Political Dreams, Institutional Nightmares, and Economic Realities. Where is the Euro?
The European Union and later the Union are the products of a political vision that seeks to unite European nations and help them overcome a history of wars. However, in creating the Eurozone, political enthusiasm overshadowed careful economic consideration and planning on the monetary union’s functioning. More specifically, the Eurozone’s economic institutions are wholly inadequate to serve the collective interests of its member states.
By abdicating monetary sovereignty to a European central bank, the GIPSI (Greece Portugal Ireland Spain and Italy) nations’ economies became vulnerable to asset bubbles that could not be prevented (by rising rates). Once these bubbles imploded and demand plummeted, these countries found themselves unable to restore demand through monetary stimulus. The ECB could not help them without violating its mandate of targeting inflation at 2% in the entire Eurozone.
The current situation is a consequence of an inadequate set of institutions to support a monetary Union. There are many institutional mechanisms that are sorely lacking in the Eurozone.
1) The ECB’s sole mandate of inflation targeting prevents it from using monetary policy to support economic growth, even when inflation is below target.
a. This is unlike the Bank of Japan, who actively manages its exchange rate to support the export sector.
b. This is unlike the Federal Reserve, who has a dual mandate of price stability and full employment.
2) The ECB cannot directly purchase its member states’ debts, which restricts those states’ ability to undertake expansionary fiscal policy in case of a recession (like now).
a. This is unlike the Bank of England, who can buy significant amount of debts (“quantitative easing”) to support economic demand and ensure that consumers and investors have access to cheap funds when demand is weak.
3) The ECB is not a lender of last resort. It cannot lend directly to troubled lenders that have no assets to put up for collateral. Therefore, the increasingly strong belief that some member states may leave the union is creating a deposit flight from GIPSI banks, making it a self-fulfilling prophecy. This incapacity to act as a lender of last resort places the burden of supporting failing banks on member states that have a limited capacity to borrow from the markets.
a. The Federal Reserve in contrasts can lend as much is necessary to prevent a banking crisis from aggravating an economic recession.
4) Europe lacks a depositor’s insurance corporation. The lack of a EDIC (European Depositors Insurance Corporation) makes depositors far more likely to run on their banks in cases of financial uncertainty.
5) Europe lacks a federal agency to buy and subsidize mortgages.
a) The lack of an agency to buy and subsidize European mortgages sets up the condition of a credit crisis. Struggling homeowners cannot get temporary reprieves from mortgage payments when they can no longer afford them, which increases foreclosure rates that depreciates property prices. Rapidly falling property prices create a situation whereby a huge proportion of properties are worth less than the mortgages on them. It then becomes rational for homeowners to default on those mortgages, and that weakens bask balance sheets as their shares of non-performing loans increase. Europe needs a Fannie Mae and Freddie Mac.
b) The lack of a publicly-funded and European-wide agency to intervene in the housing market forced the Irish government to buy most of the country’s commercial real estate as Irish people were left owning homes that are worth a fraction of their mortgages. Europe lacks a fiscal union.
6) The lack of a fiscal union, when there is no monetary union is economically dangerous as governments’ need of resources to support unemployed people increase while the economic base from which they can raise resources to meet their transfer payment obligation shrinks. Spain has to find the resources to help the 20% of its unemployed labour force, while the number of taxpayers is shrinking. The lack of a fiscal union implies that states with more resources and more robust economies cannot automatically support those whose economies have slowed down.
The weak institutional framework of European economies compounded countries’ incapacity to restore full employment to their economies through monetary intervention. All of that is bad news for the survival of the Euro as a common currency. In many ways this could have been anticipated because Europe never was an optimal currency area. The effective lack of mobility of factors of production (due to linguistic, legal, and cultural barrier) means that market forces cannot efficiently adjust economic imbalances between various geographic areas of the Eurozone. Italian, Spanish and Greek unemployed workers cannot just pack up and pick up a job in Munich.
The bad news for Europe is that institutions that can support healthy economic growth cannot be grown overnight. The good news is that the knowledge to create sound institutions exists and can be leveraged to support Europe’s aspirations to peace and prosperity.