Is it time to abolish the Eurozone?

For quite an incomprehensible reason, there exists a deeply-rooted, almost untouchable idea that the Eurozone is an indispensable monetary union without which Europe would be unimaginably less prosperous, more unstable and divided. Any time when someone attempts to suggest that the Euro is not beneficial to certain European nations and that in fact it brings about a variety of disadvantages and limitations, the response is one of disbelief and perception of the anti-Euro position as outrageously reactionary and even somehow revolting. Fully prepared to undergo such a reaction again, I will outline the arguments against the Eurozone in its current state, for the mere reason that I believe that it is doing too much damage to be ignored and dismissed as a ‘populist’ excuse for ‘greater and more complicated problems’.

If anything, the functioning of the Eurozone is precisely that — relatively complicated. To many people, including the most ardent defenders of the Eurozone as well as its most pronounced opponents, it is a complete enigma. However, a basic description of it will suffice for us to observe both its well-documented benefits and its less-known disadvantages, which exist particularly for the poorer and economically weaker member states of the Euro Area.

Arguably the most important implication of the Eurozone is the erosion of independent national monetary policy. This has occurred as a result of the European Central Bank (ECB) taking the reins of nearly every aspect of policy related to money supply and base interest rates. A second feature of the Eurozone is the interdependence of economies as distinct as Germany and Greece and Portugal and Finland, which results from all of them being tied to one signle currency. Finally, the Eurozone implies that countries have to limit their budget deficits under the Growth and Stability Pact, designed to prevent inflation occurring in one country because of the ‘fiscal irreponsibility’ of another.

The problems these features create are as numerous as they are varied. Firstly, and perhaps most famously, the member states’ lack of control of their own monetary policy leaves them with their hands tied when combatting a recession or an economic slowdown. An example would be a relatively poorer Eurozone country, with a budget deficit and a current account deficit. The exports they produce are mainly medium to low-quality and thus exposed to more competition from developing countries. A crisis sets in and the economy is a poor state, with the menace of a technical recession on the horizon. What can be done to reverse the negative growth trends and stimulate the economy?

Most economic theorists will suggest an implementation of expansionary fiscal and monetary policy and/or an export-led recovery. Of course, what’s common among these policies is the inability of Eurozone member states to carry them out to an effective extent, largely due to the restrictions which accompany membership of the Euro Area.

A truly robust expansionary fiscal policy is impossible because of a budget deficit limit imposed by the Stability and Growth Pact. This agreement forbids countries’ budget deficits exceeding 3% of GDP. Is that necessarily a negative implication? No — indeed, fiscal responsibility is crucial for the longt-term prosperity of nations. Yet during times of recession, it is admissible to discard such responsibility and spend far more than the total government revenue. If managed properly, such an expansionary recovery will facilitate the repaying of the debt incurred relatively easily, as much higher tax revenues will allow governments to spend more on debt management.

Moreover, it is common knowledge that during times of recession government revenues and a country’s GDP are both lower than in the years or quarters preceding the recession. Subsequently, a 3% budget deficit limit will signify that governments have to spend less, in nominal as well as relative terms, on virtually everything, from healthcare and education to public order and defence. Needless to say, this will cause a decrease in the standards of life of the citizens. But it will also have a negative purely economic effect. As government spending is a component of Aggregate Demand, a reduction in it will also lead to a fall in aggregate demand. In addition, a reduction in government spending is also likely to lead to fall in real wages of civil servants and public sector employees, which will consequently lead to a fall in consumption. Consumer consumption is, of course, the largest component of Aggregate Demand, and a fall in it will further decrease Aggregate Demand, reinforcing, rather than resolving, a recession. So what has this got to do with the Euro? The Stability and Growth Pact is a direct result of the creation of the Eurozone. It is only natural that the Benelux countries and Germany wouldn’t like relatively poorer countries having unlimited budget deficits, as that would result in inflation not only in the country with said deficit, but also in all of the other countries of the Eurozone. There is no point criticising that attitude — it is only normal that countries do not want to suffer from another nation’s policies. However, it is also only normal that countries which share different economic situations and views do not form part of the same monetary union and do not have the same deficit targets.

Even more impactful is the issue of an export-led recovery. While countries whose goods are generally high-quality and very competitive, such as Germany, or targetted at niche, luxury markets, such as Italy, are not affected enormously by the Euro’s relative strength in relation to other currencies, countries which produce lower-quality export goods are. A basic explanation of what occurrs in such a case is the following — Germany and the Netherlands export highly competitive goods which are bought abroad by middle-class and wealthy consumers because of their quality and brand, regardless of whether similar, but lower-quality, national goods are slightly less expensive. Their goods are in high demand abroad, which obliges foreign consumers to ‘buy’ Euros to purchase these goods. As a result, the overall demand for the Euro rises, causing its value in relation to most other currencies to appreciate. This makes all goods produced in the Eurozone for foreign export more expensive for foreign consumers. While this has little impact on, for example, German and Dutch goods, which remain similarly competitive because of their comparative advantage and high quality, it does have a significant impact on lower-quality goods with a high price elasticity of demand. Countries such as Greece, which tend to produce the latter goods, therefore suffer, as their exports are significantly more expensive than ones from developing countries, which usually have the power to devalue their currencies in order to boost their exports’ international competitiveness. Thus, demand for their exports falls, their economy suffers, and an export-led recovery is nearly impossible. But if demand for Greek goods falls, wouldn’t that also reduce the demand for the Euro and cause its value to depreciate, boosting the competitiveness of Greek goods? Unfortunately no, as demand for German, Austrian, Dutch etc. goods does not fall, and in fact probably rises, tying Greece to an exchange rate which makes them uncompetitive. Of course, if Greece had its own currency, it could devalue it through expansionary monetary policy, boost its exports’ competitiveness and stimulate an export-led recovery. Regrettably, within the Eurozone, this is impossible for countries such as Greece.

The Euro’s disadvantages are not limited to recession recovery restrictions either. A significant problem can arise when a certain economy is growing rapidly too. Normally, when an economy is expanding at a fast rate and experiencing what’s known as a positive output gap (i. e. when the current rate of growth is higher than the sustainable long-term rate), central banks in said countries will raise interest rates to make borrowing more expensive, thus suppressing Aggregate Demand, preventing excessive inflation and making sure that the economy does not ‘overheat’. Within the Eurozone, however, individual countries’ central banks have almost no control over interest rates. These are instead set by the European Central Bank (ECB), and the rate is effective for each member state of the Euro Area. Upon first glance, this might appear advantageous — after all, such a communitarian policy might harmonise the diverse economies of Europe. However, upon closer inspection, it becomes clear that there is a certain danger to such a policy. Firstly, in a situation where the majority of countries are growing slowly but one or a few countries are growing more quickly, problems might arise for the faster growing countries. To stimulate the economies of the majority of member states, the ECB will lower interest rates. However, this will have a negative impact in the countries which are already growing, as it will simply encourage more borrowing and more consumption, quite possibly resulting in excessive inflation and unsustainable growth in the medium-term. In the reverse case, where a few states are lagging behind the majority, the effect will be the opposite, but equally as negative. As interest rates will be set higher to control the growing economies of the majority of member states, the few stagnating countries will be unable to use lower interest rates to stimulate their economies by encouraging borrowing and consumption. The common deduction from both cases is clear — the Eurozone will always tailor its policies towards the ‘majority’ or the ‘larger countries’, resulting in a negative impact on individual member states whose economies do not fit into the general trend.

Clearly, the Euro has too many negative consequences to be as immune from criticism as it is currently. That being said, I do not advocate completely abolishing the monetary union and reverting back to national currencies exclusively. Instead, it appears that Europe should consist of multiple monetary unions. For example, a currency like the Euro would work very well as a common currency for Germany, Finland, Austria and the Benelux countries. A different currency could be useful as a common one for, for example, Portugal, Spain, Greece, Cyprus and Slovenia. Another one might work for the Baltic states. Monetary unions are not inherently bad, even if they always have notable disadvantages, but they need to be comprised of countries with similar economies and be much more flexible than the Eurozone is now.

Perhaps in some distant, or not so distant, future, the economies of Europe (or a majority of them) will be harmonious enough for the Euro to be a successful project. Indeed, it has worked quite successfully already for some European countries. However, for others, notably the south European ones, but also others, we must reconsider its efficacy, discard our overly positive initial perceptions and create a healthy, constructive debate to decide Europe’s monetary future.