What Options for the Euro?
| Author | George Irvin |
| Published date | 01 April 2011 |
| Date | 01 April 2011 |
| DOI | http://doi.org/10.1111/j.2041-9066.2011.00058.x |
| Subject Matter | Foresight |
dominating world trade. As we know, Key-
nes lost most of these arguments in the face
of strong US opposition.
This aside is important since large trade
imbalances usually lead to political disa-
greement; for example, between the US
and China, or between Germany and the
rest of the eurozone. In the case of Ger-
many, if we look at intra-eurozone trade
flows, we find that Germany’s large cur-
rent account surplus is roughly matched
by the sum of Club-Med deficits. Moreover,
no matter how much they cut wages, not
all weaker eurozone countries can run an
export surplus like Germany. Within the
eurozone, country A’s exports must by
definition be country B’s imports. Nor can
weaker eurozone countries solve the prob-
lem by running a trade surplus with the
rest of the world. As Philip Whyte at the
Centre for European Reform has shown,
the eurozone is simply too big for the rest
of the world to be in deficit with all euro-
zone members.
Next, consider the argument about ‘eco-
nomic governance’. An oft-repeated asser-
tion is that the southern countries need to
‘put their house in order’ by balancing the
books; that is, by eliminating government
deficits in the short term, and bringing
down their debt-to-GDP ratio in the long
term. Northern European countries – which
generally have balanced budgets and run
trade surpluses – are fond of this argument.
But there are two problems here. First, not
all countries that are candidates for sover-
eign debt crisis have run large deficits. For
example, unlike Greece which has had a
chronic government deficit since before
joining the eurozone, both Ireland and
Spain were within the Maastricht 60 per
cent debt-to-GDP limit in the years preced-
ing the 2008 crisis. In Ireland in 2008 and
Spain today, by far the largest debt burden
is within the private sector; indeed, it was
Ireland’s decision to underwrite in full the
What Options for the Euro?
Regardless of what happens in the
coming weeks and months, one
thing seems fairly certain: the crisis
in the eurozone is unlikely to abate anytime
soon.
There are two fundamental problems
that need to be solved if the euro is to sur-
vive, let alone prosper. The first is that of
trade imbalances; the second is the need
to strengthen the nature of fiscal union –
broadly speaking, a move to a federal form
of economic governance.
Why worry about trade imbalances? In
the textbook world of economists, such
imbalances can only arise for a short time
since external deficits and surpluses are self-
adjusting via exchange rate movements. If
country A is a super-efficient exporter while
country B has lost its competitive edge and
runs a large trade deficit, a large enough
rise in the value of A’s currency relative
to B’s must eventually bring about trade
equilibrium.
The problem with a currency union is
that exchange rate movements no longer
act as a stabilising mechanism, so ‘internal
devaluation’ must be achieved by wage cut-
ting alone, a painful process at best and one
that typically places the burden of adjust-
ment on the incomes of the poor.
On a historical note, Keynes recognised
that even under the exchange rate regime
envisaged at Bretton Woods, three things
might happen. First, countries might en-
gage in bouts of competitive devaluation
– beggar-thy-neighbour policies – resulting
in a race to the bottom. Second, to keep the
game fair, an international bank (the Inter-
national Monetary Fund, he argued) was
needed to regulate trade through timely
devaluations and revaluations – the latter to
be urged for countries that ran too large an
external surplus. Third, a new international
trading currency (which he called ‘bancor’)
should be created to prevent any single
country’s currency reaping the benefits of
The crisis in the eurozone will not be solved by austerity measures, says George Irvin. In the long run only
greater financial harmonisation and a federal form of economic governance will save the embattled single
currency.
massive debts of its private banks that pre-
cipitated the country’s crisis.
But there is a second leg to this argument
of which few non-economists are aware. A
budget deficit cannot always be eliminated
simply by ‘balancing the budget’ because of
the logical link between the government ac-
count and the other savings balances in the
economy. We know from simple national
income accounting definitions that the sum
of private and public sector ‘savings’ must
equal the external current account balance.
If there are no net savings in the private
sector and the external current account is in
deficit, the government account must also
be in deficit – there is no causality implied;
rather, this statement is true by definition.
Germany and other northern European
countries can ‘balance the books’ precisely
because they run an external surplus.
In short, the position of the deficit hawks
is not just empirically misleading, but it is
logically untenable. This has a number of
immediate implications for policy. First,
the eurozone’s problems will not be solved
by imposing stricter budgetary discipline
on member states. Indeed, the opposite is
more likely; a recent International Mon-
etary Fund study suggests that cutting gov-
ernment spending will weaken aggregate
demand and reduce the prospects of growth
and technological modernisation.
Second, because the lion’s share of gov-
ernment spending in the eurozone is for
social protection, cutting it has serious dis-
tributional implications and we know that
increasing inequality carries high social
costs.
Third, if one assumes that financial
markets may become worried about large
economies like Spain and Italy, the €440
billion European Financial Stability Facility
(EFSF) is far too small. Part of this facility
is already being used to help the European
Central Bank (ECB) drive down yields by
purchasing bonds from troubled member
Foresight
32 Political Insight
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