By Dimitris Lagopoulos, Economist, Geneva . 6 April 2017.
The European Union (EU) is in a state of crisis. Depending on the country, this crisis is economic, political, or social, or all of these at the same time. The signs are pretty obvious: the exploding debt in southern countries, the widening gap of economic growth and wealth between north and south Europe, the rise of extreme-right political parties across the EU, the impoverishment of the middle-class, the lack of leadership and common stance in the face of the refugee-crisis, and many more.
So what is the root of the problem? And why has Europe wasted so much time without reacting? Why, for example, after so many years of “Greek debt-crisis” there is still no solution? In 2016, the EU was the second largest economy in the world (if treated as a single country) with a gross domestic product (GDP) of EUR 16.5 trillion (nominal, according to the International Monetary Fund), representing 22.8% of the World’s nominal global GDP. The Greek debt of EUR 320 billion is only 1.9% of the EU’s GDP but seven years after the crisis begun the problem is still there. Worse, it got much bigger: in 2010, when the Greek debt crisis started, Greece’s public debt was approximately EUR 120 billion (less than 1% of the EU’s GDP at the time). The EU intervened to help Greece and today, with the “help” of the EU, Greece owes EUR 320 billion… To make things clear, I believe that a large part of the responsibility for this debt goes to Greece itself (political corruption, lack of reforms which should have taken place 50 years ago, etc.). But at the same time it shows that the EU does not have proper mechanisms or any control on the fiscal discipline of its members.
In short, I believe that Europe is designed to fail. That was not the intention at its creation, but it has become the reality today. And unless that design changes dramatically, the EU as it is known today will disintegrate. The question is not whether it will disintegrate or not, but simply when. It is just a matter of time, and the “Brexit” is just the beginning: the UK is not the country that needs to exit Europe the most!
I do not pretend to have all the answers or the right answers. My goal is to describe a few mechanisms which, I believe, explain a large part of the dysfunctioning of the EU today.
Important to understand: In the next few paragraphs where I try to explain the troubles of Europe, I often use as examples Germany and Greece. The reason is that these two economies highlight the two “extremes” within the EU: the former is a strong and competitive economy with high productivity while the latter is a relatively weak economy with low competitiveness and productivity. However, you should keep in mind that whatever I say for Germany is also true for Austria, Belgium, Holland, Finland, Luxembourg, etc. And what is said on Greece is also true for Italy, Spain, Portugal, etc. And if some of you wonder in which group France belongs, well I don’t know. The economy seems to be strong and well developed on one hand, but on the other, if we look at unemployment, the attractiveness of the labour market and competitiveness, it has a lot of similarities with the weaker group. I leave it on each one of you to decide.
PROBLEM No-1: The Euro as a destroyer of value
This is at the heart of the EU’s economic and debt problems and the major force driving Europe’s disintegration. The Euro is a clear destroyer of value, distorting relative competitiveness and widening the economic gap among the EU members which have adopted it. In short, the way the Euro is designed today, it strengthens the strong and competitive economies inside the EU and it weakens those who are already weak and have low productivity. And as I will explain further down, this is especially true in the context of the EU’s political system.
Let’s take a closer look at how this works: The Euro is a weighted average of the currencies of 19 countries. If we rank these currencies from the strongest (probably the Deutsche Mark: DEM) to the weakest (probably the Greek Drachma: GRD), we will find the Euro, the “average”, somewhere in the middle among these 19 currencies (actually not exactly in the middle but closer to the top, but let’s not fall into details).
Before the EUR
The Greek economy with its low productivity and low-competitiveness was supported by its currency: the GRD was sliding (losing value versus other currencies) by between 2% and 5% every year. This depreciation reduced the purchasing power of Greek consumers on foreign products, but left real domestic asset prices (wages, pensions and real-estate) unaffected, while simultaneously making Greek products more attractive or more “competitive” in foreign markets. The latter counter-balanced the effect of the former, providing an equilibrium. At the same time, more expensive imports and relatively cheaper exports contributed positively on the trade balance. In short, the GRD worked like the shock-absorber on cars: it took the hit reflecting the lack of competitiveness of the country, but protected the interior equilibrium.
The German economy with its high productivity and high-competitiveness was “punished” by its currency: every year, the DEM was rising versus the Greek Drachma and other southern-European currencies. This increased the purchasing power of German consumers on foreign products while simultaneously making German products more expensive and therefore less attractive in foreign markets. Again, the two effects counter-balanced each-other, providing an equilibrium.
As a result, the economic development gap between Germany and Greece continued to exist but was contained and stabilized through time by a rising DEM and a declining GRD.
After the introduction of the EUR
The Greek economy with its low productivity and low-competitiveness discovered that their exports priced EUR became 30% to 40% more expensive compared to their prices in GRD. That loss of competitiveness led to higher trade deficits permanently, as not only the EUR was a stronger currency compared to the GRD, but also it did not depreciate year-after-year to cover the competitiveness gap of Greece with other countries. The introduction of the EUR made Greek exports more expensive and imports cheaper thereby further enhancing the trade deficits. At the same time, interest rates which were around 15% to 20% with the GRD, fell to around 3% with the introduction of the EUR. Call it “monetary illusion” or lack of information or education or whatever else, but when you have spent all your life with 20% interest rates and suddenly you see 3% in your bank’s window, you think “it is cheap, let’s borrow some money, it costs nothing!” And there you start accumulating debt (both private and public sector debt).
On the other side, the German economy with its high productivity and high-competitiveness received a huge “bonus:” the day after the introduction of the Euro, German heavy-industry exports (Mercedes, BMW, hydroelectric turbines and thousands of other industrial goods) were exported at prices of 30% to 40% lower compared to those denominated in DEM. That was a huge gain for German exports: in the 27 years from 1971 to 1998 (the years before the EUR), they rose from EUR 1 billion to EUR 2.9 billion. After the introduction of the Euro, in the 17 years between 1998 and 2016, they rose from 2.9 to 18.6 billion, at double the previous period’s speed. This is far better than the export growth of emerging economies such as Thailand and Indonesia…
As a result:
- The economic development and wealth gap between Germany and Greece (or between strong and competitive economies and those who are weaker and less competitive) rose dramatically and will continue to rise every year, as long as these two extremely different blocks (in terms of competitiveness and productivity) share a common currency!
- The “extraordinary” (due to the EUR) trade deficits of the southern-European economies are created simultaneously with the “extraordinary” trade surpluses of northern-European economies. In short, through the EUR, South Europe is subsidizing the exports of the North!
- This is a “flow concept:” the mechanism keeps working every year, every month and every day as long as trades are valued in Euro. And as of today, there is no adjustment mechanism that can stop it.
So the question is: Why doesn’t Europe react to rebuild its economic system and to correct the flaws described above? There are two possible explanations I can see:
- European finance ministers and Prime Ministers who have the economic power on their hands to make big changes (i.e. the stronger and bigger economies of Europe) don’t know and do not understand any of this! This possibility could be considered naïve or even insulting… so let’s ignore it. There must be another explanation.
- European leaders who have the economic power on their hands to make important changes (i.e. the stronger and bigger economies of Europe) know and understand all this, and of course, they know it much better than me! But they do not react because their economies benefit directly from it! Quite shocking I agree, and some people may ask: how could one think that some countries in Europe preserve a system which makes them wealthier by making some others poorer? Difficult to believe and yet, this is a fact and this is how economies function within the EU for the last 17 years.
So let’s assume that all European leaders understand the problem with the EUR described here-above. And let’s also assume that they do want to change things for the better. Can they? Are they capable? Do they have the appropriate tools? This brings us to:
PROBLEM No-2: The lack of a Central EU Government
Unfortunately, this “economic and monetary mechanism malfunctioning” does not work alone. It is helped, supported and enhanced through another major error in the design of the EU: The EU is “a body without a head.”
In order to build a “federation” of states or the “United States of Europe” (USE) four basic things would be necessary (among others):
- A central government, or the “brain” leading the body, elected by Europeans
- A “federal” or common fiscal policy to empower the central government
- An independent monetary policy run by the European Central Bank (ECB)
- An army and a common military strategy to defend the region
These four pillars represent the minimum required in order to build a solid federation of countries. It is quite sad to observe that in EU only number-3 is in place! The other three are missing. This is crucial because if all four (or at least 1, 2 and 3) were in place, the EU economy and the EUR could be a different story:
We saw previously that the way the Euro is built today creates a “flow of money” from the South to the North of Europe, weakening the weak economies and strengthening the already strong. For the Euro to survive there must be a parallel mechanism or an “inverse flow of money” neutralizing this. That inverse-flow should come in the form of investments coming from the North and invested in the South, thereby:
- Creating jobs and therefore incomes in South-European economies
- Supporting consumption spending and economic growth
- Creating fiscal revenues
These investment flows can only be put in place by a “Central European Government” which will not face the local-national political costs for its decisions. If such a government directs investments towards the South of Europe, it may lose some votes from the North but will get them back in the South! In today’s politically segmented Europe there is no politician from any European nation that would take individually such a decision on investments to the South: he/she will be guaranteed to lose the next elections in his/her country!
But such a “Central European Government” does not exist, the EU is a body without head. Therefore the Euro will continue to work as a destroyer of value within Europe, further increasing the economic development gap between North and South European countries.
PROBLEM No-3: The lack of Democracy
The EU was created by European governments trying to put in place an environment with sustainable peace and avoiding its long history of wars. Of course, at the end of the 2nd World-War every European agreed and wanted a long-living peace! However, 70 years later, we see that this long-lasting peace came at the price of economic instability, value destruction and rising economic inequality! A large part of Europeans are suffering today and they have no means of expressing their dissatisfaction towards the EU authorities!
In short, the EU is a tree that was created upside-down: it started from its leaves and branches, and now it is trying to move down building the trunk and hoping to reach the earth in order to find some roots!
Strong and solid nations are those who are founded on people, people who are united by a guiding vision on who they are and what they try to achieve. The EU lacks both.
As Bad As It Gets…: Europe has tried to solve the problems created by the EUR by putting a sort of “inverse flow” in place in the form of “financial help” towards the countries that have too much debt. Here are a few examples:
- If a country cannot pay its debt, the EU lends them more money… But that, instead of solving the problem it makes it even bigger! Lending more money to someone who has debt is good only if his income rises faster than the debt (which is not the case for any country in South-Europe), otherwise it is irresponsible.
- Increased “irresponsible” lending has been combined with much higher taxes and austerity policies across South-Europe. Well, there is no better way of killing economic growth. How the bigger debt (through more lending) on one hand and lower GDP growth and incomes (through austerity measures) on the other can solve a country’s problem, is puzzling to me!
- Most times the extra-lending which comes as a help to distressed economies is linked to conditions which make it even more irresponsible: in 2010 for example, some countries borrowed money from the markets at 0.5% and lent it to South-European countries at 5%… And in many “help-lending” contracts the country in distress was obliged to use part of the money to buy military equipment from the lender!!! In 2010, when Greece received its first help-package from the EU, as part of the deal it had to buy Apache helicopters from France and submarines from Germany! Check the link below for a very interesting discussion in the European Parliament, it really begs the question of who is helping who!
For all the above reasons, the question is not “whether” but “when” Europe will fall apart. The economic gap which is already felt by European citizens in the South has already gone too far and its widening cannot go on forever. In a recent pool it appeared that a vast majority of Italians, for example, are against the EU. And it is not only the Italians.
European leaders have already started talking about a “Two-Speed Europe” confirming all the economic pressures created by the EUR explained here-above. That would only be a “half-solution” as the same pressures (although at a lesser magnitude) would continue to exist within each group. For example, the group composed of Portugal, Spain, Italy and Greece is more homogeneous than today’s EU, but there are big differences between a well industrialized Italy and the less industrialized Portugal and Greece. In the “strong-economy EU” there will be pressures too, for example between Germany and France, due to the differences in their economic structure, development and competitiveness.
The long-term solution for Europe is a re-build from scratch, with a Central Government and a Fiscal Policy in place from the very beginning. Such a “re-construction” would give the EU central government the capability to manage the economic growth and competitiveness gap between the EU’s south and north without suffering from the associated political cost.
Unfortunately (and this is only my opinion), this re-construction of Europe’s foundations within the EU as it is today, seems completely illusionary because of the extreme weakness of the current political class, which is not capable of uniting Europe under a clear “European Vision.”
So what we are left with as a solution is a disintegration of Europe, total or partial, but anyway to a large extent so that the few countries that will remain in it would be able to re-design it properly and solidly, to give it the power and credibility it needs to stand and defend its goals among global powers such as the USA, China, Russia, Japan and many others.
Dimitris Lagopoulos – Economist – March 2017
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