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1 Why is the current model of EMU not working?
The ideas of economists and political philosophers, both when they are right and when they are wrong, are more powerful than is commonly understood. Indeed the world is ruled by little else. Practical men, who believe themselves to be quite exempt from any intellectual influences, are usually the slaves of some defunct economists. Madmen in authority, who hear voices in the air, are distilling their frenzy from some academic scribbler of a few years back.
(Keynes, 1936: 383)
Germany’s deep-seated macro policy folly – the country’s notorious anti-Keynesianism – has brought Europe to its knees. Almost a decade into the euro crisis, Europe’s common currency remains a ticking time bomb.
(Bibow, 2017: 31)
Introduction
The introduction of the single currency in Europe was predicted to have beneficial impacts upon growth and prosperity across the participating member states.1 By creating price transparency, it would facilitate the further deepening of competition within the EU single market, whilst exchange-rate stability was considered to be a simulant to the further expansion of trade and, via the development of European financial markets, securing finance for new productive investment. Although the model of EMU selected had been criticised by a number of theorists in advance of its implementation, early evaluations of the initial years of the Eurozone concluded that none of these potential problems had materialised (HOL, 2007).
A decade later, and it is hard to find many commentators who sound as sanguine about the record of the single currency experiment. Indeed, the economic performance of the Eurozone as a whole has proven laggardly during the past decade (Mazier and Valdecantos, 2015: 93), whilst the operation of the single currency regime appears to have worsened the degree of business cycle volatility in the national economies of Eurozone members (De Grauwe, 2013: 6). To compound matters, the single currency area was adversely affected by the global financial and economic crisis of 2008, but, as other nations employed fiscal expansion and unconventional monetary measures such as quantitative easing, the rigidity of the macroeconomic institutional framework underpinning EMU was less effective at realising economic recovery. Thus, the Eurozone suffered a further downturn in 2012–2013, as can be seen in Figure 1.1. Indeed, by 2016 it had only narrowly exceeded the level of economic activity previously pertaining in 2007. Hence, Figure 1.2 indicates that its present slow recovery suggests that it will be problematic for the Eurozone to complete its recovery to pre-crisis growth rates and growth path, never mind exceeding them to recover lost productive potential (Hein, 2017: 61–62).
Figure 1.1 GDP in the Eurozone, 1996–2017
Figure 1.2 Development of GDP in the Eurozone, 1999–2016
The free flow of capital, perceived by the architects of EMU to be one of the key drivers of future dynamism and economic growth, magnified the problems for the Eurozone. As Stiglitz (2016: 125–126) so eloquently explains:
Ever-foolish capital markets thought the elimination of exchange-rate risk meant the elimination of all risk and rushed into the periphery countries. . . [then] . . . the same irrational money that had created the euro crisis, realising the enormous mistake that had been made, did what finance always does in such situations. It leaves.
The result is that Eurozone output will be permanently lower as a result of the financial crisis, and lower still because of the poor management of the crisis due to the constraints placed upon member states by the rules established to support the single currency (Stiglitz, 2016: 63). Moreover, in several participating nations, such as Spain, Finland, Portugal, Italy, Cyprus and especially Greece, the experience was much worse, with economic downturns for many deeper than during the Great Depression of the 1930s, and with GDP levels for all these nations still not recovering to levels a decade previously (Stiglitz, 2016: 67).
A gradual economic recovery cannot, however, obscure the fact that the Eurozone crisis highlighted a number of fundamental flaws inherent within the particular model of EMU chosen by the EU. These may be categorised within three broad classifications, namely:
- 1 Technical weaknesses
- 2 Design based upon neo-liberal or new monetarist foundations
- 3 Problems rectifying trade imbalances within a single currency.
Issues pertaining to the first of these categories indicate how inadequate technical design features have weakened the development of EMU, but which, by themselves, are not necessarily fatal to the eventual success of the project if adequate policy interventions and adjustments are undertaken. The second category identifies fundamental problems in the design and operation of the economic infrastructure established to sustain EMU. This is more serious, but a substantive redesign of these foundations could enhance the ability of the current single currency model to work more effectively. However, it is the third category where the current model of EMU is most fatally flawed and where an alternative common currency model of EMU would be superior. That, at least, is the thesis of this book.
Technical weaknesses with the current model of EMU
There are a number of technical reasons why the design and implementation of EMU in Europe has been faulty, and the single currency is a flawed currency area (Barba and De Vivo, 2013; Baimbridge et al., 2012: 96). The most obvious of which is that the introduction of European EMU was based on shaky intellectual foundations, as the convergence criteria (MCC), established by the Maastricht Treaty, focused upon transitory cyclical movements in financial indicators, rather than concentrating upon structural convergence in the real economy (Baimbridge et al., 1999). The creation of the single currency was, therefore, not based upon Optimum Currency Area (OCA) criteria (Mundell, 1961; Eichengreen, 1990, 1992, 1993; Weber, 1991; Bayoumi and Eichengreen, 1993; Baimbridge et al., 1999).
Rather than focusing upon convergence in real economy measures, such as the degree of factor mobility and both commodity market diversification and integration, the MCC rather narrowly focused upon similarities in interest and inflation rates, and limitations upon the ability of potential participants to run ‘excessive’ budget deficits and levels of national debt. The adoption of fiscal rules was intended to prevent moral hazard if individual member states were otherwise able to borrow excessively in the common currency, and thereby free riding on other members of the single currency if they subsequently got into financial difficulties which necessitated a bail out (Lane, 2012: 49). Yet even within the narrow conception of the MCC, the advent of the single currency was undermined by inadequate prior convergence between participating nations (Baimbridge et al., 1998: 5; Lavoie, 2015: 3), as political considerations to maximise participation dominated considerations of what factors economic theory suggested would constitute an ‘optimal currency area’ (Feldstein, 1997: 24–25).
The assumption was made that a shared currency would trigger sufficient structural changes to fulfil OCA conditions and thereby generate economic convergence (Boyer, 2013: 535). Thus, even if ex ante the establishment of the single currency, OCA criteria may not have been met, it is quite plausible that some or all of these same criteria may be satisfied ex post, through deliberate policy measures taken to increase factor mobility and through the natural reorientation of trade towards fellow participants in the single currency (Frankel, 1999: 30). However, it is equally possible that increased specialisation in production, encouraged by increased trade, may reduce the correlation of outcomes between participants in a single currency, thereby causing ex post failure to meet OCA criteria even if these same nations initially did so ex ante (Krugman, 1993: 260).
There is an expectation, amongst mainstream economists, that the operation of market forces will cause economies at different stages of development and at different levels of income and productivity to converge over time, as the mobility of capital and labour, in search of higher rewards, tends to equalise divergent performance of different economies. The operation of EMU would be expected to augment this tendency. However, set against this, market forces additionally generate cumulative causation (Myrdal, 1957; Kaldor, 1970) or centripetalism (Cowling, 1987). This is where an economically successful region or economy generates the profits that facilitate and attract additional investment, whilst a growing area tends to raise real wages, which in turn attracts an inward flow of migrant labour from less prosperous regions or economies. Expanding output will, in addition, potentially allow these regions to benefit from economies of scale, thereby further magnifying the initial competitive advantage of the area and thus exacerbating differences in performance (Kaldor, 1972). Less successful regions, by contrast, will experience lower levels of per capita income, higher levels of unemployment and greater constraints upon their ability to deliver faster growth rates to enable the process of catching-up with their more affluent neighbours (Arestis and Sawyer, 1998: 182). Economic growth, therefore, is path dependant (Kaldor, 1972: 1244).
Relaxing unrealistic neo-classical theoretical assumptions of equilibrium would lead to predictions of free trade increasing and not narrowing divergence between nations, since trade might enlarge differences in productivity between countries at different stages of development. As a result, Kaldor (1981: 593) concluded that:
Under more realistic assumptions unrestricted trade is likely to lead to a loss of welfare to particular regions or countries and even to the world as a whole – that is to say that the world would be worse off under free trade than it could be under some system of regulated trade.
The evidence would tend to support the position adopted by Kaldor and Krugman, in that output crises would appear to occur more frequently for countries that have adopted the Euro (Bird and Mandilaras, 2012: 13). The introduction of monetary union has also coincided with increasing divergence amongst member states, together with a profound worsening of labour’s share of national income of around 35 per cent over the last three decades (Zarotiadis and Gkagka, 2013: 546, 557–558). This should not be a surprise to policymakers since these fears were noted at the time of formation, and indeed, is one reason why convergence criteria were included in the basic membership criteria, albeit poorly formulated and weakly enforced (Weber, 1991; Bayoumi and Eichengreen, 1993).
An inadequate monetarist model of EMU
The current version of EMU, adopted by the European Union (EU), was founded upon principles drawn from what has been variously described as the ‘Berlin-Washington consensus’ (Skidelsky, 2005 : 18; Fitoussi and Saraceno, 2013), the ‘Brussels-Frankfurt Consensus’ (Whyman et al., 2012: 8–15), the ‘new monetarism’ (Arestis et al., 2001: 115; Moss, 2005: 6) or ‘ordoliberalism’, which is a variant of neo-liberalism (Stockhammer, 2016: 367). In part, this model of EMU simply internalised many features of the ‘German model’, most prominently the prioritisation of price stability and aversion to debt, due in large part to the ‘ghost of Weimar’ and hyperinflation instability in the country preceding the rise of fascism in the 1930s (Dyson and Featherstone, 1999). Indeed, it was considered to be an advantage for those countries without prior ‘sound money’ credibility to have monetary discipline imposed upon them via the operation of EMU and a supranational central bank operating on similar lines to the Bundesbank (Smithin and Wolf, 1993: 376). However, the fact that the design of the current model of EMU was drawn from these schools of thought has created a set of fundamental weaknesses within the single currency itself, and its supportive framework.
The new monetarist or neo-liberal approach is founded upon certain basic assumptions. The first of these is that the economy has a tendency to move automatically towards its full employment equilibrium. This idea is often bound up with the supply-side determined non-accelerating inflation rate of unemployment (NAIRU), which is, itself, loosely derived from the adaptive expectations-augmented, vertical long-run Phillips Curve (Friedman, 1968; Phelps, 1968; Layard and Nickell, 1985). The NAIRU approach holds that the level of (un)employment is established by supply-side factors, whether these be the interaction of market forces and/or the balance of power in a distributional conflict between labour and capital. This is, in essence, rather similar to the neo-classical formulation that the intersection of supply and demand curves determines the long-run equilibrium ‘natural rate’ of unemployment, at a given real wage (Friedman, 1968: 8). This approach holds that supply-side factors are not influenced by changes in aggregate demand, beyond the short run, but rather are determined within the labour market. If economic actors possessed rational expectations and markets were perfectly competitive, it was suggested that active fiscal or macroeconomic policy would be harmful, either in the short or medium term, as it would result in higher inflation rather than expanding output and employment (Gordon, 1997). Indeed, under this set of assumptions about how the economy works, it would be impossible for governments to stabilise the economy (Backhouse, 2009: 21).
Inflation is viewed, according to this perspective, as a monetary phenomenon and monetary policy can be directed to its control, using either direct means (money supply) or indirect (interest rates) via inflation targeting. Central banks, independent of political influence, should pursue a policy of long-term, financial ‘credibility’, in order to avoid the time inconsistency problem, which is where the existence of imperfect informat...
