Learnings

after the Euro Crisis: Does it make sense to have a common currency for countries
so diverse?

Script by Gerard Giménez Adsuar, ADE (E1)

Mario D : Italian worker, angry about his wage stagnation during the last decade.
Janet Y : American woman, very interested in European Integration.

Setting: Mario D. and Janet Y. are both sitting on a cosy bar in Frankfurt, listening to the
Economic News:

“The Eurozone is experiencing the fastest economic growth in a decade, with unemployment rate
also going down to 8,8%, also the lowest level since the crisis.”

JY: Wow, if this unemployment is the lowest, can’t imagine how high that was!

MD: Quite high, indeed. Although there’s a great diversity among the different EU countries, in
2012, which marked the height of the crisis, we reached the 12% rate. In Spain and in Greece,
however, unemployment reached 27%, whereas in Germany and France it was around 8 and
9%, respectively.

JY: That must have some serious implications, I mean, the EU has developed the Economic and
Monetary Union, right? That means that countries inside the Eurozone use the same currency,
which is equivalent to say they have fixed exchange rates between them.

MD: Yes! And that’s just the tip of the iceberg. When the Monetary Union was made effective,
you would think that inflation rates across countries would have converged, right?

JY: Well… if they we’re using the same currency and monetary policy was fully decided by the
ECB, it’s reasonable to think that inflation rates would be homogeneous.

MD: It’s a reasonable guess, but not quite what happened. In fact, although inflation rates’
divergence was greatly reduced during the period before the issuance of the Euro on 1999,
countries like Ireland and those in the South (like Spain, Italy, Greece, Portugal) had higher
inflation than their neighbours. And this fact had tremendous implications in the subsequent
years. That’s why I’m angry, the authorities should have foreseen this last crisis!

JY: But wait… What’s the relationship between a having the same currency (with different
inflation rates across the adopting countries) and the Euro debt crisis? I just don’t get it.
In the USA, we have also a monetary union among the 50 states that constitute it, and I don’t
see how this can have negative effects.

MD: Well, on reference to your question, I must first add a couple of things: first, nominal
interest rates across the countries were quite similar. Second, we must remember that the real
cost of financing must be adjusted for inflation, that is, nominal rate minus inflation rate equals
the real interest rate. Considering all these factors, given the nominal rate was the same, those
countries with higher inflation rates were actually paying lower real interest rates. For example,
the difference between real interest rates between Germany and Spain, was about 2% for
almost a decade. In the case of Ireland, the figure was around 3%.

JY: Oh… I get that! This can explain why banks in Southern Europe increased the amount of
granted loans during the early 2000’s until 2007-08.

MD: That’s exactly right, and sadly it went on to finance not asset equipment or machinery for
increase the countries’ productivity, but rather to acquire real estate. In Spain and Ireland, the
phenomena lead up to an asset price bubble, with real estate prices tripling in roughly a decade.
Meanwhile in Germany, for example, there wasn’t any housing bubble, as interest rates were
comparatively high, and households didn’t have such a great incentive to become indebted.

JY: Ok, I think I’m starting to get the point. In the absence of the Euro, the Central Banks of Spain
and Ireland would have raised interest rates, in an effort to cool their economies. By doing so,
they would have increased interest rates in order to decrease households’ incentive to become
indebted. In the best-case scenario, this policy would have avoided the massive recession that
followed the burst of the housing bubble. Meanwhile, the German central Bank, could’ve kept
the low interest rates, because the economic reality was completely different.

MD: That’s right. I believe that the Monetary Union relied entirely on political arguments, and
unfortunately for the average European worker, that project was on the brink of collapse due
to its inherent fragility, as so much diversity cannot be handled by only one central bank.

JY: But Mario, don’t you think that the political arguments must be considered? I mean, Europe
had experienced two world wars in 30 years, and we know for sure that a third conflict like that
could’ve ended the world as we know it. By using the same currency, you are achieving a level
of unity that makes these conflicts very unlikely.

MD: I agree with that, and I’m sure that that’s what European leaders had in mind in December
of 1991 in the city of Maastricht, when they officially committed on the Economic and Monetary
Union within the European Union.

JY: Yeah, also you must acknowledge that cross-border trade has increased significantly during
the last years, coinciding with the introduction of the Euro. I’m afraid that you are being far too
pessimistic about this topic!

MD: I may have been very critical, but despite all efficiency gains, I won’t change my mind that
Eurozone countries were set to have a crisis such as the last one. And not just that, I’m worried
that despite current positive economic outlook, some countries are still heavily indebted. These
financial asymmetries should set off the alarms, urging us to change what’s established. Each
national government would be much better equipped to deal with future crisis if they had the
full control of monetary policy back.

JY: But that’s not how the US works, in our case, I believe the strength lies on the fact that
despite being also very diverse, fiscal policy is also unified. We can issue federal government
bonds, and with this liquidity in moments of distress, deal with region-specific issues. The recent
financial crisis put that on a test, with massive asset price bubbles in some cities, investment
banks going bankrupt… and these where successfully addressed by our federal government and
our central bank, the Federal Reserve.

MD: Good point Janet, so you’re arguing that perhaps the solution to our current fragility is not
breaking up the Monetary Union, as I’m suggesting, but rather, take unification one final step
further by regulating and deciding fiscal policies in a coordinated manner.

JY: Yeah, if you think about it, it goes on the same direction than what the EU Commission did
to break the vicious Sovereign Debt-Bank cycle. By creating the European Stability Mechanism
(ESM), the countries of the Eurozone, all in one block, were raising money through bonds. This
is very similar than what our federal US government does.

MD: True, although I don’t see it politically feasible. Fiscal union would entail the loss of one of
the last resorts of national sovereignty. No country would want to join in.

JY: But Mario, aren’t countries already complying with important fiscal constraints? I think you
are much more fiscally integrated than what you think. Although I agree that it may not be
possible to achieve a United States of Europe overnight. First, there must be an important
political shift, and the benefits of doing so need to be explained to the population at large.

MD: It may be hard to convince to the millions of Greeks or Spaniards that were unemployed
during the crisis. The current narrative is that the “troika” (a way to refer to the ECB, the IMF
and the EU Commission) was responsible for all the social unrest, due to their greed, reflected
in their unwillingness to forgive their respective sovereign debts.
Sounds like science fiction trying to convince the public at large, that further unification will be
beneficial. Just look at the recent political developments: the rise of anti-European political
parties, Great Britain leaving the EU, …

JY: I see… I think this narrative should be rejected, and sound economic analysis needs to take
its place. These countries were in fact rescued, and therefore avoided bankruptcy, only because
of the willingness of all the other countries to help them. Both in the form of loans from Member
States and with the ESM.

MD: But, weren’t the terms of those loans very harsh?

JY: I think this has been a great misconception. In the Greek case, firstly, an important part of
the debt was restructured, meaning that lenders agreed on giving up some of the money lent to
them. Secondly, the average interest rates charged on the debt are around 1%... and the loans
needn’t be repaid until 2039. I believe that’s not harsh a treatment at all.
Looking at Spain, although the situation was milder, the terms were also quite soft: 1% interest
rate on the loans which needn’t start to be repayed until 2022. As of today, 9 billion € out of the
40 billion € lent have already been voluntarily returned. That’s an impressive turnaround,
considering that nowadays it’s the fastest growing economy in Europe!

MD: I didn’t know the exact facts and figures; perhaps I should reconsider my views on the
“troika”.

JY: I mean, you can still be critical about how the crisis unfolded, and specially with the fact that
the Maastricht treaty didn’t consider the possibility of one of its members going bankrupt.
Judging on hindsight, that was clearly a mistake. Nonetheless, I encourage Europeans to
continue fighting for becoming more united, taking advantage the economies of scale that this
brings about, which ultimately is translated into higher standards of living for everyone.