The Politics behind the Euro…

In trying to understand the reasons behind the eurozone crisis, economics can explain a lot of things (see posting below) but sometimes it doesn’t provide all of the answers.  Economics does give us an understanding of what happened over the past 10 years or so in regard to the building-up of imbalances and the actual turmoil that these caused.  But it does not give us reasons why there was a system which allowed the imbalances to occur in the first place. 

The economic problems partly stem from that the currency union of the euro has always been more of a political project than being backed up by compelling economic reasoning.  After the Second World War, the integration of countries in Europe was seen as a means to control the rise of excessive nationalism that had culminated in two world wars.  Various treaties were signed and groupings of European countries were formed up to the founding of the current European Union in 1993 and the euro was launched in 2002.  In this manner, the euro can be seen as a part of a process of European integration that had been going on for over fifty years before the euro itself came into existence.

This does not mean that there are no economic benefits from the euro as the previous post shows.  Some of the gains from having a single currency in terms of the ease of doing business or just travelling within the Europe as well as creating the large market to rival the U.S. would have given further impetus to the creation of the Euro.  However, politicians in Europe have always seemingly believed in greater integration for lofty ideals.  It was this focus on the politics and not the economics of the euro that blinded the countries involved to the potential pitfalls.

The difference between the ideals and the reality was further reinforced by the fact that the development of the European Union was very much a top-down system.  Politicians would dream up ways of bringing their countries closer together while voters in these countries didn’t seem care enough either way to put a stop to it.  As such, the citizens were never convinced of the necessity behind the growing level of integration nor did they have much of a role in pushing it forward.  Politicians could continue with this process as long as times where good.  And times were very good, too good, for some of the newer members who benefited from lower interest rates after having joined the euro.

But the mix of voter indifference and benign economic conditions may have meant the politicians pushed integration further and deeper than their citizens or their economies could manage.  Voters in Europe had shown signs before the crisis that they were not happy with the ever expanding European Union such as protests over immigration and referendum results against a new constitution for Europe.  Construction booms in Spain, Ireland, and elsewhere should have suggested that the interest rates for the euro were too low for these countries and highlighted the perils of applying the same monetary policy to different economies across the eurozone.

But it was the financial crisis that bought these issues to the fore.  And now it is the economic consequences that dominate, and voters are not happy with the mess that their politicians have allowed to occur.  Germany is not ready to make their tax payers foot the bill for the perceived prolificacy of others in the eurozone while Greece who joined for the economic benefits are not willing to toe the line and take the painful measures for the sake of the European project.  And it is renewed emphasis on economic concerns that is making the search for a solution more difficult, but that will have to wait for another positing.

… and the Economic Realities of the Euro

The eurozone had mostly been about the politics of integrating Europe.  But not anymore.  The economic consequences of the euro have come back to bite and now threatens the whole European project.

Back in the good old days, there was some economic rationale between the shared currency.  It helped to build a common market among the European countries by making it easier for businesses to operate in different countries (although different regulations in each country do hamper this).  The euro is also more stable as a currency compared to the currencies of many of the smaller members of the euro which helps to lower borrowing costs.  These benefits have been used as a carrot to get countries to reform their economies and improve their public finances (crucially, the tough rules for applicants to the euro do not apply to those countries who already use the euro).

However, on the flipside of these benefits is that in terms of the exchange rate of the euro and in terms of monetary policy (i.e. interest rates), it is necessary to adopt a policy of one size fits all.  So instead of each country having a currency which changes depending on their own specific circumstances or interest rates which could be set as each country saw fit, one exchange rate and one interest rate is applied across countries with very difficult economic conditions. 

A lower interest rate for new members is one key result of this.  The reason for this is there are risks involved in lending in a currency which is different to your own and especially when the exchange rate of the currency can change significantly or when lending to a country who can manipulate its own currency (both are usually true for members new to the euro).  Also, poorer countries typically have higher interest rates as there are less funds that are available for lending and because investments in developing countries are typically more risky.  And, for a long time (but not anymore), investors did not differentiate between the government bonds from the different countries in the eurozone.

So when a country (which is typically poorer) joins, it has a new interest rate that is typically too low for its economy but is set for the average conditions across the eurozone (a group of rich countries with low inflation rates).  The low interest rates fuel a surge in borrowing and these funds tend to be used to buy property among other things.  A booming real estate market triggers a rush to put up more buildings which also boosts the tax revenue for the government.  But this lending spree can easily get out of hand and has to end sometime and often painfully (as can be seen in the papers with regard to Greece, Spain, Portugal, and Ireland but not Italy (see previous post)). 

The political process that bought about the euro (refer to the posting above) did not set up rigorous checks and balances to make sure that imbalances did not build up.  Furthermore, monetary policy focused solely on inflation of consumer goods rather than asset prices (i.e. the real estate market).  And countries were not willing to give up control of their finances to European bureaucrats.  In the end, if no one is in charge and there is a lack of rules, things are always bound to get out of hand.  Not that politicians have done a good job at fixing that either.  This is why some government such as Greece and Italy now have governments which are not run by politicians.  The solution may be more economist in government.