The infamous prologue of William Shakespeare’s masterpiece ‘Romeo and Juliet’ seems to portray a similar situation to that of the Eurozone. The ‘star-cross’d lovers’ being doomed from the outset is, of course, the central theme to this analogy. Romeo and Juliet sought to find true love in each other, yet were doomed by the nature of the genre: Tragedy. The monetary union of the Eurozone, a ‘plague o’ both your houses’, occurred when 19 EU countries with differing monetary policies became part of the same currency. This financially integrated Europe was the subject of a 16-year experiment, designed politically, to construct a more united Europe that is now tearing the continent apart. The Eurozone crisis is now entering its fourth year and I can see no recovery on the horizon.
The main issue with the Eurozone is that each nation gave up its sovereign currency in favour of the euro. The Eurozone does not have the fiscal or banking unions it needs to make monetary union work, and it is not close to changing that. For example, the ‘too-big-to-fail’ Cypriot banks, making outrageously bad bets in Greek bonds, were the eventual cause of Cyprus’ need for a bailout. Alas, banks make bad bets all the time, every day in fact, but those bad bets are considerably more likely to bankrupt you as a country if you do not have your own central bank. This is one of John Maynard Keynes’ central ideas; monetary, fiscal and supply-side policies are the tools required for softening output gaps at times when mistakes occur. However, the impending doom does not halt here. This diabolic loop* is compounded by plenty of other flaws.
Firstly, many members of the zone are so different that they should have very different monetary policies. However, this is simply not possible. The European Central Bank (ECB) sets a single policy for all 19 members. For example, in southern Europe, wages have reached an uncompetitively high cost relative to the north. One way to fix this intra-euro competitiveness gap is for the northern European wages to rise at a relatively faster rate than southern European wages. A bit more inflation or a bit less determines this. In other words, the difference between looser ECB policy and the status quo. From past empirical evidence, we see that the ECB prefers to let wages fall, rather than risk any situation that resembles inflation. This has hazardous effects; falling wages mean debts are harder to repay which leads to intensifications in both consumer and national debt. Plummeting wages also causes less demand for domestic goods and services, reducing the profits of firms accordingly. Thenceforward, firms are required to cut costs (usually through lower wages) and so fashioning a vicious circle with little potential for recovery. Simply, the ECB is too tight with money.
Very recently, we saw the word ‘austerity’ hit the news headlines on numerous occasions. At first, the Greek crisis and the rise of the Syriza Party, but now we are also hearing the media refer to the budget deficits of the U.K. and U.S. Frankly, ‘austerity’ has been disastrous. Austerity is, by definition, the severe measures of reducing a budget deficit through either cutting government spending, or raising taxes. It has increased debt burdens across southern Europe due to the fact that it has reduced growth at a greater rate than it has reduced interest repayments, requiring a greater proportion of GDP to be set aside for debt repayments. The most recent recession showed these weaknesses and has sparked various dangerous political trends. Economic fury at European leaders, on the left and the right, is coalescing with anti-immigrant sentiments to fuel the rise of populist and xenophobic parties. Worryingly, northern Europe is now also imposing austerity measures. France missed its deficit target and so slashed spending; the Netherlands has imposed contentious tax hikes and spending cuts which have led to economic decline; and even Germany is contemplating new budget-saving measures. Mirroring the deaths of Mercutio and Tybalt, these events have served to confirm the Eurozone’s tragic fate. We now wait for its ‘untimely death’.
Thirdly, the Euro area has become disconnected (to some extent) from inter-continental trade. Exclude Germany and over half of all trade is between the Euro countries themselves. This does not seem to be a flaw at first. However, as we have seen, with unfavourable policies pushing southern Europe into depression and northern Europe towards recession, Eurozone countries lack the demand needed for trading the required quantities of products, in order to sustain economic stability. This is most prolifically felt in southern Europe, where the economies’ primary method of recovery is through exports. The cracks in the Eurozone are proving to pose serious threats to stability. The Eurozone must reinforce these cracks before a fatal tragedy befalls.
To mirror Shakespeare’s masterpiece once again, the respective families of the Montagues and the Capulets were never expected to be able to form a unity. This doomed unification, forming a single currency shared by multiple nations, has been under scrutiny even before the establishment of the Eurozone. In 1997, Milton Friedman claimed that the motivation for the Euro was driven by politics without much consideration for economics. Even this year, we have seen conflicts of interest arise from the migration crisis and the ever-ongoing Greek crisis. Europe’s common market currently characterises a situation that is unfavourable to a common currency; it is composed of separate nations speaking different languages with different customs. A domestic bias, where countries have far greater loyalty to their own country than to the idea of ‘Europe’, also plays a role in this. Thanks to the rise of xenophobic political parties, the Eurozone struggles to achieve the free movement of goods, labour and capital.
A ubiquitous, underlying weakness of the Eurozone is the absence of flexible exchange rates for each member. This tool provides an extremely useful adjustment mechanism to reduce budget deficits or to allow wages and prices to be fully flexible. Fortunately, Britain abandoned the European Exchange Rate Mechanism (ERM)** over a decade ago to refloat the pound. Britain has experienced the fastest growth of all Eurozone countries in 2014 illustrating the effectiveness of the exchange rate as an adjustment mechanism***.
I think Milton Friedman summarises the crisis at hand: “The adoption of the euro has exacerbated political tensions by converting conflicting shocks, that could have been readily accommodated by exchange rate changes, into divisive political issues. Political unity can pave the way for monetary unity. Monetary unity imposed under unfavourable conditions will prove a barrier to the achievement of political unity”. For there never was a story of more woe than this of the Eurozone and her single currency.
* The loop is whereby, without a monetary policy that is in line with fiscal policy, economies can experience fluctuations, which then require effective policy-making to diminish. This forms a feedback loop.
** The ERM was the apparatus through which foreign currencies were marked up before the euro.
*** Of course monetary policy is not the only cause of this, but the Bank of England has been recognised for its highly beneficial impact upon recovery.
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