Monetary union without political union seemed to me from the initial proposal of the Euro to be a farce. Without significant social union (the other countries are “us” not “them”) there won’t be a political solution for monetary imbalance. Great Britain was wise to keep the pound.

Jean-Baptiste Quéru

Irresponsible or unavoidable borrowing?

Growing up in Europe, I didn’t pay much attention to the construction of the Euro, and whatever little I remember has nothing to do with the economics of it. Now, older, having lived in the US for a while, with a Greek wife, I’m looking at the way the Euro is unraveling and I’ve been using the opportunity to try to figure out how it works (or, rather, why it doesn’t).

The core mechanism that allows multiple states to share the same currency is pretty simple: since the weaker states can’t devalue their currency to compensate for their trade deficit with the stronger ones, money has to flow from the stronger economies to the weaker ones in order to maintain the balance.

We see that in the US: as measured in GDP per capita, there’s about a 2:1 ratio between the strongest states and the weakest ones. To compensate for that, a lot of money flows between states, through the federal government. Most taxes in the US are federal taxes, i.e. about 75%, and the federal government doesn’t necessarily spend the money it collects in the exact states where it collects them. As an example, every year about 130 billion dollars paid by California in federal taxes don’t make it back into California. Texas and New York are the two other states that have a negative balance of more than 100 billion each. For those 3 states, that outflow on money represents 5.7%, 7.2% and 7.4% of their respective GDPs. California is literally sending money to other states so that those states can buy California stuff. The same is true for Texas, New York, and about 20 of the 50 states that are sending money to the other 30.

Looking back in history, the Marshall Plan followed a somewhat similar logic: the US sent aid to Europe, to allow Europeans to buy US goods, which was both a stabilizing mechanism for European currencies that otherwise were in a devaluation spiral, and an outlet for the huge US industrial production. For reference, the Marshall Plan amounted to 120 billion dollars (in today’s dollars) over 4 years, which is tiny compared to the amount of money that the federal government now redistributes across state lines.

We can compare that to the situation in the Eurozone/EU, where the GDP per capita varies by a factor of about 2.3:1. Germany’s balance in the EU budget is negative by less than 9 billion Euros. France’s and Italy’s follow at approximately 6.5 billion and 6 billion. Germany’s 9 billion Euros is tiny compared to California’s 130 billion dollars, especially since Germany’s GDP is 60% larger than that of California. Since the US and EU economies have approximately the same size, that’s a reasonably apples-to-apples comparison. The biggest negative balance that a Eurozone country has with the EU is about 0.41% of its GDP. The biggest positive balance is 1.3%. Within the US, only 4 states out of 50 fall within that range.

That’s the problem right there: Germany is not flowing enough money out to other Eurozone countries to compensate for its own very strong economy. That’s true of other rich European countries as well, e.g. Netherlands, Austria, France.

From the Greek point of view, the only way to get that money to flow in order to maintain balance had been for the government to borrow. That wasn’t irresponsible borrowing. That was mechanical, predictable. Greece’s poor historical discipline around government finances only accelerated an unavoidable process, but it’s not a root cause.

In fact, predictably, pushing Greece into austerity made things worse, much worse: with the root cause being Greece’s relatively weak economy compared to the rest of the Eurozone, an austerity approach can only put Greece in a position where it needs even more money to flow in in order to maintain balance.

Even if we assume that all of Greece’s debts get somehow forgiven with no further constraints and that Greece manages to run a balanced government budget, it would still be in an unsustainable position in the current Eurozone as its weaker economy would force additional money to flow in. Unless the Eurozone very significantly increases the amount of money that it redistributes across borders, Greece should get out of the Euro at the first opportunity, i.e. literally Monday morning, July 6.

Worse, with Greece out, it’s only a matter of time for another weak country to find itself in the same position: that might be Portugal, Spain, Italy, or if Bulgaria, Romania or even Hungary join quickly enough that might go through that same death spiral quickly enough to see the Eurozone as a revolving door, with barely enough time to come in before being back out.

Once that first batch of weak countries is out, there’ll always be more that’ll be at the bottom of the scale and will find themselves in the same position. France is comfortably in the middle of the pack within Europe today, but attrition will eventually push it toward the bottom, and France having to leave the Euro is a true nightmare scenario for everyone.

In order for the Eurozone to survive, its rich members will need to send a lot more money to the poorer ones: the rich ones literally can’t continue reaping benefits from a currency based on the European average without sharing those benefits with the poorer ones that bring that European average down. Otherwise, the Euro will consume country after country until it hits a country that is literally too big to fail.

Eugene Crosser July 06, 2015 10:38

Meanwhile, there is quite a number of “them” who use the US dollar as their currency…

(The difference is that they don’t have “voting power” like Eurozone members, but still.)

edit: +Jean-Baptiste Quéru’s post does not deal with “social union” at all, by the way. It is just, rich have to subside the poor if they want to sell them anything. Friends or no friends.

Michael K Johnson July 07, 2015 06:30

+Eugene Crosser Yes, there are such countries. There are other risks in running your own currency as well, of course. You can choose to accept an inability to control monetary policy. I have absolutely no knowledge of how this works for, say, El Salvador; some of the other countries that denominate in the US dollar do mint their own coins and so have some control over local money supply. I would assume with zero actual knowledge that it works better when trade and/or tourism provides an inflow of dollars. If El Salvador decided to move to its own currency, the US would not consider it a crisis, though if it were coupled with a default it would affect investors in sovereign debt.

A better parallel might be Puerto Rico, which has neither sovereign status nor control over monetary policy, and is now in its own debt crisis. In theory, Greece has, as a sovereign nation, the ability to default on its debt as a remedy for not being able to devalue its currency to save its economy; but economic union makes default practically difficult.

I agree that “social union” was not a good turn of phrase. People have been demonstrated to commonly make irrational decisions based on an internal “us vs. them” categorization. I don’t see it as likely that people will suddenly become rational. It has happened from time to time that people have been able to expand their “us” category. I expect that this is the more likely source of political will to avoid the Eurocollapse that JBQ describes than mass rational decision making.

Anyway, it’s not my area of expertise; I was just saying that as a naïve observer (neither any form of economist nor a political scientist) a few decades ago, this was what I expected to see based on my understanding of human behavior. More verbose than “Duh, film at eleven” but perhaps no more insightful. ☺

Eugene Crosser July 07, 2015 10:32

“People have been demonstrated to commonly make irrational decisions based on an internal “us vs. them” categorization.”

Tell me about that. Sigh…

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