The Tragedy of the Euro, Philipp Bagus

The Tradegy of the Euro, Philipp Bagus, Ludwig von Mises Institute.

Chapter 4

Why High Inflation Countries Wanted the Euro

Socialized Seigneuriage

Some countries, especially France, made gains at the expense of the Germans due to a socialization of seignorage wealth. [3] Seignorage are the net profits resulting from the use of the printing press. When a central bank produces more base money, it buys assets, many of which yield income. For instance, a central bank may buy a government bond with newly produced money. The net interest income resulting from the assets is seignorage and transmitted at the end of the year to the government. As a result of the introduction of the Euro, seignorage was socialized in the EMU. Central banks had to send interest revenues to the ECB. The ECB would remit its own profits at the end of the year. One could imagine that this would be a zero sum game. But it is not. The ECB remits profits to national central banks based not on the assets held by individual central banks, but rather based on the capital that each central bank holds in the ECB. This capital, in turn, reflects population and GDP and not the national central banks’ assets.

The Bundesbank, for instance, produced more base money in relation to its population and GDP than France, basically because the Deutschmark was an international reserve currency and was used in international transactions. The Bundesbank held more interest generating assets in relation to its population and GDP than France did. Consequently, the Bundesbank remitted relatively more interest revenues to the ECB than France, which were then redistributed to central banks based on population and GDP figures. While this scheme was disadvantageous for Germany, Austria, Spain and the Netherlands it was beneficial to France. Indeed, the Bundesbank profits remitted back to the German government fell after the introduction of the Euro. In the ten years before the single currency, the Bundesbank obtained euro 68.5 billion in profits. In the first ten years of the Euro the profit fell to euro 47.5 billion.

Lower Interest Rates

The Euro lowered interest rates in the southern countries, especially for government bonds. People and governments had to pay less interest on their debts. Investors bought the high yielding bonds of peripheral countries, which bid up their prices and brought down interest rates. This was a profitable deal because it could be expected that the bonds still denominated in Lira, Peseta, Escudo and Drachma would finally be paid back in Euros.

The lower interest rates allowed some countries to reduce their debt and fulfill the Maastricht criteria. Italy’s rates, for instance, were reduced substantially, allowing the government to save on interest payments. In 1996, Italy paid around euro 110 billion in interest on its debts and in 1999, only around euro 47.5 billion.

Southern interest rates were lowered for two main reasons. First, interest rates were reduced as inflationary expectations fell: the prestige of the Bundesbank partially transferred to the ECB led to lower interest payments. Second, the risk premium in rates was reduced. With the Euro, one currency was introduced as a step towards political integration in Europe. The Euro was installed supposedly for an indefinite period. The Eurozone’s breakup was not provided for legally, and would be considered a huge political loss. The expectation was that stronger nations would bail out weaker nations if necessary. [5] With an implicit guarantee on their debts, many countries had to pay lower interest rates because the risk of default was reduced.

As Germany and other countries were implicitly guaranteeing for the debt of Mediterranean states, these states’ lower interest rates were not in line with the real risk of default. The German government, in turn, had to pay higher interest rates on its debts than it would have paid otherwise; the danger of an additional burden was priced in. Markets normally punish budgetary indiscipline harshly, with higher interest rates and a depreciation of the currency. The European Monetary Union led to a delay of this punishment.

As a consequence of the expected entry into the monetary union, interest rates converged to Germany’s level, as can be seen in Graph 1. From 1995 on, it became more and more certain that Mediterranean countries (except Greece that participated in 2001) would participate in the monetary union in 1999.

Rates fell even though real savings had not increased and because the inflation premium was reduced. The lower interest rates caused capital good prices to rise. As a consequence, a housing boom occurred in many Mediterranean countries. Credit was cheap and was used to buy and construct houses. This housing bubble was fed by expansionary monetary policy until 2008, when the global crises led to a crash in oversized housing markets.

More Imports and a Higher Living Standard

High inflation states inherited a stronger currency from Germany and, consequently, could enjoy more imports and a higher standard of living. Even though Latin governments did not lower their expenditures significantly, the Euro remained relatively strong in international currency markets during the first years of its existence. The Euro was kept strong due to the prestige of the Bundesbank and the institutional setup of the ECB, as well as due to strong German (and other northern states) exports that increased the demand for Euros.

Germany has traditionally had current account surpluses, i.e., exports exceeding imports due to high efficiency and competitiveness. Germans saved and invested, improving productivity. At the same time, wage rates increased moderately. The resulting export surplus implied that Germans would travel to and invest in other countries. Germans acquired assets in foreign countries that could be sold in case of emergency. The result was an upward pressure on the exchange rate.

Over the years, the Deutschmark tended to appreciate due to productivity increases in Germany. The appreciation of the Deutschmark in foreign exchange markets made imports cheaper. Also vacations and investments in foreign countries got cheaper. Living standards went up. This mechanism of increased productivity leading to more exports and tending toward an appreciation of the currency is still in place in the EMU.

But in the southern EMU we have the opposite image. Production is less efficient there, relatively. Consumption rose in Southern Europe after the introduction of the Euro, and was spurred on by artificially lowered interest rates. Savings and investments have not increased as much as they have in Germany, and productivity increases have lagged behind. Moreover, new money has gone primarily to peripheral countries where it has pushed up wages. These wage increases have been higher than wage increases in Germany, leading to a loss in competitiveness, a surplus of imports over exports, and a tendency toward a depreciation of the currency.

As we can see in Graphs 2 and 3, competitiveness in Mediterranean countries and Ireland has decreased substantially since the introduction of the Euro. At the same time, competitiveness in Germany and even Austria has increased. Since the introduction of the Euro, Germany’s competitiveness, as measured by the indicator based on unit labor costs provided by the ECB, increased 13.7 percent from the time of the Euro’s introduction up until 2010. In the same period, Greece, Ireland, Spain, and Italy lost in competitiveness, 11.3, 9.1, 11.2, and 9.4 percent respectively. [6] According to the numbers provided by the ECB, Germany’s having a competitive indicator of 88.8 in the first quarter of 2010 is substantially more competitive than Ireland with its 118.7, Greece with its 108.8, and Spain and Italy, with 111.6 each.

Before the introduction of the Euro, Latin countries with increasing wages, strong labor unions, and inflexible labor markets also lost competitiveness relative to Germany. Yet, before the single currency, inflations and devaluations regained competitiveness, lowering real wages. At the same time imports became more expensive.

When the Deutschmark was replaced by the Euro, Germany’s export surplus was partially compensated for by import surpluses of southern states. Trade surpluses and deficits of Eurozone states can be seen in Graph 4.

In Graph 5 we see that Germany’s trade surplus has increased in recent years due to the increase in competitiveness that comes along with an increased trade deficit of other countries. In fact, Germany’s trade surplus more than compensates for the traditional trade deficits of Spain, Portugal, Italy, and Greece.

Long-lasting trade deficits drag negatively on the value of a currency. A trade deficit implies that there is a surplus in other parts of the balance of payments. There can be financial transfers toward the deficit country, or the country may increase its net position of foreign debts. Without sufficient financial transfers, a trade deficit implies that the public and private foreign debts of the country increase.

In this regard, it is not irrelevant if debts are held by a citizen or by a foreigner. Japanese government debts are held to a large extent by Japanese citizens and banks. Greek (or Spanish) government debts are largely held by foreign banks due to their trade deficits. Greeks did not save enough to buy their government debts, but preferred instead to import more goods and services than they exported. Foreign banks financed this consumption by buying Greek debts.

The Japanese government can force its banks to buy its government bonds or keep them from selling because they are within Japanese jurisdiction. The Greek government cannot force foreign banks to hold on to Greek government bonds. Neither can the Greek government force foreign banks to keep buying Greek debts in order to finance its deficit. If foreign banks stop buying or start selling Greek government bonds, the government may have to default. Deficits and resulting foreign debts make a currency vulnerable, while trade surpluses and net foreign positions make a currency stronger.

The development of the Euro pales when compared to what would have been the development of the Deutschmark alone. Imports and living standards in Germany did not increase as much as they would have with the Deutschmark. In fact, real retail sales in Germany lagged behind those in other industrial nations, as can be seen in Graph 6.

But retail sales in Mediterranean countries increased and began to fall only with the economic crisis in 2008. From 2000 to 2007, retail sales in Spain increased more than twenty percent (Graph 7).

Imports remained cheaper for southern Europe than they probably would have without the monetary union. Even though inflationary countries lost competitiveness relative to Germany, imports did not increase in price as much as they would have had these countries relied on their own currencies. The result of combining this with artificially low interest rates was the credit – financed consumption boom, especially in the southern states.

An Excuse for Budget Cuts

Southern European politicians used the Maastricht Treaty as an excuse (before a socialist constituency) for deregulation and taking budgetary saving measures necessary to prevent bankruptcy. In order to fulfill the convergence criteria, Southern countries had to reduce their deficits, cut government spending, and sell public companies. For many countries, in fact, the Euro was the only prospect for delaying sovereign default or hyperinflation. Public debts pressed European welfare states severely before the introduction of the Euro. In 1991 Belgium, Ireland and Italy had debts of 132%, 113%, and 103% of the GDP. Even the Netherlands had a debt of 83% of the GDP, with Greece not far behind. In the end, the issue of a single currency was about power and money and not about high-minded European thinking.

Gains Through Monetary Redistribution

When the Euro was introduced, it did not take long for imbalances to develop and accumulate. The current account deficit in southern states increased in a consumption boom and the German export industry flourished. An appreciation of the Deutschmark would have caused problems for German exporters and reduced the current account surplus of Germany. With the Euro, this was no longer possible.

New Euros flew from the credit-induced boom in southern countries into Germany and pushed up prices there. Redistributions occurred as the ECB continued to finance and accommodate consumption spending in these countries. New money would enter the southern countries and buy Germany products.

In Graph 8, we can see the growth of M3 (excluding circulating currency) in Spain, Italy, Greece, Portugal, and Germany. We see that the money supply indeed grew much faster in the Mediterranean countries. Spain and Greece, especially, had faster growth rates than Germany did (thick line) during the boom years of the early 2000s until 2008. For instance, when Germany’s monetary aggregate was falling in 2002, Spain and Italy had double digit increases. In 2004, Germany’s growth of money aggregates was hovering at two percent. Monetary growth was at least double in the Mediterranean countries at the same time. When Spain’s housing boom got out of control in 2007, M3 grew to twenty percent while Germany’s aggregate grew between five and eight percent.

The redistribution through different rates in money production brought on a culture of decadence. This development resembled the “curse of gold” that Spain experienced after the discovery of the New World, when new money, i.e., gold, would flow in to the country. Spain would then import goods and services (mostly military) from the rest of Europe. As a consequence, European exporters would experience profits and Spanish industry would become ever more inefficient.

The same has happened in the Eurozone. Money was injected at a faster rate in Southern states. After constructing houses, money spread to the rest of the Eurozone as Spain imported goods from Germany and other Northern countries. The Mediterranean current account deficit increased.

If the monetary injection had been a one time event only, the situation would have soon stabilized. Prices would have increased in Germany relative to the Southern countries as Euros bought German goods. Lower prices and wages in the Southern countries would have made these countries more efficient and reduced the current account deficit.

But this readjustment was not allowed to happen. New money continued to flow more quickly into Mediterranean states where it was passed on to Southern consumers and governments, keeping prices from falling (prices that were relatively higher than those in Germany). The flow of goods from Germany to the southern countries continued. The current account deficit was maintained and southern countries stayed relatively unproductive while becoming accustomed to a level of consumption that would not have been possible without the money creation in their favor. Southern inflation was exported to Germany while monetary stability was imported. Southern prices did not rise as much as they would have without the imports from Germany. German prices increased more than they would have without the exports to southern Europe.

[…]

In a gold standard, gold would leave Greece and flow to Germany in exchange for imported goods. In fluctuating fiat paper currencies, a politician would have to exchange his newly printed Drachma into Deutschmark; the Deutschmark would rise in value and the next vacation of the German automobile worker in Greece would be less expensive. In the case of the Euro, paper money flows into Germany where it is accepted as legal tender and bids up prices.

Chapter 8 : The EMU as a Self-Destroying System

The euro and the tragedy of commons

When governments in the EMU run deficits, they issue bonds. A substantial part of these bonds are bought by the banking system. [12] The banking system is happy to buy these bonds because they are accepted as collateral in the lending operations of the ECB. This means that it is essential and profitable for banks to own government bonds. By presenting the bonds as collateral, banks can receive new money from the ECB.

[…]

In the EMU, the deficit countries that use the new money first win. Naturally, there is also a losing side in this monetary redistribution. Deficit countries benefit at the cost of the later receivers of the new money. The later receivers are mainly in foreign member states that do not run such high deficits. The later receivers lose as their incomes start to rise only after prices increase. They see their real income reduced. In the EMU, the benefits of the increase in the money supply go to the first users, whereas the damage to the purchasing power of the monetary unit is shared by all users of the currency. Not only does the purchasing power of money in the EU fall due to excessive deficits, but interest rates tend to increase due to the excessive demand coming from over-indebted governments. Countries that are more fiscally responsible have to pay higher interest rates on their debts due to the extravagance of others. The consequence is a tragedy of the commons. Any government running deficits can profit at the cost of other governments with more balanced budgetary policies. [14]

[14] An additional moral hazard problem arises when banks holding government debts are bailed out through monetary expansion. Banks knowing that they will be bailed out and that their government debts will be bought by the central bank will behave more recklessly and continue to finance irresponsible governments.

[…]

The tragedy of the Euro is the incentive to incur higher deficits, issue government bonds, and make the whole Euro group burden the costs of irresponsible policies — in the form of the lower purchasing power of the Euro. [21] With such incentives, politicians tend to run high deficits. Why pay for higher expenditures by raising unpopular taxes? Why not just issue bonds that will be purchased by the creation of new money, even if it ultimately increases prices in the whole of the EMU? Why not externalize the costs of government spending?

[21] We are faced here with two sources of moral hazard. One arises from the working of the Eurosystem and the implicit bailout guarantee by the ECB, the other one from the implicit bailout guarantee by fellow governments. The effects are moral hazard and an excessive issue of government bonds.

[…]

There was another attempt to curb the perverse incentives of incurring in excessive deficits. … The stability and growth pact (SGP) was adopted in 1997 to limit the tragedy in response to German pressure. The pact permits certain “quotas,” similar to fishing quotas, for the exploitation of the common central bank. The quota sets limits to the exploitation in that deficits are not allowed to exceed three percent of the GDP and total government debt not sixty percent of the GDP. If these limits had been enforced, the incentive would have been to always be at the maximum of the three percent deficit financed indirectly by the ECB. Countries with a three percent deficit would partially externalize their costs on countries with lower deficits.

However, the regulation of the commons failed. the main problem is that the SGP is an agreement of independent states without credible enforcement. Fishing quotas may be enforced by a particular state. But inflation and deficit quotas of independent states are more difficult to enforce. Automatic sanctions, as initially proposed by the German government, were not included in the SGP. Even though countries violated the limits, warnings were issued, but penalties were never enforced. Politically influential countries such as France and Germany, which could have defended the SGP, inflicted its provisions by having more than three percent deficits from 2003 onward. With a larger number of votes, they and other countries could prevent the imposition of penalties. Consequently, the SGP was a total failure. It could not close the Pandora’s Box of a tragedy of the commons. For 2010, all but one member state are expected to violate the three percent maximum limit on deficits. The general European debt ratio to GDP is eighty-eight percent.

The tragedy of the euro and the case of Greece

The fiscal developments in Greece are paradigmatic of the tragedy of the Euro and its incentives. When Greece entered the EMU, three factors combined to generate excessive deficits. First, Greece was admitted at a very high exchange rate. At this rate and prevailing wages, many workers were uncompetitive compared with the more highly capitalized workers from northern countries. To alleviate this problem, the alternatives were to (1) reduce wage rates to increase productivity, (2) increase government spending to subsidize unemployment (by unemployment benefits or early retirement schemes) or (3) employ these uncompetitive workers directly as public workers. Owing to strong labor unions the first alternative was put aside. Politicians chose the second and third alternatives which implied higher deficits.

Second, by entering the EMU, the Greek government was now supported by an implicit bailout guarantee from the ECB and the other members of the EMU. Interest rates on Greek government bonds fell and approximated German yields. Consequently, the marginal costs of higher deficits were reduced. The interest rates were artificially low. Greece has experienced several defaults in the twentieth century, and has known high inflation rates and deficits as well as a chronic trade deficit. Nevertheless, it was able to indebt itself at almost the same rates as Germany, a country with a conservative fiscal history and an impressive trade surplus.

Third, the tragedy of the commons comes into play. The effects of reckless Greek fiscal behavior could partly be externalized to other members of the EMU as the ECB accepted Greek government bonds as collateral for their lending operations. European banks would buy Greek government bonds (always paying a premium in comparison with German bonds) and use these bonds to receive a loan from the ECB at a lower interest rate (currently at one percent interest in a highly profitable deal).

[…] There was a demand for these Greek bonds because the interest rate paid to the ECB was lower than the interest the banks received from the Greek government.