So, the euro is in turmoil. A crisis that started in Greece is now spreading to Spain, Portugal, and possibly even to France and Italy. However, as the Nobel prize-winning economist Paul Krugman pointed out on his New York Times blog a few months ago, the real story is in Spain, not Greece. This is partly because Spain is the much bigger economy. It is also because, for most of the first seven years of this millenium, Spain kept to the rules and maintained its budget deficit well with the 3% limit demanded by the Maastrict Treaty. In fact, over that period it actually ran a small cumulative budget surplus (see Paul Krugman's blog for details). That, though, did not save it from the effects of the credit crunch and the financial collapse of late 2007. Greece on the other hand is a totally different kettle of fish. Unlike Spain, it didn't even try to play by the rules, so it is hardly a surprise that it is in the economic mess that it is.
The lesson to be learned from the experiences of these two countries is that the problems of the Eurozone are two-fold. Firstly, there are some countries that were admitted to the club (probably for political reasons) that were fiscally irresponsible and failed to obey the rules. In short, they probably shouldn't have been there in the first place. Then there were other countries, like Spain and Ireland, that generally obeyed the rules, but suffered from what Krugman terms asymmetric shocks. It is how the euro deals with these asymmetric shocks in the future that will ultimately determine whether the euro can survive in its present form. In my view, the measures so far proposed do not address the real issues, or provide any real solution. In order to understand how these asymmetric shocks can be prevented you need to understand their cause. In the cases of both Spain and Ireland, the primary cause was (surprise, surprise!) a massive property boom, driven in part by large speculative capital inflows, which then led to excessive local price inflation. So, no stable solution will be found unless it addresses the problems of capital flows, and local inflation in wages and house prices.
The problems in Spain started with the property boom. This led to massive inflows of cash into the economy that meant that Spain ended up running a massive current account deficit. This inflow of cash also stimulated the economy to such an extent that it caused inflation in local goods and services, and particularly in wages. The critical factor, however, is that the property boom ultimately led to a boom in GDP and thence to a huge increase in government revenues. So the government was able to spend more without either raising taxes, or borrowing to fund a deficit. The problem was, this extra spending then fuelled the boom in GDP even more, thereby exacerbating the underlying problem. However, because the economy was expanding and the government was still balancing its budget while its spending increased, few people saw the impending crisis looming. Unfortunately, when the property bubble burst, as it inevitably had to, government revenues collapsed with GDP, while government spending rose even further to fund the consequences of rising unemployment. The result is a massive deficit of over 12% of GDP. That, then is the history, as Paul Krugman outlined previously on his blog. The question for the euro though, is how could it all have been prevented?
Of course, it is patently obvious that central to this whole mess is the inflation in asset prices that occurred during the boom, mainly in housing and other real estate property. Now it has been argued by some at the Adam Smith Institute (ASI) that the flaw in the whole euro project is the common interest rate set by the European Central Bank, and it was this that caused the property boom because the bank rate was set too low. Unfortunately there are two major flaws to this argument.
For a start, the argument that housing booms are, or can be, effectively controlled by changing interest rates is not well supported by historical economic evidence. Governments and central banks are generally reluctant to raise interest rates in order to dampen house price inflation for fear of strangling economic growth or strengthening the currency too much. As I pointed out a few months ago, the only way to effectively control house price inflation is by controlling mortgage lending. Secondly, Britain and the USA suffered from their own housing bubbles without being in the Eurozone. They had the freedom to adjust their interest rates upwards to counter their own housing booms, but chose not to. Finally, it should also be remembered that the property booms in Spain and Ireland started long before either country joined the euro.
An alternative possible solution currently being touted is to go for greater fiscal integration in the EU. This is the approach that was suggested by the German government recently. Unfortunately, such a policy would reduce the ability of member states to run their own domestic affairs. It could lead to outside agencies (like the European Commission) telling member states how they should spend their own money. It would inevitably lead to greater tax harmonisation across the Eurozone (something favoured by Germany), together with a reduction in democratic accountability and plurality. It would also make the EU more like the USA. Of course one way the USA deals with fiscal imbalances between member states is to tax nationally and then redistribute money to the different states via federal grants. There is, though, no political appetite in the EU for a similar strategy.
The USA is also a more integrated economic region than the EU, with greater geographical movements of people. Paul Krugman has suggested that one solution to the Spanish problem, and asymmetric shocks in general, is an increase in "fiscal and labour integration". In other words to make the EU more like the USA. The problem with this is that there are deep structural barriers in Europe to the free movement of labour: language, culture, education and recognition of qualifications. In reality, it is far more likely that companies will move jobs to regions of low wages and high unemployment, than people will move between countries to find jobs.
There is, however, a third option that has so far been ignored. Rather than the EU taxing all citizens, as happens in the USA, it could tax all member governments in the Eurozone. The tax rate would be designed to counter the capital inflows that Spain enjoyed, and which led to its inflation rate exceeding the Eurozone average. By using this rate of surplus inflation in Spain as the figure of merit (i.e. the difference between local Spanish inflation and the Eurozone average), and calculating the tax due by applying that rate to the current value of Spanish GDP, such a measure would effectively counteract the effects that the capital inflows had in distorting the economy.
For example, the data in Paul Krugman's blog shows that local inflation in Spain between 2000 and 2007 was on average about 4% more than in Germany (and the Eurozone average). At the same time the current account deficit varied between 4% and 10% of GDP. So, if the European Central Bank (ECB) were able to tax the Spanish government at a rate of 4% of GDP for that period, the Spanish government would then have been forced to pass on that tax to the population via tax rises, or spending cuts, in order to maintain its budget balance within the 3% Maastricht limit. Both of those measures would have acted as a dampener on economic growth in Spain, thereby counteracting the effects of the housing boom. Moreover, the tax revenues generated by such a measure, and thus acquired by the ECB, could then be used as bailout money for Spain in any future banking or economic crash. In fact such a policy would have resulted in Spain building up capital reserves at the ECB equivalent to around 25% of its GDP in the period up to 2007. That would have funded its current deficit for at least two years and thereby negated much of the economic crisis that it now finds itself in. This policy would therefore eliminate most of the potential for asymmetric shocks within the Eurozone while also providing the financial means to compensate for any shock should it ever occur.
There is, however, another issue that needs to be addressed if the euro is to work effectively, namely, how to regulate the banks. What this crisis also demonstrates is that EU member governments need adequate tools to be made available to them that allow them to regulate the lending policies of their local banks, and to the control the level of indebtedness of their own local populations. The problem is, the single currency zone of the euro and its single interest rate make that virtually impossible for any individual government. This though, is not just a problem with the Eurozone. It is also a problem that has its roots in how the European single market is constructed. You only have to look at the difficulties that Britain and the Netherlands had in regulating Icelandic and Irish banks to see that. As I have pointed out previously to those at the ASI, that can only be achieved if the EU allows member states to restrict lending of local banks to local customers, as at least used to happen in the USA.
The problems with the euro that I have described above, not only represent an important economic issue, but also an important political issue. The debate over whether Britain should ever join the euro may have been consigned to the cryogenic freezer now that Cameron is PM (given that the Tories will probably never agree to it), but it could still resurface as a major issue for the Labour Party, either in the forthcoming leadership contest, or in any future coalition with the Lib Dems. That is why it is important that the Labour Party has a coherent policy in this area. The question is, what should that policy be?
It is no secret that the issue of joining the euro strongly divided the last Labour government. It could also strongly divide the main leadership contenders. While large parts of British industry may be in favour of joining the Eurozone, that in itself is not sufficient justification. Moreover, part of the attraction of the euro is historical. It dates back to the 70's and 80's when Britain was a country of high inflation, and Germany was the epitome of monetary stability. That justification has now been rendered largely redundant. For the last twenty years Britain has enjoyed low inflation as well. In addition, because the Eurozone now includes fifteen countries, that is fourteen fewer currencies that British companies need to deal with, so the euro has already greatly simplified the problem of foreign exchange for British industry without the UK needing to join the euro, even if it has not completely eliminated it. What is clear, though, is that both the euro and the single market need substantial reform of the type I have outlined before Britain can even consider joining the euro. At the moment, that looks a long way off.
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