What's Wrong with the Euro? (3)

Image credit. Continued from What's Wrong with the Euro? (2)

 The Euro's Design Error

According to Wynne Godley (see his Maastricht and All That), the fundamental error in the design of the Euro consists in the assumption that economies are self-adjusting:

As the treaty proposes no new institutions other than a European bank, its sponsors must suppose that nothing more is needed.  But this could only be correct if modern economies were self-adjusting system that didn't need any management at all ...

Source. Time mark 33:27

To Godley, it stands to reason that a system that is not self-adjusting and provides no means of adjustment is destined to end up in crisis. The additional constraints established in the Maastricht treaty ensure furthermore that the EU-construction is going to exacerbate the inevitable crises.

Writes Wynne Godley,

... the power to issue its own money, to make drafts on its own central bank, is the main thing which defines national independence. 

If a country gives up or loses this power, it acquires the status of a local authority or colony. Local authorities and regions obviously cannot devalue. 

But they also lose the power to finance deficits through money creation while other methods of raising finance are subject to central regulation. Nor can they change interest rates. 

As local authorities possess none of the instruments of macro-economic policy, their political choice is confined to relatively minor matters of emphasis – a bit more education here, a bit less infrastructure there. 

I think that when Jacques Delors lays new emphasis on the principle of ‘subsidiarity’, he is really only telling us we will be allowed to make decisions about a larger number of relatively unimportant matters than we might previously have supposed. Perhaps he will let us have curly cucumbers after all. Big deal!

Source.

So far the inherently faulty design of the Euro and the inevitable consequence of creating endogenous shocks and exacerbating external shocks. Now let us turn to the causes of the crisis.

Causes of the Crisis

The official line identifies excessive government deficits as the cause of the crisis, recommending debt reduction as the appropriate remedy. In particular, Germany's Finanzminister Schäuble argued that erroneous bond pricing had given rise to the crisis. When the Euro was introduced such faulty pricing had brought about a convergence of prices of bonds from economically highly divergent economies. The crisis was triggered by a crisis of confidence, whereby it was suddenly discovered that certain countries were not as competitive as suggested by the low yields of their government bonds. Upon this realisation, they were radically repriced, soaring from yield levels close to those of German government bonds (2%) to 18% and more. Structural reforms (deregulating labour markets, privatisation of public institutions, reducing public debt etc.), rather than more public spending were seen as the correct way to solve the problem. In sum: it was a European crisis with causes specific to Europe, and the need to reduce government debt being the major avenue for redress.

Interestingly, the only country to consistently comply with the Maastricht criteria was Spain, while Germany was among the violators; but Spain's economic performance was abysmal, while Germany did very well.

Reducing government debt may actually lead to a rising debt/GDP ratio, if there is a positive contribution of debt to GDP growth, and GDP falls faster than government debt.

By contrast, there is an argument suggesting that there was a worldwide common feature of the crisis.

To be continued in What's Wrong with the Euro? (4)