Should We Dump the Euro?

Should We Dump the Euro?
Profile photo of Frank Hollenbeck

ecbThe Greek drama continues to unfold with the risk of a “Grexit” becoming increasingly likely. Yet, a large majority of the Greek people want to keep the euro. This would force the Greek government to live within its means, which isn’t a bad thing. With anti- austerity parties gaining strength continent wide, Greece may be the first, and not the last, to leave. Yet, the problem in Europe is not the euro, but excessive government regulations, spending, and taxation.

For many years, it has been fashionable to blame the euro for all of Europe’s problems. Economists who suggest breaking up the euro are like people selling gimmicks promising massive weight loss without either exercise or cutting back on pizza or doughnuts. They want the gains without the pain. They argue it’s much better to reduce your debt by inflating it away – thus robbing your creditors- than having to take on the painful adjustment of limiting government’s size to what can be justified only with direct taxation. The real problem is not the euro, but debt-financed government spending.

The theoretical justification for breaking up the euro comes from the literature on optimal currency areas. Suppose you have two regions, Los Angeles and Las Vegas, with an economic boom in Vegas and a slump in Los Angeles. Salaries would slump in Los Angeles and surge in Vegas. Labor would normally move from Los Angeles to Vegas. Both of these factors, immigration and wage costs, would temper the boom and improve the slump. These are known as automatic stabilizers.

If labor, instead, cannot move to Vegas, because of differences in languages or other restrictions, then the adjustment will fall exclusively on labor costs. If instead, the two regions had different currencies, then a depreciation of the currency of Los Angeles could substitute for this adjustment in wages and immigration. In other words, an external adjustment in the currency would replace internal adjustments in labor costs. Hence, a region with low labor mobility is better off with its own currency, such as the individual countries in Europe, while a region of high labor mobility, like the USA, would be better off with a common currency. In other words, a country with its own currency can run independent monetary and fiscal policies. Of course, Austrian economists would view such constraints as a very good thing if such monetary or fiscal policies only redistribute income and interfere with the ability of prices to efficiently allocate resources and guide production of goods and services to where it is most needed.

The benefits of a common currency are massive. Transparency is improved and uncertainty and risks are reduced. Money should be viewed as we perceive any unit of measurement. We don’t have an optimal size for a ruler, nor do we want it to fluctuate constantly. It should be of a certain length and not change much if it is to serve its function best. The same is true for money. Capital flows and real investment booms in an environment where the unit of account is mostly stable.

Anyone who has travelled to a foreign country knows the hassles of dealing with a foreign currency. You first have to pay a fee to convert your cash, and then you have to make sure you spend it all before you leave the county, otherwise you will be left with useless coins and bills at the bottom of your sock drawer.

Those who advocate the breaking up of the euro cite the higher labor costs in Italy than in Germany. Of course, no one really asks why labor costs became so much higher in the first place. If Italy has higher costs than Germany in making, for example, cars, then the car industry in Italy should go bankrupt. If the Italian government props up Italian car production with subsidies or tax advantages, it should not be surprised to see higher labor costs in the Italian car industry. It is not the euro but government policies that caused labor costs to get out of whack in the first place.

Furthermore, in most southern European block countries, the government accounts for nearly 50% of the economy. Most people either work directly for the government or work for the private sector whose revenues depend directly on the government’s largess. Most of the economy is not even affected by the international competiveness of its private sector.

Advocates of breaking up the euro never talk about the southern block’s labor costs relative to those in China or India. It’s always about Germany’s labor costs. The real problem is not labor cost but a lack of competitiveness. Great Britain has gained very little from the significant drop in the pound’s effective exchange rate since 2007. In today’s world, a product made in Britain probably has parts coming from all over the world, so a drop in the currency’s value only give producers a temporary small gain from lower domestic costs, which is mostly labor. These gains are likely to disappear quickly since labor unions are keenly aware of how depreciations reduce the real value of nominal wages. Government should focus on policies to improve competitiveness (such as reducing the weight of taxes and regulation) instead of trying to gain a very temporary and possibly illusive gain in competiveness though currency devaluation.

Some would argue that competing central banks with competing currencies would be a preferred choice to a single central bank with a single currency. Of course, there is nothing “competitive” about government actions since they have a captive audience. We only have to look at the current state of the world’s “competing” currencies to see that this is simply a race to the bottom. As Mises foresaw,

“A general acceptance of the principles of the flexible (exchange rate) standard must therefore result in a race between the nations to outbid one another. At the end of this competition is the complete destruction of all nations’ monetary systems.”

A single central bank with a single fiat currency is no panacea. All fiat currency systems, without monetary reform, must end in hyperinflation. An independent central bank is an illusion of protection. When push comes to shove and a government is backed to the wall, it will do anything to ensure its short term survival. The “independence” of a central bank would simply be a “bump in the road”. Only an external constraint such as gold can stop a government from using the printing presses to quell its insatiable desire to expand by consuming more and more resources and goods and services.

The problem with the euro is not that it is a common currency but that it is a fiat currency. Unlike the Federal Reserve in the U.S, the ECB has only one mandate – price stability. Yet, the ECB is just as responsible as the FED for the housing bubbles and other mal-investments at the start of the century.

The ECB’s current monetary policy structure is a bubble-creating machine. The ECB provides liquidity on collateral; the higher the quality of the collateral, the greater the liquidity. European banks quickly realized that the best collateral was government bonds in the euro zone since the bonds were all given AAA ratings by the ratings agencies. The assumption, of course, is that governments never default.

With a large demand for government bonds, interest rates quickly fell euro-wide to levels that only Germany experienced before the creation of the currency. By lowering the cost of borrowing, countries such as Greece or Italy had a much greater incentive to borrow to pay for vote-getting public expenditures (especially increases in public sector wages). Governments issued an excessive amount of bonds, which led to an excessive amount of liquidity and credit and led to the massive housing bubbles and malinvestments experienced between 1999 and 2007 throughout the euro zone.

Without such a monetary policy structure, Greece, Spain, and Italy would never have been able to get into this much debt trouble. The bubble in government bonds can be directly attributed to the ECB’s liquidity-granting structure. What is unbelievable is that this system is still in place, and the ECB seems totally unaware of what it has done and continues to do. European banks are currently up to their eyeballs in government debt, but the ECB seems oblivious to its role in this massive charade.

Indeed, the ECB is now purchasing 60 billion euros per month of government bonds inducing governments to borrow even more. Of course, printing intrinsically worthless paper will not solve Europe’s fundamental problem of supply being misaligned with demand – a misalignment created by government’s incessant interference with the workings of the price system. The printing however will make things worse since it interferes with the workings of a capitalist system. It alters relative and absolute prices causing a divergence between what society wants to be produced and what is produced.

With this new phase of printing, Europe is slowly walking down the same slippery slope towards hyperinflation that is the inevitable endgame of all fiat currency systems. A common currency must be divorced from government’s ability to influence its value.

Few economists understand why so many advocate a return to the gold standard. Keynes called gold a “barbaric relic”. It’s not because gold is somehow special. Gold has many drawbacks, but gold’s primary advantage makes all of these drawbacks moot. The most important aspect of a gold standard is that it constrains governments from using the printing presses to finance government expenditure.

A stable unit of account and exchange is a great idea, but it needs governments willing to accept the discipline it imposes. If anyone should dump the euro it should be Germany. Its current strategy to protect the euro is to use debt to solve a debt problem: to send good money chasing after bad. Germany would be wise to join likeminded countries on monetary policy and create a northern Euro backed by gold. Southern euro countries are a lost cause. People are not in the streets rioting for less government, but for more government. Let them have what they want: a worthless currency!

Profile photo of Frank Hollenbeck

Frank Hollenbeck, PhD, teaches at the International University of Geneva.

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