Why the Euro can’t survive without radical change

Austan Goolsbee, professor of economics at the University of Chicago and former chairman of President Obama’s Council of Economic Advisers from 2010 to 2011 has written a short and brilliant analysis of the European monetary crisis. It’s in the May 30, 2012 Wall Street Journal and entitled “A Fiscal Union Won’t Fix the Euro Crisis”. His analysis is so excellent and profound that I can’t improve on it and for those of you who don’t subscribe to the WSJ, you can find its text in the blog below.

Goolsbee concludes that the ONLY solutions to Europe’s crisis are: 1) allowing easy and complete mobility between European countries for workers, 2) allowing strong inflation in German and other Northern Europe economies, or 3) creating strong and ongoing subsidies from countries like Germany, France, Belgium, Finland and the Netherlands to countries like Portugal, Italy, Greece and Spain.

As you read Goolsbee’s insightful commentary, consider the following:

1. Mobility is an unlikely candidate for any improvement in the next few years. Differences in language, culture, eating habits, greater difficulty in selling homes in a down market and racial bigotry means that truly open borders will take a long time – if ever – to happen.
2. Germany’s agreeing to high wage inflation, as Goolsbee suggests is unlikely in the extreme. It’s not a political possibility until anyone who was born before 1950 has passed. High inflation in Germany led directly to the ascendancy of Hitler, who promised its cure. More than any other causal factor for WW II, this inflation permitted a lunatic to take over the German government with the majority of populace supporting him. In the resulting world war, over 25 million perished. Of that number an estimated 10 million were Germans.
3. Large and ongoing subsidies from the northern economies to the south? That’s nowhere envisioned in the European constitution or principles. Goolsbee clearly indicates that it’s not going to happen either.

Read on to understand better Goolsbee’s remarkable insight that the American fiscal union’s most important principle is one of subsidies from the rich states to the poorer ones – without asking permission from those richer states. Then you’ll understand that the Euro’s problem is really pretty much unsolvable. And for how long and how far can this bucket be kicked down the road? And what does it mean to us? Europe is a far larger and more important trading partner to the US than China (80% larger total 2 way trade). More to come later…..

Wall Street Journal, May 30, 2012
 A FiscalUnionWon’t Fix the Euro Crisis
The only practical choices are more geographic mobility, inflation, or subsidies.
By AUSTAN GOOLSBEE

Recently Kurt Bills, a candidate for the U.S. Senate and a devotee of Ron Paul, introduced a bill to consider an alternative currency for Minnesota and its citizens. When I heard this idea I thought what every mainstream economist probably thought: Wow is that nuts.

Yet many observers (and online betting markets suggest a majority) believe that Greece must return to its own currency. The economies of Greece and of Minnesota are about the same size (2% of U.S.gross domestic product), so why is an independent currency viable for one and quackery for the other?

One key economic difference is the existence of a fiscal union in the United States. Increasingly, euro-zone hardliners have called for putting in a disciplined, unified fiscal arrangement similar to the one we have in the U.S. Unfortunately, their vision of fiscal union has badly missed the essence of the U.S. experience and would not fix the euro crisis.

At root, the euro-zone problem remains the locking together of very different economies into a monetary union without a way to adjust. Since the start of the union in 1999, productivity in the North, especially in Germany, has grown rapidly while wages have not. In the South, productivity has lagged. As a result, the unit labor costs in Germany have fallen about 25% since the euro’s creation as compared to the Southern countries and France.

Normally, exchange-rate adjustments would reduce this gap. The slower growing, poorer country would become more competitive as its manufactured goods and its tourism became cheaper. Real incomes would take a hit initially, but the economies would have a path to growth. Inside a monetary union, however, there are no exchange rates to change.

That alone doesn’t need to doom the monetary union. But without an exchange-rate safety valve you need an alternate way to rebalance economies. Moving, inflating, struggling, or subsidizing are your only choices—and none of them is easy.

If workers move freely to high-growth areas or if the central bank is willing to loosen monetary policy to get the high-growth economies to start inflating, that can replace the exchange rate as the safety valve. Inflation in the high-growth economies will change the relative real wages between the counties the same way a devaluation can. Labor mobility helps the U.S.in that sense. In Europe, though, mobility between countries with different languages is low and German tolerance for inflation seems even lower. That leaves suffering and subsidies.

Southern Europe can struggle through the problem—grinding down wages through high unemployment and structural labor-market reforms to make a country such as Greece more competitive internationally. History suggests this will not be an easy sell. Wage cuts usually come only after tremendously extended bouts of high unemployment. Structural reforms can take years to actually raise productivity growth rates.

Or Northern Europe could decide, for the sake of a united Europe, that it is willing to permanently subsidize euro-zone countries with low productivity growth. That could be through explicit subsidies or through bailouts and broad-based guarantees. But in the North, subsidies remain anathema. The Germans are quite right that the euro zone was absolutely not created to enable permanent subsidies, and their opposition is easy to understand.

Thus, lacking the normal safety valves to keep dangerous imbalances from destroying the monetary union, the euro hardliners are left with the idea of fiscal union. These hawks, however, misunderstand a fundamental strength of the U.S.fiscal union. They seek a union to impose budgetary discipline and structural reforms on laggard countries while the U.S.fiscal union serves mainly as an engine of subsidy.

Last year, the Economist compiled census data from 1990 to 2009 for all 50 U.S.states on the amount of federal spending in each state minus the amount the state’s residents pay in federal taxes. Over 20 years, states like Minnesota and Delaware annually paid in about 10% more of their state GDP than they got back. On the other side, for the last 20 years New Mexico, Mississippi and West Virginia have received annual subsidies of more than 12% of state GDP. While not a perfect measure of subsidy, it conveys the basic point well. These are big. Greece’s entire 2011 deficit, for example, was 9.1% of GDP.

The U.S.fiscal union has worked, in no small part, by enabling subsidies to the Mississippis without requiring the approval of the Minnesotas. It creates an important form of insurance. When Texans suffered from the collapse of the oil market in the 1980s, they could rely on the fiscal union to help them. When Texas boomed with rising oil prices in the 2000s, it contributed to the union to help harder hit regions.

Giving Northern Europe a veto over Southern Europe’s budgets will not hold a monetary union together. The euro zone will continue to need the weaker countries to stomach decades of high unemployment to grind down wages.

Without some significant inflation in the North or mobility from the South, holding the European monetary union together will cost Northern Europeans a great deal of money. In other words, if a fiscal union is to save the euro zone, it would need to facilitate subsidies from North to South, not eliminate them. As far as the likelihood of that, I wouldn’t be willing to bet a dollar—even if it were backed by the state of Minnesota itself.