United States to benefit from economic uncertainty in Eurozone

Monday, July 6, 2015

Demystifying the present travails of the Eurozone

By Farrokh Langdana, Director, Executive MBA Program & Professor of Finance and Economics

Faculty Blog: business.rutgers.edu/langdanamacro

Here is a primer that may help demystify the present travails of the Eurozone. I have gone to the very fundamental “bedrock” causes of the present agony of the Southern European economies. We are sticking with very basic macro-issues here, and not getting distracted with who said what to whom, and who promised how much to which institution.

The current problems in the Eurozone do not have that much to do with Greece, per se, but instead, they have their genesis in the original design of the Eurozone - the impossibility of “marrying” two fundamentally different macro-models to one set of fiscal and monetary constraints. The Southern European economies are all Keynesian, while the French, Germans, and the Benelux (Belgium, Netherlands and Luxembourg) economies, are supply-sider.  This is worse than oil and water; the two models simply cannot mix.

Why is that so?

Keynesian economies can indeed stimulate output and can create jobs by actually increasing government spending on infrastructure, etc., and (if confidence has not crashed) by increasing monetary growth and weakening their currencies (and thereby spurring exports in the short run).  In other words, when these economies find themselves in a pickle, they can create infrastructure projects to jump-start growth and jobs, and also devalue their currencies to increase exports.  (From your macro days in class, Keynesian economies have a positively sloped aggregate supply curve.)

Supply-sider economies, in sharp contrast, would vociferously disagree with these policies; in their world, government spending does nothing to create growth and jobs, and increasing money growth to weaken (devalue) one’s currency only results in inflation in the long run.  In short, supply-siders strongly believe that increasing government spending or loosening money growth is one vast and obscene exercise in futility.  (Their model has a vertical aggregate supply curve.)

So how does this tie-in with the mess in the Eurozone today?

The Eurozone has been designed by supply-side Germany, with France essentially providing moral support.  Its monetary policy is conducted by the European Central Bank (ECB) in Frankfurt that, until lately, strongly disapproved of attempts to loosen money supply and weaken the euro, thanks to the searing memory of the ravages of the German Hyperinflation of 1919-23.  In the Eurozone, the 19 member countries have no ability to influence their individual money supplies.  It would be as if the internal temperature for your house was decided in, say, the New Jersey State capital in Trenton. If you wanted to adjust your air conditioning to make your house cooler, you would not be able to do so---only Trenton could do that!  And if Trenton decides that the temperature is fine, then it will not change it.  This is the famous “one size fits all” monetary policy that, ultimately did not “fit all”. 

In addition, the Eurozone has the Stability Pact with prevents individual countries from increasing government spending by imposing upper limits on allowable budget deficits.  So Keynesian Italy, Greece, Portugal, and Spain were powerless upon joining the Eurozone; they could not press their Keynesians buttons to revive their economies.

But what makes one country “Keynesian” and another “Supply sider”?

Very simply, if the percentage increase in inflation is rapidly matched by an equal increase in wages, then the economy has a vertical aggregate supply curve, or is a supply-sider economy.  So, if inflation is 3% and wages are quickly pushed up to 3% by typically high-skilled workers who have market power, then we are in a supply-side model.  In a Keynesian world, if inflation is, say, 5%, wages may go up only 2 or 3 %, for example. Emerging economies are typically Keynesian economies.

So we have the Southern Europeans unable to do what they should be doing to provide some macroeconomic relief, thanks to the straightjacket of the Eurozone!  But why would they agree to be in the Eurozone in the first place?  If we can see the futility of the “one size fits all” monetary policy, and the restrictions of the Stability Pact in just a few paragraphs here, how on earth could this thing have reached this sorry state?

It is very important to keep in mind three points here.  (i)  The Eurozone was never ever designed to be a macroeconomic tour de force; it was never meant to be a macro masterpiece. The fundamental original driving force for economic unification in Europe was that France and Germany should never go to war ever again.  To this end, it all began with coal and steel unification between France and Germany after WWII. The economic union (the EU) and then the monetary union with the common currency and common monetary policy (the Eurozone) were add-ons that came much later.

(ii)  It is very important to understand that when the Eurozone was formulated in 1979, the political landscape of Europe was very different. Germany was just a manageable West Germany then. The Soviet Union’s brooding presence served to bind the member countries together for mutual protection.  But after the Eurozone was up and running, both the above equations changed!  Germany became a giant again, and the Soviet Union’s dissolution removed much of the pressure on Europe to stick together.

(iii)  Finally, labor was supposed to be mobile within the Eurozone---much like within the United States.  That never happened.  Unemployed workers from say, Greece, would not and could not move to another country that might have plentiful jobs. The restrictions on labor mobility within the Eurozone, particularly regarding medium- and low-skilled labor, coupled with the inherent and historical cultural and linguistic challenges, prohibits movement.

But then, if their lives were clearly going to get worse, why did the Southern Europeans join the Eurozone in the first place?

Initially, their lives got better.  Most of the Southern European countries are “receiver” countries. Upon being admitted to the Eurozone, they benefitted from large grants and financial and trade assistance from the other Eurozone countries.  It was a big privilege to be part of the Euro ‘club’; it was an exclusive club and membership required demonstrable fiscal and monetary disciple. Many of the Southern European economies may have adopted creative accounting techniques to show fiscal/monetary discipline (the Maastricht convergence criteria) in order to be admitted into the Eurozone.  And the rest of the Eurozone turned a blind eye to these accounting sleights of hand.  At that time, there was an obsession to have a Eurozone that was “bigger” than the US in population, GDP, etc., and Eurozone membership was dispensed quite freely.  It was only later, when their economies slowed and when they realized that the macro policies that had pulled them out of recession in the past were no longer available to them, that things took their tragic turn for the Southern Europeans.

So what are the implications for the US?

The European Central Bank, historically well known for its strong monetary discipline, is run today by a Keynesian Italian, Mario Draghi. This is tantamount to a Buddhist monk being head chef at a Texas steak house; it just will not work. The new ECB today has scandalized the German financial establishment by increasing money growth to create jobs and growth; in short, by behaving like a Keynesian institution. The ECB is now attempting its version of quantitative easing (QE), which is nothing but massive monetary growth.  This will not work, just as it has not worked here or in Japan.  As long as business confidence is low, printing money will do nothing.  This is the dreaded “Liquidity Trap” situation that we and the Japanese have just lived through.

Be prepared for much of the European and Asian liquidity to find its way into the US stock and housing markets. Be prepared to see the Europeans, Asians, and Brazilians snapping up houses here, and pumping up US equities.  Expect to see a constant downward pressure on our interest rates--Janet Yellen’s warnings of rate hikes notwithstanding--thanks to the flood of hot capital that will be parked here, the last real "Safe Haven" in this troubled world.  Expect the best minds of the traumatized countries to leave their homes and families and seek fertile ground here, in the United States.  In all this global turmoil, paradoxically, the stage is set for the United States to, once again, wrest global macroeconomic and political pre-eminence. 

TAGS: Business Insights Euro European Union Executive MBA Farrokh Langdana Macroeconomics MBA