Europe's Problem Is the Euro
Surveying Europe’s problems, German chancellor Angela Merkel has stressed repeatedly the need to deal with “root” causes. By this, she means profligate spending, wayward fiscal policy and an excessive use of debt. But there are other “roots” the chancellor would seemingly rather ignore. These lie in the structure of the euro itself and how it advantages Germany at the expense of Europe’s periphery.
The euro’s structure was so skewed from the start that it ordained today’s crisis. By exchanging its deutsche marks for euros at a remarkably low rate relative to its productivity and profitability fundamentals, Germany gave its producers great pricing advantages over their competition elsewhere in the union. Because Greece and much of the rest of Europe’s periphery exchanged their national currencies for euros at much richer rates than their economic fundamentals could justify, they became natural consumers of those well-priced German products. Still more, the low exchange rate of Germany’s entry understated German incomes in Europe, creating a feeling of austerity that encouraged people there to save and cooperate with cost-containment efforts. In contrast, the periphery’s initial rich exchanges inflated the euro-buying power of their populations, giving these counties a false feeling of wealth that encouraged spending, borrowing and an easy attitude toward public benefits.
Precision in these matters is elusive, but the International Monetary Fund (IMF) offers a rough gauge. It compares existing exchange rates with the rate that would equalize the costs of tradable goods in different countries—what economists call purchasing-power parity. On this basis Greece, Spain and Ireland seem to have made their conversion to the euro some 6 percent richer than Germany did.
The differences grew wider over time. Though the rates were fixed in the euro, the respective national fundamentals changed. High levels of German sales and savings improved that economy’s competitive fundamentals. Because euro valuations in the periphery discouraged savings and encouraged importing, these countries neglected their productive, competitive sides, making the original high rate at which they joined the euro less and less realistic. By 2009, just before the crisis broke, IMF figures show that Greece stood at a 12 percent disadvantage to Germany, Spain at a 20 percent disadvantage and Ireland at a 32 percent disadvantage.
Even with these huge biases, matters may never have reached today’s level of intensity had not the currency union also actively encouraged the periphery to borrow aggressively. The EU actually sold the euro on the basis of easy credit. Over and over, proponents tempted smaller, weaker economies to join the currency union by explaining how it would enable them to borrow more easily at lower rates than they could in their own currencies. Such arguments recurred as each nation considered joining. In 2007, Iceland’s euro advocate, the Kaupthing Bank, made lower credit costs its main selling point. Euro advocates in Britain’s Liberal Democratic Party put “lower interest rates” second on its list of twelve reasons for joining the common currency. Remarkably, even Estonia, joining the euro in 2010 in the midst of the breaking sovereign-debt crisis, still clung to the argument of cheaper financing costs.
Now, in the face of all today’s financial pressure, it is easy to criticize spendthrift Greece, Ireland, Portugal, Spain and Italy and characterize the austerity they face as just deserts for their past spending and borrowing sprees. But at the same time, it should be easy to see that the Germans owe something in this situation as well, for the selling spree their exporters have enjoyed. They, too, should face their inevitable deserts, especially since none of these fundamentals look likely to change and hence the advantages will remain.
Milton Ezrati is senior economist for Lord, Abbett & Co. and an associate of the Center for the Study of Human Capital and Economic Growth at the State University of New York at Buffalo. He writes frequently on economic and financial topics. His book, Kawari, addresses the needed changes in Japan’s economy.