The euro was pointless
It’s easy to forget now, but the single currency wasn’t created purely as a political project
Many economists in the 1980s and 1990s thought monetary union would encourage cross-border investment and trade by eliminating the risk premiums associated with the supposedly destabilising devaluations of the past. The net effect would be converging living standards, dampened business cycles, slower inflation, and faster productivity growth for everyone — the benign Germanisation of Europe.
The euro was pointless
Matthew C Klein
| Nov 11 18:34 | 50 comments |
It’s easy to forget now, but the single currency wasn’t created purely as a political project.
Many economists in the 1980s and 1990s thought monetary union would encourage cross-border investment and trade by eliminating the risk premiums associated with the supposedly destabilising devaluations of the past. The net effect would be converging living standards, dampened business cycles, slower inflation, and faster productivity growth for everyone — the benign Germanisation of Europe.
This was a laudable goal, but unfortunately it’s not how things worked out. The policy mistakes that exacerbated the eurozone crisis, while deeply destructive, can’t be blamed. A stimulating conference recently hosted by the Centre for European Reform made it clear to us the euro had already failed to meet the expectations of its architects before the crisis. Sharing currencies was unnecessary for economic convergence, if not actively harmful.
The monetary unions that weren’t
Before getting to the specifics of Europe’s situation, consider the most natural currency union never to exist: Australia and New Zealand.
The two commonwealth countries have remarkably similar economies, a shared culture, a common language, and even the same banking oligopoly.
About a fifth of New Zealand’s exports are bound for Australia and, until very recently, around the same proportion of its imports came from Australia. About 12 per cent of New Zealand’s exports to Australia are used as components in Australia’s exports, while about 20 per cent of New Zealand’s imports from Australia are used as inputs into New Zealand’s exports to the rest of the world.
A little more than half of New Zealand’s outbound direct investment goes to Australia and about half of New Zealand’s inbound direct investment comes from Australia. The stock of Australian FDI in New Zealand is equivalent to about 26 per cent of New Zealand’s GDP.
New Zealand’s population is less than a fifth the size of Australia’s, and a large bulk of the changes in the number of people living and working in Middle Earth can be attributed to New Zealanders moving back and forth from Oz, based on the relative health of the two countries’ job markets. (The two governments agreed on free movement of labour among citizens back in the 1970s. After many years in which more Kiwis moved west than the other direction, the commodity bust has finally pushed net migration in the opposite direction.)
Truly, if there were any reason for any rich countries to enter into monetary union, there would be a case for New Zealand to join the Australian dollar zone.
Yet despite having a lot more in common than, say, Portugal and the Netherlands, Australia and New Zealand have been perfectly content to have separate currencies and independent monetary policies. Moreover, the exchange rate has been quite flexible over the past 45 years:
The kiwi fell by a fourth against the aussie dollar from mid-1979 through mid-1981, soared by a fourth from the start of 1986 through the beginning of 1988, plunged again, rose by a third from mid-1992 through mid-1995, fell by 21 per cent from then through 2000, went back up, back down…you get the idea. All of this currency volatility has coincided with stable (and roughly identical) inflation rates in both countries for more than 25 years.
We could stop there, but there are a few other country pairs worth exploring.
Norway and Sweden are neighbors with basically the same language, similar cultures, and roughly comparable levels of economic development. (Yes, oil obviously affects Norway differently than it affects Sweden, but we never said these countries were identical, just similar.) Presumably if two countries could work out a shared currency, besides Australia and New Zealand, it would be these two eminently reasonable Nordic countries.
Sweden exports more to Norway than to any other country in the world and, until the oil price crash, it imported more from Norway than from every other country besides Germany — which is remarkable given the far greater variety of products produced in Germany. Norway imports more from Sweden than from anywhere else, including Germany, and exports more to Sweden than to every other country in the world besides a few large oil-hungry European neighbors. Sweden is the largest source of foreign direct investment in Norway by a large margin, and the actual linkage may be even bigger than official data suggest given the outsize importance of Luxembourg and the Cayman Islands.
Yet, just like Australia and New Zealand, the Swedes and Norwegians have done just fine floating their currencies against each other and pursuing independent monetary policies according to domestic conditions:
With the notable exception of Sweden’s financial crisis in the early 1990s, the two countries have had almost identical inflation rates going back to the 1950s. (The recent divergence in inflation is less meaningful than it first appears because Sweden’s price index is distorted by floating-rate mortgage payments.) Clearly the volatility in their exchange rate hasn’t been a serious impediment to real economic integration.
We could make similar comparisons between Norway and Germany and between Sweden and Germany, given their tight integration with the dominant economy of the euro area, but we want to end this section with our favourite pair of highly integrated economies: Canada and the US.
America is Canada’s biggest trading partner by an overwhelming margin — 77 per cent of Canada’s exports went to its southern neighbor in 2014, while 55 of its imports came from there. Canada is also America’s biggest trading partner and biggest export destination. This shouldn’t be surprising given cultural similarities, language, and the ease of moving from one place to the other. Canadian banks operate south of the border, while the high-end manufacturing industry, especially for motor vehicles, is tightly integrated along the Great Lakes region. (This is why the Canadian government contributed to the bailouts of General Motors and Chrysler.)
About half of the foreign direct investment in Canada comes from the United States, while 42 per cent of Canada’s outbound FDI is held in the US. The true economic exposure to the US is probably higher, since roughly 17 per cent of Canada’s outbound FDI is invested in Barbados, the Cayman Islands, and Luxembourg. Similarly, a little more than 8 per cent of foreign direct investment in Canada comes from Bermuda, the Caymans, and Luxembourg.
Around 11 per cent of the foreign direct investment in the US comes from Canada — more than any foreign country besides the UK, after adjusting for tax-minimisation strategies that imply significant foreign investment from Belgium, Luxembourg, the Netherlands, the British Virgin Islands, etc.
Looking the other direction, 28 per cent of US outbound FDI is held in the Bahamas, Bermuda, the Caymans, the British Virgin Islands, Ireland, and Luxembourg. Another 15 per cent of US direct investment abroad is held in the Netherlands, which is also known to be friendly to multinationals keen on cutting their tax bill. Add in Switzerland, Hong Kong, and Singapore, and you get another 8 per cent. Of the remainder, about 16 per cent is invested in Canada, second only to America’s foreign direct investments in the UK. (That number, in turn, may be distorted by the Channel Islands, some of which are also tax havens.)
Canada and the US have long had comparable inflation rates and tightly-linked business cycles, yet Canada, which is roughly one-tenth the size of America, has also been happy to have an independent monetary policy and floating exchange rate:
From 1976 through 1986 the loonie depreciated by a third. Then it rallied against the US dollar by 24 per cent until the end of 1991, sank another 29 per cent through the end of 2002, soared by two thirds until the crisis, collapsed, rose again with oil, and has since plunged around a fourth. As with New Zealand and Australia, this currency flexibility seems to have been no impediment to linking Canada’s and America’s real economies.
All of these examples should have been known to the founders of the euro by the 1990s, yet they moved ahead regardless.
The biggest convergence in Europe had nothing to do with the single currency
Having gotten that out of the way, let’s focus on the genuine success story of European integration: the quartet of the Czech Republic, Hungary, Poland, and Slovakia. (The absorption of East Germany into the Federal Republic is also a relatively happy tale but it’s so different from how monetary union was advertised that it isn’t worth further discussion here.)
In the early 1990s they emerged from the iron curtain far poorer than western Europeans. In 1995, GDP per person in the Czech Republic — the richest of the bunch both then and now — was only about 18 per cent of Germany’s, while Greece’s average annual income was about 41 per cent of the German level. By 2014, the latest full year for which eurostat provides data, Czech GDP per person had soared to 42 per cent of the German level. Greece was at 46 per cent.
You might say that’s not a fair comparison — Greek GDP has plunged by a quarter since its peak in 2008, and things probably wouldn’t have been so bad if euro area politicians and the ECB had made better decisions.
(An unconvincing counterpoint we’ve heard is that Greek growth up until 2008 was unsustainable and everything since then is simply the economy returning to its older trend. The financing arrangements were obviously unsustainable, but the absence of rapid inflation during the boom combined with the catastrophic magnitude of job losses since 2008 suggests Greece’s problem wasn’t domestic spending in excess of underlying productivity.)
Look then at Portugal, which never had Greece’s big boom, and check the whole time series rather than just the beginning and end. In 1995, GDP per person in Europe’s westernmost country was 37 per cent of Germany’s. Convergence — driven in part by slow growth in Germany following the tech bust — pushed up Portugal’s average income to 54 per cent of the German level by 2005, and it stayed there until 2010 before steadily sinking.
For comparison, Czech output per person, relative to Germany’s, has been relatively stable since 2007, and grew far more rapidly in the period leading up to the crisis:
In absolute terms, the improvement in living standards among the four central European countries has been truly impressive:
These successes were exactly what the architects of the euro area hoped would happen to poorer members after joining the single currency. The founders dreamed of building a unified European economy with transnational supply chains centred around the core of Germany, Austria, and the Benelux countries. Technology transfers, foreign management, and new investment in plants and equipment would foster convergence across the bloc.
(Read “ One Market, One Money” or the Delors report on “ Economic and Monetary Union in the European Community” for more context.)
And in fact, a recent study by the International Monetary Fund demonstrates how the central Europeans prospered because of their rapid integration into the core of the euro area. Bilateral trade between the central European countries and Germany soared from 1995-2012:
The only other countries with a comparable level of economic integration with Germany are Austria and the Netherlands, and even they are less connected to the greater German supply chain than Hungary and the Czech Republic. The central Europeans are the only ones to experience a meaningful increase in the German content of their exports, which also suggests they were the ones to experience the greatest integration into the greater Germanic supply chain:
The eastward expansion of the German auto industry played a big role in all this. The number of cars made in Germany itself has been flat at around 5.5 million each year since 1992, but thanks to massive direct investment from abroad into their automotive sectors, the four central European countries have gone from making a little more than 1 million cars on behalf of German companies in the mid-2000s to about 3 million by 2012:
The auto sector contributed to more than half of the total growth in exports since 1995 in the Czech Republic, Poland, and Slovakia, and to a third of the growth in exports in Hungary. Cars and trucks account for a comparable share of total exports in the Czech Republic and Germany (17 per cent), while Slovakia’s auto sector is even larger, at about 22 per cent of exports. The IMF thinks the tight integration of these countries into the greater German economy led to productivity gains significantly beyond what would have happened otherwise. Delors’s dream came true.
And yet!
With the exception of Slovakia, which officially joined the single currency in 2009, these central European countries have floating currencies and independent monetary policies. This has led to some big swings in their exchange rates against the euro:
The Polish zloty depreciated by more than 27 per cent between the start of 2002 and the beginning of 2004, subsequently appreciated by more than 50 per cent from then until the peak in summer, 2008, and then fell again by more than 30 per cent during the crisis. (Going further back in time, it depreciated about 50 per cent against the deutschmark from 1993 through 1998.) This is a volatile exchange rate.
The Czech and Slovak koruna both appreciated more than 50 per cent against the euro since early 1999, although there were also periods when the Czech koruna fell against the single currency by more than 10 per cent at a time. In 2013 the Czech National Bank explicitly devalued the koruna and pledged to fight its appreciation against the euro in an attempt to boost inflation and growth. The changes in the ratio of Czech GDP per person to German GDP per person shown further up closely track these currency moves since 2007.
The Hungarian forint hasn’t had the same kind of secular move as the koruna nor quite as much volatility as the zloty, but it’s still had some big moves. From mid-2005 to mid-2006 it fell about 14 per cent against the euro, only to appreciate by 21 per cent over the next two years. Then it fell 22 per cent during the crisis, rebounded partly, plunged another 16 per cent towards the end of 2011, only to (partly) rebound again.
Clearly, floating currencies weren’t an impediment to integration within the European Union.
But what’s really striking is the way common nominal interest rates (before the crisis) and a common currency failed to promote genuine economic integration within the euro area.
Economists estimate the creation of the single currency boosted trade among members by, at most, 10 per cent, although these estimates don’t account for the trend of rising trade among rich countries throughout the 1980s and 1990s. Factor that in, and the euro failed to boost trade at all.
On the financial side, the monetary union certainly led to a boom in cross-border bank lending and portfolio investment, but it’s not clear this produced any real economic benefits. Hyun Song Shin has even argued, not implausibly, that the euro’s creation and the ensuing “banking glut” was the underlying cause of America’s subprime housing excesses and subsequent crisis. It’s reasonable to suspect the central Europeans were partly shielded from the excesses experienced in Spain, Ireland, and the Baltics because they maintained monetary sovereignty.
Moreover, sharing nominal interest rates and a currency with Germany did nothing for direct investment. After comparing cross-border financial flows among the central Europeans against the quartet of Spain, Italy, Portugal, and Greece, the IMF concluded “while FDI was the predominant inflow into the CE4, portfolio and other (bank) flows were the main types of external financing for the SP [selected peripheral countries]“.
Direct investment had basically peaked in the poorer euro area countries by the time they officially joined the monetary union, even though the stock of FDI in both groups of countries, relative to GDP, was the same in the mid-1990s:
There were also differences among the types of FDI flowing to each group of countries. Mergers and acquisitions were more common among the euro area countries while the central Europeans tended to receive greenfield investment in new productive capacity.
While bank lending is important in both central Europe and the euro area’s poorer countries, the character of these loans was different. In central Europe, thanks in part to their floating currencies, the lending occurred through local subsidiaries, while loans to other countries in the euro area were often made by banks based elsewhere. This also fits with the gradual growth of bank claims on the central Europeans, in contrast to the massive upward spike in the euro area’s periphery starting in 1999 with the creation of the single currency.
(Not coincidentally, Hungary, which did the best job of stabilising its exchange rate against the euro in the years before the crisis, was also the one central European country to experience large inflows of bank lending from outside its borders.)
The IMF concludes:
There is evidence to suggest that financial integration between the CE4 and Germany evolved in a more durable manner owing to the relative predominance of FDI which was most likely associated with the GCESC. In contrast to the SP, both global and German FDI exposures were larger in the CE4. FDI seems to have been directed to the manufacturing—and in particular, motor vehicles and other transport equipment—sectors, and a substantial amount of this FDI comprised greenfield investments. However, the SP attracted a greater share of portfolio and cross-border banking flows, which—with the benefit of hindsight— exacerbated overheating pressures. In general, while FDI flows promoted durable growth in the CE4, non-FDI flows added to macroeconomic and financial imbalances across the SP.
In retrospect, it’s clear the euro simply shifted risk from exchange rate fluctuations to defaults (for foreign creditors) and nominal income (for domestic workers and businesses). This wasn’t sufficiently obvious at the time, however, or we wouldn’t have seen such massive growth in cross-border banking and portfolio flows within the currency bloc before 2008.
Contrary to what the euro’s founders believed, it now appears the absence of monetary union is what’s needed to channel capital flows most productively across borders. That’s the real tragedy of the single currency: it was pointless from the start.
Related link:
Intra-euro area trade linkages and external adjustment — ECB monthly bulletin, January 2013 |
