness returns?

2. How much higher does youth unemployment have to rise (now at 53 per cent in Spain)?

3. If nominal wages are not yet falling, what will make them fall?

4. What will be the impacts on the net wealth of home owners if prices fall that much?

5. What estimates of the rising poverty rates have the government’s provided to their citizens that will accompany the fiscal retrenchments required to satisfy the ECB and the Euro masters?

6. How can the government guarantee that the in time the real exchange rate effect will fill the gap left by the fiscal contraction? Why would the citizens already pushed into poverty by their government want to give an ever increasing quantity of their resources away to the rest of the world (including the rich EMU nations who are basically forcing this poverty on them)?

Conclusion

The problem with all the extant economic analysis of this issue is that it conducted within a mainstream macroeconomic paradigm which assumes erroneously that under a fiat currency system the national currency issuing government is financially constrained.

The reality is that countries such as Spain, Greece and Ireland could revert back to currency sovereignty notwithstanding the adjustment costs and use the fiscal capacity that they would re-acquire to advance their domestic economies.

The claim that a massive real depreciation is the only way to restore balance in the “peripheral” economies assumes that the Euro system provided balance prior to the crisis. It did not. The massive asset price booms in Spain and Ireland suggest that a non-sovereign monetary policy and a tightly controlled fiscal policy (obsession with budget surpluses) were not in the interests of these nations despite the short period of growth that the asset booms generated.

A massive real depreciation would commit an entire generation to significantly reduced circumstances and undermine social stability.

The European project has been driven by fears of extremism of the type that caused millions of people to be slaughtered during the 1930s and 1940s. It is obvious that political arrangements that can subvert the rise of fanatics is highly desirable.

But the reality is that extremism is rising anyway in Europe with far-right groups once again parading with credibility on the political stage. The shift to these nationalistic extremist movements will be accelerated if countries ignore their citizens and hang onto economic arrangements that guarantee a generational rise in poverty.

Finally, in the words of Benjamin Cohen (2000 ‘Beyond EMU: The Problem of Sustainability’, in Eichengreen and Frieden (eds), The Political Economy of European Monetary Unification, Boulder, Westview, 179-204.):

In a world of sovereign states nothing can be regarded as truly irreversible.

Haiti

Sympathy to Haiti. If you consider their history they have been victims of colonial oppression; brutal local dictators propped up and fed with military resources by first world nations (for example, the US); a rampaging military that has often thought slaughtering its own citizens was more important than defending them … and now this.

Saturday Quiz

Back again some time tomorrow.