THINKING about or discussing the “counterfactual” can usually be a big waste of time, but sometimes knowing what would have been, what could have been, or what hasn’t happened, can help brighten or sharpen perspectives.
Personally, I have found it quite useful and mentally liberating to theorise about the shape the world would have been in today without the euro. Then I looked at Greece, and the periphery at large, and wondered what shape the euro would be in today absent their inclusion in the economic and monetary union.
A bigger nemesis than ‘euro flaws’
I think the biggest mistake some people make when analysing the euro’s structural flaws is to forget that the abundance of cheap credit and global liquidity during the first decade of the euro’s existence or longer are probably bigger reasons for the state many euro area countries find themselves in today, as opposed to the simple reasons most people give, which are that “the euro doesn’t work right”, or that “the euro needs to be an optimal currency and political union”. Importantly, these explanations ignore the fact that private and public sector debt burdens ballooned not only inside the euro area during the last decade, but also outside it as well.
Take the UK as an example. During the last decade, Britain’s foreign assets grew significantly given the country’s status as “banker to the world”, but as more capital flowed into the country than out of it in order to be extended in the domestic economy as “cheap credit”, sterling rose to enormous heights, resulting in a dangerously wide trade deficit and a dangerous loss in competitiveness. This is how Britain grew during the last decade or more.
The great miracle was in fact largely a credit phenomenon. Britain was not alone – not by a long shot – but that this imbalance occurred outside the economic and monetary union highlights the fact that when liquidity is abundant, when monetary policy is too loose, and when credit is overly cheap – as it was during the last decade and probably still is – faulty or perhaps impetuous investment decisions are made.
Would overvalued nominal exchange rates in Europe’s periphery in the absence of the euro have stopped the inflow of cheap credit and the endless cycle of lower borrowing costs? Overvalued prices in America’s mortgage and housing market didn’t stop the inflow of cheap credit there – not until the bitter end anyway – so valuations probably wouldn’t have stopped the flow in Europe either.
Subprime is to America’s housing market what Greece is to Europe’s economy, and this would have been the case with or without the euro. Greece has no growth potential now, and it didn’t in the past either, except for when credit was flowing to the government and the cost of it was cheap.
Inside or outside the euro, the lack of sustainable growth potential in many peripheral European economies, and the fact that cheap credit flows to wherever there is demand for it, mean that most of Europe’s periphery would have experienced sharp deteriorations in competitiveness during the last decade as capital flowed in and their nominal exchange rates appreciated, while wild exchange rate fluctuations today as those imbalances unwound would have probably been an even bigger problem for Europe’s core. With the periphery outside the euro today, there would perhaps be even bigger catastrophes – not just with Greece, but with Italy and France.
A euro without Greece and the periphery
Policy makers in Europe didn’t use the calmness of the last decade to fix the structural flaws of the euro with the periphery inside it, so they probably wouldn’t have done so without the periphery either. Absent Spain, Ireland, Portugal and Greece inside the euro during the last decade, Italy and France would have still faced the need for structural reforms today; however, their debt burdens would have probably been larger, as surviving in a monetary union without Europe’s south and dominated by Europe’s north would have probably required greater public sector spending during the first decade of the euro’s existence in order to cope with the dampening effects of a strong currency and tight monetary policy. For 2005 as a whole, Germany’s trade surplus at €122bn was more than three times the size of the trade deficits of France and Italy combined, meaning there wouldn’t have been much of an offsetting downward impact of Germany’s positive trade flows on the euro.
Meanwhile, the weak dollar years of the last decade and the corresponding global imbalances would have pushed the euro to even greater heights, making even German competitiveness an issue. In fact, the dollar may have become a problem even before the euro, leaving Europe’s problems to fester longer.
At any rate, once a full-scale debt crisis in France and Italy ignited, a bailout of the two countries would have been unavoidable, but this time the debt burdens would have been far more significant, and far too high for the remaining euro members to absorb.
Germany and its core counterparts would have been thrust into a cataclysmic banking crisis. Meanwhile, the collapse of the southern economies’ credit bubbles would have hurt growth equally as bad as it has now, but with even more damaging exchange rate fluctuations for the euro area as a whole, particularly to France and Italy.
The euro area crisis of the “real world” as opposed to the “counterfactual one” has not been dealt with properly or efficiently, of course, but the participation of weak links such as Greece, Portugal, Ireland and Spain in the economic and monetary union has probably brought the euro’s structural flaws to the surface sooner, made the ultimate size of the debt burdens that need to be dealt with smaller, and provided Germany with a much weaker euro in the process. The proper decisions need to be taken, but a more competitive exchange rate is giving Germany the breathing space in which it can take those decisions.
Every economy and every monetary union will have its fly in the ointment, but some things are worth paying for, and Greece may have saved the euro.
A strong currency, in both nominal and real effective terms, at some point becomes synonymous with complacency and invariably results in a loss of competitiveness. At least today, Germany doesn’t have these problems. What Germany does have is an important decision to make, seeing as the cost of this more competitive euro is not being able to have the euro area look as perfect or as robust as it would like. What will Germany choose? Only time will tell, but this is Germany’s choice.
Stephen Gallo is head of market analysis at currency broker Schneider Foreign Exchange