Nov 11, 2015, 11:00 AM
The Euro-zone is on the verge of deflation, with inflation rate closer to the zero lower bound and expected to only reach 1.4% in end 2016. Mario Draghi, the President of the European Central Bank promised to do what ever it takes to stimulate the economy.
Recently, the European Central Bank (ECB) has made one giant step to purchase more than $1.4 trillion of eurozone governments’ bonds, to much dismay from German Officials. They openly objected to this unconventional monetary tool as it translates to transferring risk from lenders to ECB, effectively to the European Tax payers. For starters, this is called Quantitative Easing, and they hope this will jump start the Eurozone economy that is mire in recession and threatened by a potential deflation- More on this in the second part of this series.
While that was happening, the people of Greece were preparing to vote in the Left is Syriza party. Syriza had promised to abandon the much maligned austerity measures known as the TROIKA-(ECB, EU and IMF agreed program). It will be interesting to see how this ends, as it has ramifications on the entire fiscal consolidation program in euro, spearheaded by Germany.
Reading the European press for the past few years pits Germany against the rest of Europe on how to solve the current economic crisis in Europe. Germany insist on much needed structural reforms in the affected countries while most people think what the economies needed was more public spending to cover for the loss of private spending. Despite near zero interest rates, demand is anemic in the Eurozone.
In 2012, I wrote a seminar paper (in the course: Economics and Politics of European Integration) as part of the requirements for my MSc Economics program. In light of current events unfolding in Europe, I thought it would be interesting to update this piece. I asked: Was the Euro more Beneficial to Germany or Greece, Italy, Ireland and Spain (GIIPS) countries before the Financial Crisis (2008).
The Part I of this series attempts to look into the evidence of the above question. The Second Part, We look at the events after the crisis.
“One Market, One Money” captioned the Delores report in 1991.It is no brainer to guess the implied endorsement of the above title. The argument put forward amongst a host was that the Single Market created by the EU in goods and services needed a single currency for its effectiveness; albeit, there was at least one example of a free market zone in North America Free Trade Area(NAFTA) which was not using a single currency. The proponents will not take any of this. On record, there were numerous articles rubbishing the claims that the Euro will be more beneficial than its associated disadvantageous pointed out by the Euro skeptics. For example, the heterogeneous nature of the different economies that are bound to react to various shocks differently. It brings the argument if the Euro was more of political gains than economic ones. For the purpose of this Essay, I will give the benefit of the doubt and “take” that it was introduced purely on Economic grounds.On economic grounds, a currency union as in the Euro will establish a supranational Central Bank (ECB) to set unified monetary policies across member states binding on all member countries. It is a loss of sovereignty on individual countries on monetary policies.But, crucially fiscal policy was left completely with national governments.
Arguably, the introduction of the Euro was hyped with the below mentioned associated benefits
Trade Gains:With the Euro, a great deal of payment obstacles will be removed thereby improving already existing free movement of goods and services in the EU.
Exchange Rate: conversations and forward cover required in the previous flexible exchange rate systems will be eliminated.
Price wage flexibility and transfers: It should ease wage and price rigidities in member countries.
Capital Flows: Starting with speculative capital flows, which will be eliminated; long term interest rates are expected to decline in member countries.
Capital Market Gains: With the Euro, national capital markets will be converged which has the potential to deepen markets, increase greater competition, consequently, more investment opportunities will be ushered in member countries.
In the formative years, it was a truly plain sailing as low interest rates induced investment booms and expansionary fiscal policies across the member states , and in particular the GIIPS countries. It was like the Utopia predicted by the proponents came to reality. In short, real convergence seemed possible as intended. The possibility of the less privileged south to catch up with their more prosperous North was becoming a reality.Some skeptics argued that it was too early to blow the whistle indicating that the Euro was a success. Among the critics was Martin Feldstein of Harvard University, who had been a staunch critic from the pre-euro era; “With no serious downturn, the ECB has been able to focus on the goal of price stability”.
Then the financial crisis erupted from the US Housing Bubble in 2006. With Globalisation, economies are interconnected, small wonder few of the Euro-zone countries started facing difficulties in the aftermath of the financial crisis. Mainly the southern periphery countries faced risk of Sovereign debts and a looming Banking crisis. As the cliché goes, it is when the going gets tough that resolve is determined. The Euro and its very existence or continuity should I say began to be questioned in member countries. France some argued vehemently supported the rescue packages for the GIIPS countries mainly to avert a potential banking crisis due to the stake its Banks had in indebted countries (Hanns-August 2010). Germany on the other hand is playing the role of a victim in the current turmoil. The GIIPS countries too accused Germany of benefiting too much at their expense during the best years. The accusations and counter accusations continue to flow. In the light of this, this essay attempts to shed light to what extend are both theories true. For there appears to be an element of truth in both theories depending who you read and or what definitions you restrict yourself in the analysis. This part of the essay does not cater for the post crisis era; to be specific the implications of the bail outs on Germany and GIIPS are not factored for now. It focuses on from the time of introduction up to the start of the crisis - the best years, so to speak.
“The removal of nominal exchange rates within the euro zone lowered transaction costs, trade within the euro zone increased, competitiveness rose as firms benefited from economies of scale and scope, and investment and consumption were boosted by low interest rates,” McKinsey
But who benefited most? I will review Germany and the GIIPS countries performance after the introduction of the Euro in the aforementioned benefits proposed as reasons to adopt a single currency: Trade Gains, Capital flows, Price wage flexibility and transfers.
The German Arguments- that is The GIIPS Countries benefited most
To start with, nowhere in the literature that the proponents of the arguments claimed that Germany did not benefit from the Introduction of the Euro. That will be denying the obvious. What they all seemed to be saying is that, by far the Euro was more of a benefit to the GIIPS countries than Germany. Some even argued that much needed funds at home were flown away into the GIIPS countries consequently improving those countries and denying the real sectors of the Germany economy such investments. Below I enumerate all the relevant arguments, where possible with existing data to back up such claims.
Current Account Balances
This is a contentious issue as some people consider international trade to be a zero-sum game. Arguably, this is an erroneous concept and to some extent could mislead fundamental truths about an economy’s structure. This seems to be the case, at least in the arguments put forward to defend Germany. The Germans argued that much of the trade surplus is due to the severe capital flight from Germany into the GIIPS countries. That is to say Capital exports accounted for most of the trade surplus. How then could that be an advantage to have much of your capital flown out of your country, only in the view of few German investors and that is provided they get their monies back.
On the other hand, thanks largely to the unimaginable low interest rates in the GIIPS countries, credit constraints eased and functional capital markets were established. As Hanns stated, these countries prior to the Euro “were all sucking in capital to finance their investment and to enjoy a good life.”
Gross Domestic Product Growth Rate
With more investment, productivity follows naturally. All the GIIPS countries with the exception of Italy and Portugal at 16 %( that is a giant leap for Portugal) registered a better average growth rate than Germany for the period under consideration. Between 1999-2008 Germany’s economy grew by 17% contrast that to say Ireland at 51%. A further comparative statics between these countries and other old EU countries showed marked difference, as these countries grew faster and larger than them. It is then safe to say these to a significant extent were as a result of the massive booms in the economies thanks largely to the introduction of the euro.
As envisioned, the Euro created a common European Capital market. This made it possible for the convergence of nominal interest rates across Europe. In the past, Germany was much more competitive than the GIIPS countries in that aspect. Matter of fact, this enabled functional capital markets in these countries. For instance, Spain for the first time started issuing 20-year fixed mortgage loans. Prior to the euro, such will be a distant dream. This is one of the driving forces behind the boom in the Spanish economy. Similarly, Ireland was also successful in this aspect with the popular asset- backed special purposes papers issued by Irish special purpose vehicles.
Foreign Investment Rates
Indeed the German economy had its own issues that impacted on the rate of investment, for example the rigidities of the labour market and the minimum wage settings. Notwithstanding, there were enormous outflow of resources that could have been used to help investment in Germany. The GIIPS countries benefited hugely compared to Germany in Foreign investments.Other data on net investment showed that in 2008, Germans exported 60% of their current savings while the net investment was only 40%.
Shortly after 1999, investment started an unprecedented increase in the GIIPS countries, almost certainly at an unsustainable rate.
GIIPS countries Arguments;
Apparently, with the euro investment began to grow at high rates, employment improved, boom was witnessed in the construction and housing sectors in the GIIPS countries. There is no argument here. However, what is apparent is that much was to the benefit of Germany while the Periphery countries witnessed what was an unsustainable growth rate. For example, commentators argued that with good life, lot of imports from these countries came from Germany. It is like I lend you money and you buy my products. Further to that, wealthy German investors will gain a lot (provided they get paid) out of the boom in the periphery countries. An anti- capitalist will smile and say that is Capitalism for you. The few wealthy exploit the others. Below, I present some of the strongest arguments on the hypothesis that “Germany gained more in the euro than the periphery countries, or much more than expected as some commentators argued.
Loss of Competitiveness: The rapid growth in these countries induced wage and price inflation. This is fundamental for sustainable economic growth. It is estimated that the GIIPS countries appreciated about 30% compared to their trading partners. For example Germany’s labour cost has fallen more than 15% against the average labour cost in the euro zone and 25% against GIIPS countries.
Stemming from the above point of Germany being in a competitive position thanks to the Euro, meant that the German export market witnessed a boom that would not have happened had Germany stayed with the D- Mark. Simply put, this under normal circumstance would have appreciated the D-Mark against other trading partners. This is a key aspect of the growth of the German export market.
The single currency allowed German exports to be less expensive, lowered unemployment and improve economic growth.’ Approximately, 40% of German exports go to the Euro-Zone. A staggering figure that is not debatable. All these due in large part to the expanded single market, and removed exchange rates barriers.
Anchor role in a Currency Union
Without a doubt, Germany is the engine of the euro-zone. It is argued that as an Anchor country in the currency union, most of the monetary policies of the ECB reflect to some extent reactions to realities of the German economy. Hence, average inflation has been lowered in Germany in the 12 years of the euro period compared to the preceding years.
Public Finances: The GIIPS countries are all running monumental budget deficits since the financial crisis of 2006. Much more worrying is the fact that these budget deficits are financed at huge cost in terms of interest repayments compared to Germany. To some extent this has helped Germany to be in a better position to finance its public debt.
Be it the North or the Southern Periphery countries the euro has served as a shock absorber for the euro countries during the financial crisis. Inflation rates were kept at a reasonable level, improved trade, and aided the specialization in trade for the member countries.
Further to the above, the euro for a start succeeded in bridging the gap between the more illustrious North and their southern European counterparts, albeit at a severe cost. Recently, that convergence process has not only stopped but it seemed to be reversing. Naturally, break up calls have been made. Irrespective of who gained most during the mid 2000s, this seems to be a hot issue right now.
Based on the evidence gathered, if I am to be the whistle blower here, on any day I will call in favour of the GIIPS countries. This is strictly based on sustainability. True, they grew more than Germany, but it was always going to happen (their crisis) as their deficits were growing at an alarming rate. Some commentators argued that sooner or later it would have happened anyway. More like an itch that needed to be scratch. It just has to happen.
As for Germany, with the current health of their economy, it would have been impossible to be this competitive under the D-mark, by any economic reasoning. In addition, yes Germany grew less than the GIIIPS countries but it is indeed a sustainable model. Although, I must hasten to add that Germany need to incentivize their domestic demand. Currently, it is more like Switzerland depending hugely on foreign demand.
Looking forward, domestic demand will be particularly weak in France, Italy, and Spain and in the other European periphery countries. Major fiscal adjustments will be needed. Contrary to that, robust demand will be witnessed in the North due in large part to favourable refinancing conditions.
As both sides battle to return to the glory days of the mid 2000s, much has been made of the German model, worryingly coming from eminent politicians from Germany. It is impossible for trading partners to both run a budget surplus. This is so basic that one suspects that the German policiticians are unnecessarily playing hard ball in negotiations.
To conclude, for the gains of both sides to return and to a large extent the survival of the euro-zone, Europe needs German extravagancy and the conservatism of the GIIPS countries and by extension even France. To paraphrase the then French Finance Minister and now IMF Chief Christiane Lagarde, it takes two to tango.
The AuthorMomodou K. Dibba wrote this article while he was a student at the University of Berne, Swiss.