May 21, 2012
The only thing that can stop the euro from breaking apart in the short term is old-fashioned capital controls. Otherwise, more and more money will flow from the periphery to the core. The weaker the peripheral countries become, the higher the risk of political instability and the greater the risk of a change in policy.
Peripheral Europe – including Ireland – suffers from that most politically regressive type of economic policy, one that hurts but doesn’t work. And it doesn’t work eventually – it doesn’t work at all and never has worked anywhere.
A policy that hurts but doesn’t work will become an ex-policy in short order. If all the countries in the euro had full control over their currencies, they wouldn’t tolerate a policy that hurts but doesn’t work. But because they don’t have control, they have to tolerate a policy which hurts but doesn’t work until it becomes insufferable.
However, right now, we do not have control over the currency we use. For a currency to be described meaningfully as a “country’s currency” or “our currency”, we have to be able to print the currency freely or not as we choose, and we have to be able to change its value as we choose.
The problem is that the euro is no one’s currency and everyone’s currency at the same time. For Ireland and Spain and any of the other peripheral countries that have huge debts, the implication is that we have to pay debts in another country’s currency.
If a country is already running a current account deficit, as much of the periphery is, paying back all the debt will make the economy contract. As the economy contracts, unemployment rises and this – understandably – prompts political instability.
So without the currency to offset the different competitive positions of the countries, the entire adjustment has to come via the rate of unemployment in the weak country. This is because wages rarely fall. The academic idea that you can get wages to fall effortlessly goes against everything we know to be the actual way things work. In an actual economy, everyone at work fights to keep his wage up.
For those in work, it’s better that the rate of unemployment rises rather than their individual wages falling to absorb the unemployed. So the labour splits into a classic insider/outsider pattern, where the interests of the employed are pitted against the unemployed, rather than the old Marxist line where the interests of the employed are pitted against the boss classes.
The only way to quickly get real wages down in this type of scenario is to devalue the currency, generating a bit of inflation and reducing wages both externally and internally through currency depreciation and inflation. That’s how it is done. (See Iceland, all the Asian tigers, Scandinavia in the early 1990s, etc.) But if you can’t do that, then the rate of unemployment rises permanently. This puts huge pressure on the afflicted country’s budget deficit.
Furthermore, if the afflicted country has high levels of debt, the people will want to pay that debt back, and the banks of that country are also likely to have large amounts of bad debt. This means that the people don’t want to borrow and the banks don’t have the ability to lend. This is a classic liquidity trap which – regardless of the rate of interest – will have no effect on the economy. Everyone is saving to rebuild their balance sheet.
This is exactly what is happening in Ireland, Italy, Spain and, of course, Greece, where the dilemma is most severe.
Now think what happens when everyone is saving and a foreign country instructs the afflicted country that its government must save too. Well, if everyone is saving, no one is spending and, as your spending is my income, everyone’s income falls too.
This is what austerity does in the liquidity trap – it makes things worse. I likened it on BBC’s Newsnight the other night to putting an anorexic on a diet and expecting that person to put on weight.
Now let’s see what happens to capital in such a strained environment. Some bits of classic economic theory state that capital will flow into the afflicted area to avail of opportunities. But that is not what actually happens. It will only happen after a massive policy change, like a devaluation – not before. Until then, the risk that there will be a devaluation pushes capital away.
But why could there be a devaluation in the euro? Wasn’t it supposed to be an irrevocably fixed system? Well, it was until last week. The minute the European elite in Brussels under JosÃ© Manuel Barroso told Greece that the election should be a vote on whether it is in or out of the euro, the notion that the euro was permanent evaporated.
We now have a currency which is conditional. And it is conditional on local politics, which are themselves dependent on local economic conditions, which we know are getting worse in the periphery.
If it is not a monetary union, it is a system of fixed exchange rates, and the credibility of this system is based of the willingness of the weaker countries to tolerate austerity and the willingness of the stronger countries to tolerate what some have called “peripheraid”.
Peripheraid is the ongoing cash infusion from the rich countries to the poor countries, which could go on for generations.
The working model for peripheraid is Italy. In Italy, the north has been transferring money to the south for years. But this is one country, with one language and one political system.
Do you think that Germans will pay for Spaniards for the next few generations? Nor do I. The people with money in Spain think exactly the same, and that is why they are getting their money out.
As a result of this analysis, money is flooding out of the periphery. There is what looks to be a bank run in Spain. In Greece, whatever money hasn’t left is on its way. We are seeing similar developments in Italy.
A friend who works at a large bank in London told me last week that it was experiencing a massive inflow of money into sterling. Significantly, she said that the bank didn’t have many peripheral clients, so the money was coming from countries like France and Belgium.
The only way to stop this is with capital controls. It will buy the afflicted countries a bit of time, but once you introduce capital controls it means you have given up on the central basis for a monetary union. Once that goes, so will everything else.