Commentary

The Euro Isn’t the Problem, but Europe Is

What actually ails Europe is bloated government bureaucracy, over-regulation, and unfunded pension and healthcare obligations

Brussels – What ails Europe? That was the title of last Monday’s missive from Paul Krugman, in which he argued that the perceived value and stability of the euro caused an inflow of capital during the past decade, driving up prices and making European goods uncompetitive. A nice thesis – but almost completely wrong. What actually ails Europe is bloated government bureaucracy, over-regulation, and unfunded pension and healthcare obligations. Meanwhile the problem with the euro is not, as Krugman further asserts, that it is too much like a gold standard, but that it is too little like gold.

The centrepiece of Krugman’s thesis is that “the creation of the euro fostered a false sense of security among private investors, unleashing huge, unsustainable inflows of capital into nations all around Europe’s periphery.” Krugman then notes that European nations had “roughly balanced trade in 1999,” but as manufacturing became uncompetitive, and costs and prices increased because of the capital inflows, those nations began running large trade deficits instead.

While the euro was certainly an ill-conceived project, the woes of Greece, Italy, Spain, Portugal and Ireland owe more to malfeasance on the part of their own governments than to the trade effects of monetary appreciation.

It is true that the creation of the euro led to capital inflows, though initially the euro fell against the dollar, sterling, and other currencies. When it began at the end of 1998, the euro traded for 0.85 dollars; the dollar then gained against the euro steadily for three years, reaching a peak of 1.17 euros/dollar in October 2000 and again in June 2001 before falling again slowly. By March 2003 the euro was again 0.85 dollars, eventually hitting a low of 0.63 euros to the dollar in June 2008.

But euro-induced capital inflows alone wouldn’t have caused a catastrophe. If that capital had been put to productive use, then the rise in prices of goods produced in the Eurozone could have been kept down.While this process may have occurred in some Eurozone countries, such as Germany, it did not occur in Greece, Italy, Spain, Portugal and Ireland. And the reason it did not occur in those countries is that perverse incentives existed for the capital to be diverted into bad investments.

Krugman won his Nobel for international trade theory. That no doubt colors his perspective on economic problems. But not all problems are related to international trade. In this case, the problems result from restrictions on domestic trade and other ineffective government policies – such as allowing teachers to retire at 50 (something that happens only in big-government places like Greece… and California). Blaming international trade and associated monetary phenomena clouds the real issues and results in solutions that are unsustainable, namely devaluation and inflation.

As financial economist Dr. Warren Coats explained clearly on his blog last week, devaluation and inflation do nothing to solve the underlying problems they merely provide a temporary respite that likely delays reforms and ultimately makes the problem worse.

The reason Greece (and some other countries, such as Italy) joined the euro in the first place was that their governments had a habit of either defaulting on debt or monetizing it through inflation. That’s why the yield on Greek bonds was around 35 percent in the mid-1990s. Before joining, they were supposed to get their public finances under control, but instead they worked out some clever fuzzy math, such as putting a substantial portion of their debts off their balance sheets and simply failing to include unfunded liabilities such as those pesky pensions. Many people knew that the numbers were nonsense but the EU let these countries in anyway.

This raises the fundamental problem with the euro, which is that it is a political project and not a monetary project. It was never really necessary as a monetary project since all European currencies were fully convertible with one another and several of those currencies were reasonably well managed – the Duetsche mark in particular. Moreover, as I pointed out in a study over a decade ago, prices were becoming increasingly transparent across Europe, largely as a result of Internet-based tools, ensuring that consumers could get the best deal on a product regardless of the currency in which it was sold.

If a European country really wanted to impose a set of strictures on itself that would have ensured monetary stability resulting in more rapid and sustainable growth, then all it needed to do was to tie its currency to a rare commodity such as gold. When a currency is truly backed by a rare commodity, it is impossible to use inflation to monetize debt, since that debt remains redeemable in that commodity. This induces more rational monetary and fiscal decisions.

Ironically, Krugman seems to think that the gold standard contributed to the Great Depression and that the euro is behaving like a gold standard. Both claims are nonsense. Peter Boettke observes that “The Great Depression was a consequence of (a) credit expansion to pay off war debts from WWI during the 1920s, (b) monetary contraction during the 1930s, (c) government microeconomic policies which completely curtailed the ability of market forces to adjust to the changing circumstances, and (d) government policies which eliminated the ability of individuals to realize gains from trade. None of this is about the gold-standard.” But more to the point: if the euro is behaving like a gold standard, then the ECB is Rumpelstitskin.

The euro was always intended as a stepping-stone on the road to a full fiscal and monetary union as part of a project to create a United States of Europe. The effort to create a joint European fund to bail out Greece (and perhaps Portugal, Italy, and Spain down the line) is consistent with this overall aim. There’s only one problem: previous attempts to force taxpayers in one country to shoulder the debts of other nations have not always turned out so well. I am of course referring to the requirement that German taxpayers be forced to pay reparations to the allies after WWI, which indirectly led to German hyperinflation and thence to WWII. It is just possible that in the attempt to create a European superstate, the Europhiles have sown the seeds not only of the destruction of the EU but also of peace in Europe.

Julian Morris is Vice President of Research at the Reason Foundation. This article was originally published by RealClearMarkets.