Some Thoughts on the Problems the Euro Has Fostered
If the euro were abandoned, then the previous regime of free-floating fiat currencies, each of them administered by its own central bank, would presumably be reestablished.
After all, unless the euro were to revert to its previous incarnations of national free floating fiat currencies the supply of which can be altered at will be the national central banks, there would be no point in leaving the euro area.
From the point of view of sovereign debtors that have difficulties financing themselves in the markets, the idea of being able to print their own money and have their national central banks back-stop the financing of the government is of course quite seductive and the primary motive that may induce some of them to consider leaving the euro. Moreover, the ability to pursue 'beggar-thy-neighbor' type trade policies by unilateral devaluing one's currency is similarly tempting, as most modern-day governments continue to believe in the mercantilistic fallacy that trade is not mutually beneficial, but instead creates winners and losers. The popularity of this facile and entirely wrong notion will probably never go away. Naturally, not everybody can beggar his neighbor – if everybody did, then the desired effect could not be achieved.
It is widely acknowledged that one of the main problems the euro has created consists of the inner-European current account imbalances and the large differences in the competitiveness among the various member states that have arisen.
However, if we think these assertions properly through, it should be obvious that there can be no simple aggregated arithmetic determination of these effects. Ricardo's law of comparative cost remains operative after all – albeit, given the mobility of labor and capital in the euro area, only in a somewhat restricted manner.
We could for example compare a range of products that can be produced by both Germany and Spain and come to conclusions about which mix of production activities would yield the greatest output for all these products. It seems inconceivable, even if one agrees that Spain has become relatively 'uncompetitive', that it would be better for Germany if it became autarkic and produced all the goods it could in theory produce by itself and that it would no longer make sense to produce any of them in Spain.
Moreover, there are certain things that Spain or Greece can produce that Germany can not produce at all and vice versa. Greece is not known for the achievements of its automobile industry, but neither is Germany famous for it olive groves.
We happen to believe that the fundamental nature of the problem the euro has fostered remains widely misunderstood. To say that Greece or Spain have become 'uncompetitive' relative to Germany and the Netherlands is not enough. One must rather ask: why has this happened? Once one grasps the why, it should be easier to determine a viable way forward.
Ignoring for the moment the question of whether the original exchange rates of the national currencies to the euro that were applied upon its introduction were valuing these currencies 'correctly', one can probably assume that the condition of the regions comprising the currency area on the eve of its introduction were such that this uncompetitiveness problem did not exist. It is clear however that with the passing of time, conditions always change. The market economy is in constant flux after all – the only thing that can be said to be permanent about it is change.
And yet, why should using a common medium of exchange per se be the primary agent of the changes that are now considered a negative outcome of its adoption?
The Example of Argentina
In a way, the euro acted like a 'peg' roughly comparable to the USD-Peso peg Argentina employed in the 1990's, which was guaranteed by a currency board.
The case of Argentina in fact sheds light on the problem:
In theory, every peso in issuance was to be backed by one US dollar held in reserve by the currency board. This removed foreign exchange risk and caused a notable drop in Argentina's interest rates. Foreign capital was attracted to Argentine government debt, as it promised to pay a decent spread over comparable US government debt, even while the peso was guaranteed to remain unchanged against the dollar. The IMF was enthused by this scheme, as it helped to combat the recurring evil of inflation that had plagued Argentina previously. After all, so it was reckoned, Argentina's monetary policy was no longer independent and so the temptation to inflate was permanently removed.
Only, it wasn't.
Nobody gave due consideration to two major points:
Firstly, Argentina's government, egged on by the surge in international demand for its debt and the concomitant lowering of its interest costs, was tempted to issue far more debt than it had been able to issue prior to the adoption of the peg and began spending money hand over fist. After all, it could suddenly afford to do so on account of interest rates having fallen.
Secondly, while Argentina adopted the rigidities of a currency board, it did not abandon the practice of fractional reserve banking inside Argentina. The same low interest rate environment that tempted the government to increase its spending and take on ever more debt financed by foreign investors set an ultimately unsustainable domestic credit boom into motion. The banks rushed to create ever more credit and fiduciary media, businesses embarked on major new investment projects financed by this sudden abundance of credit, while consumers concurrently never endeavored to restrict their consumption – on the contrary, they increased it. All the effects trade cycle theory predicts and expects under such conditions began to manifest themselves. A giant boom began to take hold.
For most observers, this boom provided additional confirmation that Argentina's peg worked – at least initially. In reality, the currency board's promise of backing every peso extant with one US dollar soon became nothing but an empty slogan: money substitutes began to pile up in Argentina's banking system at astonishing speed, and these claims to money proper were of course not 'backed' by anything at all.
Inevitably the point was reached when foreign investors began to have doubts. It became increasingly evident that Argentina's boom, its deteriorating current account balance and its growing mountain of public debt were utterly dependent on an uninterrupted continuation of capital inflows from abroad.
The boom had of course exerted all the inflationary effects that are the hallmark of such an unbridled credit expansion: prices and wages in Argentina rose, with no concomitant offsetting increase in economic productivity. The country became uncompetitive.
In short, on the eve of its crisis, Argentina found itself in exactly the same situation as the 'PIIGS' found themselves in on the eve of their recent crisis.
Argentina's government eventually defaulted and decided to rescue the banking system by means of a confiscatory deflation stiffing depositors and savers: it restricted access of depositors to their money, forcibly converted all dollar deposits into pesos and then abandoned the currency board and massively devalued to peso.
Today, a little over a decade later, Argentina is once again on the cusp of a major crisis. It has returned to its old ways. Amidst price controls, capital controls and a growing pile of authoritarian government decrees, it slowly but surely slides toward yet another hyper-inflation episode – precisely the thing the currency board was once designed to avert.
So what can we conclude from this with regards to the euro area? There is in fact no practical difference at all.
Think for instance about Greece : its interest rates fell to a tiny spread over German ones, tempting the government to take on far more debt than previously and inducing it to spend money hand over fist. Foreign investors, no longer worried about exchange rate risk, piled into the debt issued by the government. The Greek banking system, egged on by the same low interest rates, began to expand the credit and money supply at astonishing rates. A major boom ensued and prices and wages rose sharply.
And then, one day, foreign investors began to have doubts about the sustainability of this arrangement.
In short, it is the fractionally reserved banking system and its ability to create money from thin air that is at the root of the problem. The fact that this banking system is backstopped by a central bank only has made the problem far worse. It is not, as many maintain, impossible for European citizens to use a common medium of exchange. The problem is that the medium of exchange is a fiat money the supply of which can be expanded willy-nilly.
A notable difference between the 'PIIGS' and Argentina is that the withdrawal of foreign private investors has not led to imminent collapse, devaluation and theft of deposits (not yet, anyway), because the euro-system of central banks has made it possible to replace the financing of current account deficits by private sector investors with a behind-the-scenes bailout by the central banks (see the 'TARGET-2' imbalances we showed yesterday).
