An Unstable Union
June 27th, 2018
At first glance, the European Monetary Union (EMU) appears to be almost fully recovered from the 2008 global economic crisis. The unemployment rate for the EMU as a whole is close to its pre-crisis level, roughly 7.0%.
However, when observed under greater scrutiny, it is clear that the current economic conditions of the EMU vary dramatically by country, unlike pre-crisis conditions. The economies of smaller, periphery countries, particularly Greece and Spain, have not recovered as well as larger, core countries like Germany and France. The graph below from the New Economics Foundation shows that during the period between the introduction of the Euro and the 2008 crisis, unemployment rates between these two cohorts differed. It also shows that the difference has become much more dramatic since the crisis, with Greece’s unemployment rate over 25% in 2013, compared to Germany’s approximate 5% rate.
What changed as a result of the crisis that produced these inter-country disparities? Unfortunately, it is what hasn’t changed. The structural problems ingrained in the EMU run deep and are not easy to solve.
Joining the EMU is a strict process, and member countries must give up their independent monetary policy, and some measures of control of their fiscal policy. Having control over both monetary and fiscal policy have historically been extremely important tools in times of economic crisis. When a crisis hits, a country with independent monetary policy can use expansionary monetary policy (cut interest rates) to boost demand, specifically investment, to revive the economy. This action would also make the domestic country’s currency cheaper, boosting demand for their exports and decreasing imports from other countries by making their currency (and therefore, their goods) relatively more expensive. Expansionary fiscal policy, namely an increase in government spending or a cut in taxes, may also be used to boost demand in the economy, but is proven to be less effective as an option due to the fact that both these actions increase debt. In addition, a temporary fiscal expansion can lead to a phenomenon known as “crowding out.” The expansion results in an increase in interest rates and thus an appreciating currency. This appreciation lowers the overall demand for domestic goods on foreign markets, thus muting the total economic recovery.
How does this situation apply to Greece and Spain? The European Central Bank is in control of monetary policy for all 28 members of the EMU. In response to the 2008 crisis, the interest rate was immediately cut to boost demand, but was only reduced an amount adequate to help the core countries, such as Germany. These countries were already doing relatively well compared to other member countries, such as Greece, before the crisis. The cut in the rate was not dramatic enough for Greece and Spain, which is part of the reason why these countries have been in a perpetual recession since 2008.
To add another dimension to this problem, politicians and officials from the core countries that have recovered have started to blame the spending behaviors and decisions of periphery nations for their lack of recovery, rather than the problematic structure of the EMU. According to officials from core countries, the periphery countries lack “fiscal discipline.” As a result of this rhetoric, austerity measures have been introduced with the intent of reducing the debt of the periphery countries. The austerity measures include huge cuts to public spending, These policies have only deepened the recession, causing deflation, and put huge political strain on countries’ respective governments.
Countries undergoing a crisis would typically lower interest rates or expand government spending. However, with little to no control over fiscal and monetary policy, countries in crisis are forced to take extreme measures such as slashing social programs and wages to make their exports more competitive in world markets. Lower wages decrease the price of the product, making it relatively cheaper than similar products made in other countries. However, cutting wages and aid programs exacerbated the recession. Greece’s economy has shrunk compared to its pre-crisis RGDP level by 27.6%. Greece has two options: stay in the EMU and continue to experience deflation and perpetual recession, or leave the EMU and experience a much more severe economic downturn.
If Greece stays in the EMU, its economy will continue to hurt. The structural problems of the EMU will remain and given its massive debt load, things may worsen in the next global recession. If Grexit were ever to happen, Greece would experience a brutal recession, but with the possibility of recovery in the distant future. Argentina experienced a similar situation in 2002 when it broke its currency peg from the US dollar, resulting in a rapid devaluation. However, even though its economy collapsed, this devaluation gave Argentina an advantage because it made its currency (and therefore its goods) relatively cheaper than foreign currency (and goods). Argentina was able to revive its economy with the boost in demand for its exports by 2005, although it is currently struggling and looking to accept a $7.5 billion deal from the IMF to finance its budget.
If Greece left the EMU and recovered, other struggling countries may decide to leave the EMU as well. Though many economists believe a breakup of the EMU would cause a global financial disaster worse than the 2008 crisis, struggling countries are looking for relief and will act in their own best interest. This may be to abandon the Eurozone. If the EMU does not make any structural changes, its eventual breakup becomes more likely. Fortunately, the probability of a Grexit within the next decades has been reduced to nearly zero as Eurozone finance ministers have just approved a massive Greek debt relief program. Repayments on the €228bn will be minimal through 2030.
Clearly there are plenty of economic reasons for member countries to leave the EMU, but there are also many political reasons. Although the UK was only a part of the EU, and not the EMU, it demonstrates the political reality of how a member country may break from the union. Ultimately, the UK government lost control over policy. Many political analysts point to the European refugee crisis as the kickstarter for the modern Eurosceptic movement. Studies show that xenophobia was strongly correlated with voting for Brexit. This was a vote against government officials perceived to be out of touch with the nationalist interests of the people. Brexit demonstrates the gravity of purely political decisions given the lack of credible economic justification available to leave the EU. The decision rested solely on xenophobia.
The tensions between debtor and creditor nations also reveal the EMU’s unsustainable nature. The US is arguably a better currency zone than the EMU because the federal government of the United States can direct spending and resources to regions of the country that are struggling relative to the rest of the country. The EMU is comprised of 28 sovereign member states, and has no such overarching political structure. When a periphery country like Greece goes into default, it must be bailed out by the rest of the EMU members. This burden usually falls on the core countries, such as Germany. The resulting tension and resentment can lead to increased political conflict.
Resulting from related political tensions, right-wing populist parties are growing in strength and center left parties are weakening in both core and periphery countries. In France, Marine Le Pen partially campaigned on leaving the Euro. She won over a third of the vote, the highest ever for the National Front Party. Meanwhile, the Socialist Party, a center-left party that previously was a major player in France, won only 7% of the vote.
On the other hand, in Italy the anti-establishment 5 Star Movement became Italy’s largest party this past March. On the right, the Anti-Immigrant League went from having 4% of the vote to 18%. Both the 5 Star Movement and Anti-Immigrant League are Eurosceptic, although the current coalition government claims to have no interest in leaving the Eurozone. The parties that are gaining support and even coming to power in many periphery countries have integrated anti-EMU sentiment into their campaign platforms. Support for the Democratic Party, which has enforced unpopular austerity measures in compliance with EMU policy, fell to 19%, causing Prime Minister Matteo Renzi to resign.
Will the EMU break up, or will structural changes be made? Either way, we are sure to see changes to Europe’s economic landscape, with a host of political and economic crises looming on the horizon.