One Currency, Two Europes: Towards A Dual Eurozone

Towards a Dual Eurozone

Bruno Dallago

• Publisher: WSPC
• Year: 2016
• eBook ISBN: 9789814759038
• Topic: Economics
• Subtopic: Banks & Banking
• Index: Economics

The aftermath of the US subprime mortgage crisis in 2008 saw its influence spread around the world, including Europe. The European crisis turned out to be longer, deeper and more resilient than anticipated. An unexpected consequence was the increasingly divergent economic and financial situation of two main groups of countries within the Eurozone, which includes the countries that adopt the euro as their common currency. The divergence was caused by a number of factors, fundamentally stemming from the dissimilar economic and financial situation of its member countries and from the incomplete institutional architecture and the monetary and fiscal policies in the Eurozone.

One Currency, Two Europes: Towards a Dual Eurozone seeks to explore these factors which give rise to the Eurozone's asymmetric composition and the growing difficulties and ineffectiveness that policies meet. It presents evidence to show how the presently incomplete institutional architecture of the Eurozone is the main reason for the extreme detrimental effects of the international crisis and austerity policies, along with the asymmetric economic situation and the insufficient mutual trust demonstrated by the vulnerable as well as resilient countries.

Other than presenting a complete overview and analysis of the events that unfolded in the Eurozone as a result of the financial crisis that first emerged in the US, this book also suggests possible solutions which could help to reunify the Eurozone, and make the common currency sustainable and beneficial for all member countries. One Currency, Two Europes will be useful for policymakers who want to learn from the Eurozone's experience with the financial crisis and the importance of complete institutional architectures and inter-country economic convergence. It will also serve as a reference to students and researchers who would like more in-depth analysis of the crisis and the Eurozone's fiscal, monetary and institutional past, present, and future.

Contents:

• Acronyms
• Preface and Acknowledgments
• Introduction: Prolegomena to the International Crisis
• The Facts: The Crisis and the Eurozone:
  • The World Economy and Europe
  • The International Crisis and Its Origin
  • Financial Causes and Real Sources of the European Crisis
• Institutions and Policies:
  • The Internal Economic Asymmetry of the Eurozone
  • Convergence and Divergence in the Eurozone
  • The Eurozone as a Quasi-Optimum Currency Area
  • A Detour on the Working of the EU: The Asymmetric and Incomplete Build-Up of the Union
• Outcomes and Ways Out:
  • Policies and Their Frames
  • The Crisis and the Incomplete Institutional Architecture
  • Internal Contagion and the Eurozone Economies
  • Policies Under the Blow of the Crisis
  • Conclusions: An Uneasy Match
  • Bibliography
  • Index

Readership: Students, researchers and policymakers who are interested in learning more about the fundamental nature and recent developments in the Eurozone and the European Union and the ways that it can respond to its ongoing economic and political challenges.
Key Features:

• Provides both a complete overview and in-depth examination of the causes, evidence and features of the duality in the Eurozone
• Offers a novel approach to examining the need for internal convergence within the Eurozone through institutional and structural reforms and balanced policies
• Important contribution to ongoing research and policy debates on the European Union, particularly with the Eurozone's management of the recent financial crises
• A useful introduction to the recent economic crisis in the Eurozone in 2015

Part I

The Facts: The Crisis
and the Eurozone

“Countries, therefore, when lawmaking falls exclusively to the lot of the poor cannot hope for much economy in public expenditure; expenses will always be considerable, either because taxes cannot touch those who vote for them or because they are assessed in a way to prevent that.”

— Alexis de Tocqueville (1969, p. 210)

1

The World Economy and Europe

The post-war decades were a period of great economic success, particularly in Western countries. Western economies never experienced such sustained growth rates for such a long period of time in their history. This success benefited most citizens and social groups and classes, particularly in the first half of the period. Economic flexibility and social mobility increased in all countries. As a consequence, societies and democratic polities appeared fundamentally strong and stable. There were periods of economic and financial difficulties; however, these never reached systemic levels. The overall performance was such that there was growing confidence in the ability of governments and international organisations to manage instability in ways that kept damages and risks at a controllable level.

There were different reasons to believe that economies were more resilient — and crises in a sense obsolete — as a consequence of a host of important facts and transformations, in both economies and policies. Countries were considered to be less vulnerable, thanks to deep and important transformations, and more resilient due to strengthened and refined policies. Transformations took place in production, trade, finance, international governance, and economic beliefs: production and markets became more open and integrated and trade became distinctively of an infra-sectorial nature; financial activities greatly expanded and their influence on the working of markets and economic outcomes dramatically increased; the activity and role of transnational companies (TNCs) expanded significantly; and the role of international organisations increased.

As a consequence of the deeper integration and international institutional evolution, national economies became increasingly subject to the impersonal rule of world financial and goods markets and the visible power of large countries and powerful international organisations and transnational companies. Policies, although improved in their knowledge and information basis and in their effects, were increasingly considered to be less important and useful. Indeed, the prevailing economic creed created the idea of fundamentally efficient markets, believed to regulate themselves in the best possible way by making use of all the available information, although trials and errors were credited some role (Fama 1970, 1991; Fox 2009). Thus, asset prices would incorporate and reflect all available relevant information and it would be impossible to “beat the market”. The business cycle was bound to become obsolete and major systemic crises a memory of the past.

Yet this reading of the changes contributed to misleading of policies. The 1990s was the crucial period when changes and policies proceeded to make a major crisis inevitable. Similarly to the 1920s, the end of the economic cycle and an age of endless growth and prosperity were repeatedly announced. Unfortunately, the very success of these changes and beliefs, together with growing real and financial disequilibria and increasingly uneven distribution of the outcomes of growth, made the appearance of the crisis particularly damaging and difficult to tackle.

1.1 The World Economy and Globalisation

The dynamic growth of the Western economies in the postwar decades was interrupted by various factors starting from the 1970s (Crafts 2003, 2012; Crafts and Toniolo 1996). This period came to be known as “stagflation”, a blend of stagnation and inflation comprising low growth rates, considerable price increase and high unemployment. Indeed, and contrary to the policy conviction of the time, inflation and stagnation characterised much of the 1970s and part of the following decade. Traditional policies were based primarily on the Phillips curve, showing an inverse relationship between unemployment and inflation. Under stagflation conditions, traditional policies were ineffective or counterproductive. Policies to combat inflation by means of austerity measures tended to cause stagnation and unemployment.⁸ Policies of monetary, fiscal or regulatory stimulation used to combat stagnation and unemployment risked to directly fuel inflation by creating inflationary expectations and decrease markets efficiency through excessive regulation.

Two different explanations of stagflation were identified, depending on the theoretical and policy approach used (Barsky and Kilian 2000; Blinder 1979; Blinder and Rudd 2008). One explanation looked at aggregate supply shocks as the fundamental cause of stagflation. Shocks came from an unexpected and sudden increase in the price of inputs, particularly if these inputs were critically important for the economy. Shocks that increased input prices and made supply more rigid translated into higher costs and lower production. During the 1970s, shocks were important in the raw material markets, and, in particular, in the energy market due to the oil shocks of 1973 and 1979. Shocks were also important in labour markets: since the late 1960s labour became more militant and economically stronger following the economic boom in the postwar decades and wages increased accordingly.

A second explanation found the cause of stagflation to rest in an inappropriate monetary policy that led to an excessive money supply. An excessive money supply in turn caused excessive private and public spending and consequently higher prices and debts. The resulting inflation triggered lower production and higher unemployment. Inflation proved particularly difficult to combat if prices, taxes, profits and wages were indexed: the inflationary spiral that such institutional assets caused led to self-inflating production costs and further contributed to stagnation and unemployment. Changes in the international monetary system and political events fuelled these processes (see next section).

Policy measures implemented to control stagflation were generally based on the rejection of the previously dominant Keynesian consensus. Thus, they opened the way to what was later on defined as “neoliberal” policies. Anti-stagflation policies were mostly based on a “disinflationary scenario”, consisting primarily of a sharp increase of interest rates. The latter took place between the end of the 1970s and the first part of the 1980s. Although these policies were successful in stopping inflation, they also pushed Western economies into recession and high unemployment. Expansionary fiscal and monetary policies were used to fight recession and unemployment later in the decade. Also important were measures taken to make economies more efficient and competitive, in particular through deregulation and privatisation.

These policies had success in pushing economies out of stagflation. Yet these policies had a role in changing economic institutions and creating the conditions for the wave of financial crises that characterised the years leading up to the 2008 international crisis. This was a period when the role of finance increased vigorously, at a much higher rate than the real economy. It was also a period when Western economies saw emerging economies overcoming them in the rate of growth of productivity and in the expansion of foreign trade. The West kept absolute advantage in productivity levels through the period, yet this advantage was eroding at a fast pace.

The context that the 1990s provided for the onset and the unfolding of the 2008 crisis included a set of deep and far reaching systemic changes. These on the whole made economies more interdependent than ever before, more financially powerful, governments weaker in their ability and willingness to manage economies through policy instruments, and the production profile of economically advanced countries deeply transformed. When the crisis started, national economies proved to be more vulnerable and their situation less resilient, due to greater interdependence and less effective policies.

Two major forces led to the increase of international economic integration: the decrease of transportation and communication costs, via innovations such as containers and information and communications technology (ICT), and institutional developments (Eichengreen 2006). Compared to the first wave of globalisation prior to 1913, the globalisation of the 1990s was overall more extensive, except for net capital flows and migration. In fact, migration was slowed down and hampered by different kinds of regulations. The second wave of globalisation was also distinguished by greater trade and production integration, higher gross capital mobility, and lower labour mobility. However, the 1990s did not actually bring novelties in the expansion of international transactions. In fact, such expansion was the continuation of trends that had been under way during the preceding half a century, without any significant increase of their pace of growth (Eichengreen 2006).

The most important general developments, particularly during the 1990s, were the growth of emerging economies, the growth of financial activities mainly among Western economies, and the rise of regionalism. These developments accompanied globalisation, in part supported it and in part introduced some mild segmentation in the world economy (Eichengreen 2006). The growth of emerging economies, in particular the so-called BRICS countries (Brazil, India, China and South Africa, while Russia followed later on towards the end of the decade), was perhaps the most important achievement of the 1990s and the following decade and a half. Their rising role became apparent in high growth rates, attraction of foreign direct investments (FDIs) and the expanding share of world exports.

The second important general development was the growth of financial activities, including higher capital mobility. Capital mobility originated in the abundant liquidity of financial markets, growing savings in emerging countries and some Western countries (particularly Germany and Japan), and growing debts in the United States. A distinctive feature of this period, compared to the period preceding World War I, was that capital mobility took place particularly among Western economies and chiefly towards the United States. In mid-1990s, three-quarters of the world’s stock FDIs were in the Organisation for Economic Cooperation and Development (OECD) countries, while the latter countries exported more than 90% of the world’s stock of FDIs (WTO 1996). In more recent years the BRICS, in particular China, became more active, particularly as destination countries. Yet OECD countries continued to dominate.⁹

The most dynamic component of capital mobility was short-term flows, the most volatile component that contributed to the vulnerability of economies to the crisis. Also important was in this period the internationalisation of production, including FDIs and cross-border mergers and acquisitions (M&A). Before World War I, FDIs were heavily concentrated in developing countries (nearly two-thirds of their global stock) and in extractive industries.

Quite different was the situation in mid-1990s, when more than two-thirds of FDIs were located in developed countries and mostly in manufacturing and services (Eichengreen 2006; OECD 2014a; UNCTAD database; World Bank database; WTO 1996). In nominal terms, the annual outflow of FDIs from OECD countries to all destinations (including other OECD countries) was US$25 billion at the end of the 1970s. This level increased to $60 billion by 1985 and to US$315 billion by 1995, a more than five-fold increase (WTO 1996). In this period, between 1973 and 1995, FDIs increased 1.5 times faster than exports of goods and services, respectively more than 12 times against 8.5 times (WTO 1996). The growth of FDIs accelerated until 2000, and then decreased in 2001–2003. The new upsurge, started in 2004, reached its peak in 2007 on the eve of the great contraction. FDI inflows increased respectively to US$1,500 billion and to around US$2,000 billion (UNCTAD database).

Also noteworthy was the expansion of transnational companies’ activities: by 1995 their intra-firm trade accounted for about one third of world trade, while trade among national firms (excluding transnational companies) accounted for another one third. The remaining one third consisted of TNC exports to non-affiliates.

The rise of regionalism in the form of regional trade agreements (RTAs) is a third important feature, particularly since the early 1990s. At the present (7 April 2015), there exist 406 RTAs in force between two or more partners according to the World Trade Organization (WTO) (WTO 2015). However, few of these agreements are truly economically important. Among the most important RTAs, the ones which account for an important share of world trade are the European Union (EU), the European Free Trade Association (EFTA), the Asia-Pacific Economic Cooperation (APEC), the North American Free Trade Agreement (NAFTA), and the Association of Southeast Asian Nations (ASEAN). Some of these agreements also involve a problematic relation between the highly developed and the less developed member countries of each agreement. In spite of this apparent fragmentation of the world economy, regionalism does not appear to have discouraged globalisation: “Regionalism developed quickly but in ways that complemented global markets and institutions rather than undermining their operation” (Eichengreen 2006, p. 66).

The growth of emerging economies, the growth of financial activities, and the rise of regionalism created new opportunities and opened new problems and threats. Economic achievements during the two decades before the crisis notwithstanding, the management of the world economy and of national economies became increasingly difficult and less effective. Also new problems appeared. In particular, the inability of the international economic and financial architecture and of international organisations to keep pace with high short-term capital mobility and financial market volatility became sources of growing concern. Contradictory were also the consequences of deregulation (Bernstein 2006) and, more generally, the shrinking and weakening competence and role of governments. The importance of these developments became apparent during the crisis.

At the microeconomic level, the most important development in the decades preceding the crisis was the new organisation of productio...

Table of contents

• Cover
• Halftitle
• Title
• Copyright
• Contents
• Acronyms
• Preface and Acknowledgments
• Introduction: Prolegomena to the International Crisis
• Part I The Facts: The Crisis and the Eurozone
• Part II Institutions and Policies
• Part III Outcomes and Ways Out
• Bibliography
• Index