Unseen economic effects from the single Euro currency...
FROM WHERE did Europe’s recession come? asks David Howden, assistant professor of Economics at St. Louis University in Madrid, Spain for the Cobden Centre.
To listen to some commentators
one would think that it came from nowhere. Indeed, the idea that a
contagion is engulfing Europe – that one insolvent member state could
cause innocent bystanders to fall – is so pervasive that its mere
mention seems redundant. It is unfortunate that such a belief is
prevalent as it ignores not only common usage of the English language,
but also some very simple and relevant economic facts.
Like many economic phenomena, the important aspect is not what is
seen and readily apparent. As Frédéric Bastiat was able to so cogently
stress over 160 years ago, the crucial role for the economist is to
discern the unseen economic effects.
While it is all too easy to focus on European member states’
burgeoning public debts, widening credit default spreads, dwindling tax
bases and climbing ranks of dissatisfied unemployed citizens, the hidden
causes are what are needed to be assessed to correctly foresee a
prosperous future. While it is increasingly becoming accepted that
European governments spent more money than they had, and that the ECB
held interest rates too low for far too long, the specific reasons why
these events manifested remain largely shrouded in mystery.
Philipp Bagus has just written the first coherent book
explaining the origins, functions and consequences of the European
Central Bank. An understanding of how this institution functions is
essential to anyone – from the general population to the pundit to the
politician – to grasp how a seemingly beneficial institution could reap
In particular, I would like to focus on two of the most important consequences of the formation of the common currency area.
First, let us turn our attention to the now well-recognized fact that
the ECB held interest rates too low for too long. Accession to the
Eurozone meant that a member state would become subordinate to a common
interest rate policy set in Frankfurt. While one base nominal interest
rate pervaded throughout Europe, divergent inflation rates quickly
created distinct real rates. In the high inflation periphery countries –
the PIIGS of today – real interest rates dropped to levels lower than
most of their citizens had ever witnessed. The result was an expansion
in interest-rate sensitive projects. Investment in housing, for example,
The Spanish economy illustrates the worst of these excesses. In 2006
Spaniards constructed over 700,000 new homes – more than Germany, France
and the United Kingdom combined could tally. That 2006 was also the
midst of a housing boom in the United Kingdom should more than allude to
the severity of this problem. Today more than 1 million Spanish housing
units stand empty – more than the whole of the United States.
This common interest rate policy was heralded throughout the 2000s as
allowing the periphery countries access to cheap credit markets. This
would allow, in turn, for quick and easy development of infrastructure
to enable their rise to power. If a housing bubble qualifies as a
positive buildup of infrastructure, mission accomplished.
Next let us turn our attention to the common exchange rate imposed
throughout the Eurozone as a consequence of the shared currency. During
the convergence to the common currency throughout the 1990s the member
states of the future Eurozone saw their respective currencies more or
less equalize in value. In retrospect the situation was like two sides
of the same coin. In Northern Europe, especially Germany (but also
Netherlands, Austria and to a lesser extent, Belgium) the once powerful
Deutschmark declined in value to meet the future euro’s shared value. In
contrast, along the Eurozone’s periphery a sharp increase in currency
values coincided with the eventual appearance of the euro. As the common
currency replaced the individual member states’ currencies a single
foreign exchange rate was imposed throughout the whole of the monetary
The consequences are all too painfully obvious today. Italians,
Spaniards and Greeks – countries and people accustomed to less valuable
currency units – were able to buy foreign goods at much lower prices
than was possible just a short period earlier. A spending boom developed
which saw the demand for imports grow at a fevered pitch.
At the same time the uncompetitiveness of producers in these countries against foreigners was becoming apparent. Indeed, as Bagus explains on page 43
of his book, unit labor costs of the PIIGS countries soared anywhere
from 10 to 35 percent over the decade from 1999 to 2009. The consequence
was a drastic decrease in exports coupled with an increasing demand for
cheap imports. Severe trade imbalances developed, as savings from these
periphery countries flooded overseas markets in exchange for cheap
Not surprisingly, the situation was the opposite in the economically
stronger Northern European countries. German unit labor costs declined
about 10 percent from 1999 to 2009, largely because of its newly
devalued currency shared with its Southern European neighbors. The large
trade surplus that Germany enjoys today and which is largely viewed as a
positive glimmer of light from the otherwise dismal continent is caused
by the same phenomenon that plagues the peripheral countries: a shared
currency with a shared foreign exchange rate, the value of which is the
average of the implicit currencies of its component countries.
Unfortunately, very few individual data points comprise an average. A
consequence in the Eurozone is that no one country has a currency valued
at a sustainable level.
Europe’s unsustainable state of affairs did not come into existence
from nothing. Nor is the current threat of “contagion” founded on any
application of the real phenomenon. The same malady affects all Eurozone
economies the same as every other one. More striking is that this
disease has continued unnoticed for over a decade… until now.
The effects of the common currency are now apparent. While knowledge
of how a car’s engine is of secondary importance when it is in good
repair, as soon as it breaks down such knowledge is essential to make it
roadworthy again. The Eurozone is an analogous case. Understanding how
the euro functions, and how regional politics play a role in forming the
common monetary policy is essential to understanding where the current
recession came from and how we will get out of it.
Philipp Bagus’ new book “The Tragedy of the Euro” is essential reading to everyone who wants to gain a better understanding of both these points.
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