A Riposte to Niall Ferguson
Niall Ferguson and I have different views of the euro crisis, but there are also aspects on which we agree: The Eurozone is stuck in a wretched crisis that has brought about unbearable unemployment levels in southern Europe, and which cannot be solved satisfactorily through deflation. Deflation would cause bankruptcies among over-indebted households and companies because they would be unable to service their debts. We also agree that the crisis was triggered by the US financial crisis sweeping over to Europe, and that Germany accumulated large current account surpluses after the introduction of the euro that are the mirror image of the distressed countries’ deficits.
One point of disagreement is in the interpretation of the current account imbalances. According to Ferguson, the euro helped Germany because it created current account surpluses at the expense of the southern countries.
This view is plainly wrong. Ferguson fails to realise that, by definition, a current account imbalance is a capital flow, and that over the period in question, the latter indeed explains the former. When capital flows from country A to country B, A falls into a slump and B experiences a boom. The booming country sees its imports rise, while its rising wages depress exports. The opposite holds for the slump country. For that reason alone it is absurd to say that a country profits from a current account surplus or suffers from a deficit. That’s primitive mercantilism which was put to rest already by nineteenth-century economists.
The now-troubled countries were the recipients of the capital mobilised by the euro. The announcement of the euro eliminated exchange risk, leading investors to demand lower yields. This fuelled an economic boom that turned into an inflationary credit bubble, causing massive current account deficits. The bubble burst when the financial crisis spilled over from the US and investors refused to continue financing the current account deficits, leaving in its wake overly expensive economies that had lost their competitiveness and are now on the brink of collapse.
Germany, under the euro, was the largest capital exporter and plunged into a deep slump. Only one-third of its savings was invested at home, the rest being exported. As a result, during the early years of the euro the country had the lowest net investment rate and the lowest growth rate in Europe. Rapidly rising unemployment forced the Schröder government in 2003 to enact painful social reforms. When the euro was irrevocably announced in 1995, Germany’s GDP per capita was the second-highest among the current euro countries. Now it is seventh. That’s not exactly the performance of a “euro winner”.
Things started to perk up for Germany only after the credit bubble in southern Europe burst, because it became a safe haven for its savings. Confidence in German property fuelled a construction boom which, if capital is not artificially escorted abroad, will gradually eliminate the current account imbalances.
And herein lies the other disagreement. The measures suggested by Ferguson, namely institutionalising redistribution among the euro countries through a common deposit guarantee, a common Eurozone budget and Eurobonds, are counterproductive because they would perpetuate the structural differences in competitiveness that arose from the southern European credit bubble. Their misuse cannot be fully prevented even by creating a powerful European state. They would maintain wages that do not reflect productivity and would turn a temporary crisis into a chronic malaise. They would also tend to revalue the euro, undermining the crisis-hit countries’ competitiveness.
Thus, muddling through is the only solution. Germany must accept more inflation while the southern countries reduce theirs to bring about the necessary realignment of relative prices. This process, not much in evidence among the crisis-stricken countries bar Ireland, can be carried out only when the austerity demanded by the markets is only modestly alleviated with intergovernmental credit. The European Stability Mechanism ESM has already been generously endowed for this task.
Those Eurozone countries that despite the support cannot cope should be allowed to leave the currency union temporarily, to be readmitted after they have devalued and implemented the necessary structural reforms. Since the euro area is no unitary federal state with a power monopoly and a democratically elected government, the euro cannot function as the dollar does. The Eurosystem should be recast as a currency system whose flexibility lies between that of the Bretton Woods system and the dollar. As things now stand, Greece’s competitiveness would already benefit very quickly from an orderly exit followed by devaluation, while the readmission option would strengthen its zest for reform. The exit should in any case be accompanied by a haircut that converts debts, according to the Lex Monetae, into the national currency. A debt conference granting a debt moratorium to overly indebted countries that are not exiting the euro may also be needed.
Of course all of this implies risks for investors. However, the risk posed by the market-incompatible mutualisation of debt through Eurobonds is much greater, as US history shows. After the US first mutualised state debts in 1791 under Alexander Hamilton and, again, after the second war against Britain, the American states went into a borrowing binge. A massive credit bubble emerged that burst in 1837 and pushed more than half of all states into insolvency over the following five years. As Ferguson’s historian colleague Harold James of Princeton has shown, the only result of debt mutualisation was animosity and strife.
The USA and also Switzerland have opted for a no-bail-out clause for overly indebted states or cantons. Otherwise, they would have to be much more centralised, bestowing the central government intervention rights that would go all the way to the imposition of a delegate governor. But a European federal state, if it should come to pass, will surely not be more centralistic than the USA or Switzerland. Even if such a state were established, mutualising debt would therefore still fail to be defensible.