When the euro was formed, the economic debate was marked by a paradox. Liberal economists on the continent were enthusiastic – they believed the euro’s adoption would force reforms on the EU. Free market economists in the UK were more pessimistic. They feared that economic shocks would result in complete social dislocation, due to inflexible labour and product markets. And while UK free-marketeers argued that the euro would lead to an EU superstate, their continental counterparts trusted that fiscal and monetary policy would be kept entirely separate.
UK opponents of the euro have been vindicated, though to no one’s satisfaction. The European Central Bank (ECB) has conducted monetary policy in such a way that both government debts and banking system debts are now being shared. Eurocrats have concluded from this that, if debts are to be shared, there should be strict centralised EU control of banking systems and national budget decisions.
The EU is now behaving like a panicking man in quicksand. The ECB’s operations are ensuring that the banking systems of more solvent countries are implicitly bailing out the banks of nations in trouble, and government debt is being socialised at the EU level. It is believed that, by repackaging debt, it will somehow disappear. Instead the burden grows, day by day.
Average EU government debt is half as much again as the legal maximum under EU rules. In Greece, it stands at 170 per cent of GDP. It is impossible to imagine EU countries dealing with this burden unless there is rapid economic growth. But growth will not come unless labour markets, business regulation and services are speedily reformed. And this is unlikely to happen soon. Only this week we saw one EU commissioner suggest crazy new regulations to impose compulsory quotas on female board members.
But even if pro-market reform does happen, austerity will have to continue. Governments cannot carry on borrowing – bond markets are effectively shut and are only kept open because of extraordinary measures by the ECB.
Unfortunately, austerity may affect growth in the short term. Countries with floating exchange rates that cut borrowing do not have to worry so much about the impact on growth. The reduced capital inflows needed to finance government deficits lead to benefits from lower exchange rates, interest rates or both. In the Eurozone, however, exchange rates are effectively fixed and austerity is more painful in the short term.
Added to this problem is the need for countries like Greece to become competitive again. To do this, wages and prices must fall by about 25 per cent. On a fixed exchange rate, this can only happen through deflation.
However, delivering deflation on the scale needed, given the EU’s appallingly rigid labour markets, will prove an economic nightmare. It will also make the debts of Greece, Spain and others even harder to service, as wage levels and tax revnues fall, but debt interest payments do not.
We may as well short-circuit the years of pain that the EU and ECB are imposing upon the Eurozone by trying to postpone the inevitable. We should look for an orderly default on government debt in highly indebted countries. Default should come with conditions like the mass privatisation of state assets, the proceeds of which would be used to repay creditors. This would cause a crisis in the Eurozone banking system – though UK banks would probably survive intact. The priority must be ensuring that those banks that fail do so in an orderly way.
Wealth loss is sadly inevitable because governments have borrowed money they are not able to pay back. We cannot avoid that problem and, however much the ECB postpones the day of reckoning, we may as well face up to it.
To get back to growth, unless the EU can enact the necessary labour market reforms, the Eurozone will have to unwind. And the Eurozone can only be unravelled by keeping the euro as a legal tender currency across the current single currency area, while allowing member states to issue national currencies in parallel if they wish.
All other viable paths would seem to lead to a Eurozone superstate and, whatever the coalition government thinks, Britain could not remain outside its grasp for long.
This article originally appeared in City AM.