The Inevitability of the Euro’s Demise

I don’t know why David Cameron prevented any future accord on fiscal discipline being incorporated into a revised European Union treaty at the last European summit. Whether he saw something in its provisions that was potentially damaging to the United Kingdom, or whether he was simply trying avoid a potentially catastrophic split in his own party, he alone would be able to tell us. What I do know, however, is that this question is completely irrelevant.

Nor is this simply because those who are currently trying to make political capital out of his decision, arguing that Britain will now become isolated in Europe, are quite clearly being disingenuous. For not only do they know that there are bound to be other countries, outside the Eurozone, which will not sign up to the treaty – countries like Hungary, which has already stated that it will have nothing to do with any treaty that requires tax harmonisation – they are also aware – because they are made of the same stuff – that the vast majority of politicians who rise to be heads of governments are nothing if not pragmatic. They do what is in their interest. And if it is in their interest to continue doing business with Britain, they are not going to cut off their noses to spite their face. After all, the Eurozone exports more goods and services to the UK than to any other country in the world.

It is not primarily for this reason, however, that I say that all this politicking is irrelevant, but rather because, even if an intergovernmental agreement on fiscal union is eventually signed by the Eurozone members, I do not believe that it will not have any effect.

I say this for three reasons. Firstly, there is too little provision in what has so far been agreed to counter the immediate threat of member government insolvency. It is why yields on Eurozone bonds have continued to rise, and why the credit rating agencies are threatening a wholesale downgrading of Europe’s credit status. Secondly, although the new fiscal rules may prevent Europe ever getting into this mess again, it will be many years before some member states are able to reduce their annual deficit to just 3% of GDP and even longer before they are able to get their accumulated national debt down to 60%. In the case of Greece, for instance, it is unlikely to happen before 2025. Thirdly, and more importantly, however, is the fact that there is nothing in any of the drafts of the treaty so far put forward to tackle the Eurozone’s most serious underlying problem, which is not primarily a lack of fiscal disciple, or even the lack of competitiveness among some of its member states, but rather the variability in competitiveness across the monetary union.

One can see this variability most clearly in the per capita GDP of the member states, as shown in Table 1. The figures are those from in 2010.

Member States	GDP Euro Millions	Population Millions	GDP per Capita (PPP)	GDP per Capita (Nominal)	PPP as % of European Average
Luxembourg	41,597	0.48	69,990	87,450	246%
Netherlands	591,477	16.60	34,055	35,631	120%
Ireland	153,938	4.40	32,488	34,986	114%
Austria	284,410	8.40	32,174	33,858	113%
Belgium	352,941	10.80	30,294	32,680	107%
Germany	2,498,800	81.80	29,981	30,548	105%
Finland	180,253	5.30	29,563	34,010	104%
France	1,932,802	64.70	27,265	29,873	96%
Italy	1,548,816	60.30	25,593	25,685	90%
Spain	1,062,591	46.00	25,593	23,100	90%
Cyprus	17,465	0.80	24,862	21,831	87%
Greece	230,173	11.30	22,459	20,369	79%
Slovenia	35,974	2.00	21,833	17,987	77%
Malta	6,233	0.40	21,101	15,583	74%
Portugal	172,699	10.60	20,684	16,292	73%
Slovakia	65,905	5.40	18,908	12,205	67%
Estonia	14,501	1.30	16,401	11,155	58%
Eurozone Average	9,190,575	330.58	28,426	28,426	100%

Table 1: Per Capita GDP per Eurozone Member State in 2010

For those unfamiliar with this kind of analysis, you will notice that the table has two columns of ‘per capita’ data: one labelled ‘Nominal’, the other ‘PPP’. The first is simply the country's GDP divided by the population. GDP, however, is measured in terms of local pricing. In rich countries, where prices are high, GDP will therefore be exaggerated. In poor countries, where prices are low, GDP will appear to be lower than it actually is. To overcome this distortion, we therefore introduce PPP, 'Purchasing Power Parity', which uses average prices from across the entire sample to give us a more accurate comparison.

Unfortunately, this does not help us resolve inaccuracies in the underlying data, and most readers will have already spotted at least one rather glaring anomaly in the above figures, which appear to show Ireland as having the third largest per capita GDP in the Eurozone. This, however, is due to the fact that when the table was compiled, Ireland’s actual figures for 2010 were not yet available. The figures included are therefore the forecast figures from 2009, which even at that point were almost certainly over-optimistic. The important point, however, is that even if we mentally downgrade the Irish data, and ignore the figures for Luxembourg, which has a micro-economy all of its own, it is still absolutely clear that the Eurozone encompasses member states with wide variations in productivity and hence competitiveness. 

Having accepted this, the question you still may be asking, however, is why this is a bad thing. The answer is that, within a monetary union, these variations have a polarising effect, exaggerating them over time and actually making them worse. This is because the value of a currency is indirectly related to the performance of the economy it represents. The factors determining this value may be vague, numerous and complex, ranging from market demand to speculators’ expectations, but in the end it all comes down to how well the economy is doing. In the case of a monetary union, however, the currency represents the aggregated economy of the union as a whole – both its strong parts and its weak parts. It represents, that is, the average performance across the entire community. As a result, the stronger parts will find themselves operating with a currency which is undervalued with respect to their own performance, while the weaker parts will be burdened with one that is overvalued. The strong parts, as a consequence, will find that their exports are that much more competitive in international markets, and will become even stronger as a result, while the weak parts will find that their exports are overpriced and will therefore become even weaker.

We can see this in the difference between Germany and Greece. While Germany has clearly benefited from an undervalued Euro, making its  luxury cars even better value around the world, the only thing which Greece exports is overpriced olive oil. This is not to say, of course, that an undervalued currency is the only reason for Germany’s success. Its focus on high-end manufacturing and its long-term approach to investment have had a lot to do with it. But an undervalued currency has certainly been a factor, just as an overvalued currency has been a factor in Greece’s steady deterioration. 

The problem is further exacerbated by the fact that once this polarisation has started, it is very hard to stop it, not least because other factors then kick in. With poor economic performance in the weaker parts of the union, unemployment inevitably rises, tax receipts drop, public expenditure increases, and a budgetary deficit develops. If the union also facilitates freedom of moment, the brightest and best young people from the poorer areas then start migrating to the richer ones. The richer areas thus reap the benefit of their talents while the poorer areas are further impoverished. 

In fact, this is a phenomenon we can also see happening within national economies. In Britain, for instance, we have something called the north/south divide, which is the result of more than half a century of such polarisation. It primary cause was the loss of heavy industries and manufacturing from the north during the post-war years. The problem has been made much worse, however, by the fact that although its labour costs are generally much lower than in the south, the north-east, in particular, has had to try to rebuild its economy while operating with a currency which more accurately reflects the increasingly successful service based industries of London and the south-east. As a result, it has acquired an almost permanent disadvantage, which successive British governments have tried to overcome, largely by throwing tax-payers’ money at the problem through such institutions as regional development funds. All these palliative measures have actually achieved, however, is the creation of an economy which is almost totally dependent on government subsidies and hand-outs.

Indeed, in many ways, the European Union has done exactly the same thing, channelling grants and subsidies to its less advantaged member states, in order to try to overcome the disparities. Infrastructure projects, in particular, have been used a mechanism for redistribution. Drive down any major road in Spain or Portugal and you’ll see a signed telling you that it was financed by the EU. This, however, is no way to build a sustainable economy, which needs to grow organically from within itself. If you also lock these grant-assisted peripheral states into a monetary union, which then makes their goods and services permanently uncompetitive on international markets, you finally have a recipe for the kind of disaster that is now unfolding in Greece.

So what is to be done? For Greece, there is only one answer. It has to leave the Eurozone. It will, of course, be difficult. When they return to the Drachma, the Greeks will almost certainly see their currency fall in value by at least 30% against the Euro. This will mean that imports from other countries will be 30% more expensive. However, Greek exports will become 30% cheaper. So will Greek holidays. They will be able to start rebuilding their tourist industry. With lower labour costs, multinational companies will start investing there. It will take time, but eventually Greece will be able to rebuild its economy, and this time on a firmer foundation.

But what about the bigger picture? What happens to the Eurozone once Greece has left? The answer is, I’m afraid, ‘More of the same!’ For what applies to Greece today, will eventually apply to all those countries with per capita GDPs less than the Eurozone average. Once polarisation has set in, relative to Germany and the Benelux group, they will all steadily become less and less competitive.

It is why some economists believe that the Eurozone will eventually break into two, with a northern, richer grouping, and a southern, poorer grouping. This, however – or so I believe – is to misunderstand the inexorability of the polarisation to which variations in competitiveness across a monetary union give rise. For even though, with two monetary unions in play, the variations may be smaller, the same economic principles apply, and polarisation will still occur. In the northern grouping, for instance, the country that would be would most disadvantaged is France. By remaining in a monetary union with Germany and the Benelux countries, its economy would get weaker and weaker. It is almost certainly one of the reasons President Sarkozy is so desperate not have any of the Eurozone member states leave.

Not as desperate as Angela Merkel, however. For if all the weaker economies in the Eurozone were to return to their original currencies, leaving just Germany and the Benelux countries to form a Eurozone core, the value of the Euro against other currencies, would very probably rise by somewhere between 20% and 30%. This would mean that Mercedes and BMWs sold around the world would go up in price by between 20% and 30%, and the dent in sales would almost certainly be considerable. Factories throughout the motor supply industry in German would have to lay off workers; unemployment would rise; tax receipts would fall; a budgetary deficit would open up; and so on and so on.

The question you will be asking, of course, if Angela Merkel knows all this – as she surely must –why is she trying to sustain a situation which she must also know is unsustainable. As a politician, however, the question is really what else can she do? To preside over the demise of the Euro, and be responsible for the worst calamity to hit the German economy since the second world war, is simply unthinkable. She therefore has no choice but hang on and fight a rearguard action for as long as she can. The truth is, however, that eventually the whole house of cards must collapse. And there is nothings she or anyone else can do about it.