by Sara Eisen
Between 1914 and 1946, gold was accepted as the measure by which currency relationships between countries would be managed, but so many crises intervened that individual countries suffered inflation, deflation, overheated growth, or depression depending on their relationship to gold—were they tied to it or not? Although moving into and out of a tight relation with gold allowed countries to manipulate their economies, the gold standard could not overcome other social and economic problems that prevented it from fostering the development of a stable global economy. Many people believe that gold was much more successful in the 44 years prior to World War I. At that time, the gold exchange standard coexisted with strong global trade growth and the aggressive European and North American expansion of manufacturing. Four systems in 142 years! The one thing we can say is that we have no stable system and the future is uncertain.
Europe’s unsettled position influences two interrelated currency dilemmas that are troubling our current floating-rate system at this time. The turmoil within Europe will shift the balance of global power away from that continent for the next few decades, but by itself it should not cause undue disruption in the floating-rate system of the past 39 years. However, it should dramatically alter the relative values among currencies and could affect the choice of the reserve currency or the reserve system itself.
The political hubris that led to the construction of a unified currency, a system far more constricting than the gold exchange system, must lead either to the creation of a unified European state, a process that is likely to span many decades, or to the destruction of the European Union and the renewed fragmentation of Europe. This feeds the second dilemma, one that we have seen before: as global reserve structures are inherently unstable, what happens as Europe’s collapse hastens the West’s loss of its dominant status?
The currency hegemon, England in the late nineteenth and early twentieth centuries, and the United States since 1946, seems to become increasingly enfeebled as a result of its reserve status. Because the monetary stance of the dominant reserve country defines the tightness or looseness of money throughout the world, money, once created, runs from its domestic banking system to the most profitable investment arenas around the world. Throughout the twentieth century, this drew money away from the reserve country, but now, since the start of the twenty-first century, this move has become an exaggerated sucking process, as the hegemon is forced to run a too-loose policy no matter what its own internal system might demand, since the world economy depends on the dollars it prints.
For decades on end, the United States has been the source of global liquidity just to keep its own economy moving along. As a consequence of the resulting tendency toward dollar weakness, over the past few decades, the global reserve responsibility has been expanding to other currencies, most recently the euro, which has become the secondary reserve currency (see Figure 4-1). The perceived advantage of seignorage, or the power to borrow unlimited amounts in your own currency, ultimately becomes the curse that destroys the monetary hegemon. Eventually this must lead to a new order, the fifth in the last century and a half. This latest shift has been proceeding in a benign manner, as the role of the reserve currency seems to be evolving to a shared one, but the uncertainty surrounding the euro could threaten this gradual shift toward duality.
Figure 4-1 Global Reserve Currencies
When the euro was being established during the 1990s, many economists warned the political leaders and other elites within the European Union that the project to establish a single currency could not work unless the economic and social structures underlying the new currency were far more unified than the political situation would allow. Convergence did not have to be absolute, but it needed to be reinforced by the social, economic, and legal systems supporting the still politically independent members of the new eurozone. That advice was ignored. The project went ahead, with only the commitment of the political leadership as its cohesive glue, plus the naïve hopes of the as-always economically unsophisticated populace.
It was, and still is, argued that the political will of the countries involved is so strong that all problems will be overcome. This smacks of hubris, as political power depends, at a minimum, on the acquiescence of the populace, if not its support; and without widespread economic well-being, this is not likely to be forthcoming, especially as the years of penury drag on. As politics is the art of the possible, political analysts cannot ignore that what is possible in any country derives from the social and economic realities of the society involved. What politicians can do and expect from their populace in Germany is far from what is politically possible in Greece or Italy.
A quick reading of The Moral Basis of a Backward Society, written in 1958 by Edward Banfield, with a major assist from his southern Italian wife, Laura, analyzing the impact of culture and social structure on economic and political development, should send chills down the spine of anyone hoping for a successful euro. Banfield notes that the comfortable assumption is often made that if the structure and incentives in the system are good, then the capital and the organizing skill will spring up and grow, allowing the society to advance. “This assumption overlooks the crucial importance of culture, [as] people live and think in different ways and some of these ways are radically inconsistent with the requirements of formal organization” (p. 8).
The Hobbesian reality of much of life in southern and Eastern Europe, which has been well known and documented by modern sociologists, should have been enough to convince any northern European political leader of the folly of expanding the eurozone to countries lacking a modern political society. Greece, Portugal, Cyprus, and Malta come immediately to mind as countries in which significant parts, if not the majority, of the society largely fit Banfield’s definition of amoral familism, “unable to act together for the common good or indeed any end transcending the immediate material interest of the nuclear family” (p. 9).
Morality and public spiritedness are critical if taxes are to be paid and corruption is to be minimized, and when these qualities are lacking, no matter how draconian the externally imposed northern European regulations might be, they will be avoided and ignored in every instance. Countries with these cultural deficiencies will not succeed as part of the eurozone unless Brussels and the more civic-minded countries continue to pump money into them, just as Rome has pumped billions of euros into southern Italy through La Cassa per il Mezzogiorno for the past 50 years, with almost no results. (La Cassa per il Mezzogiorno was the Italian government’s effort to build up southern Italy’s economy but was thwarted by poor oversight and misguided investment.) Spain and Italy would seem to hug the borderline, with sections of the countries being more socially advanced and tending to enlightened self-interest or even public-spiritedness. We can hope that they are on the northern side of the divide, as the euro cannot survive without these two countries. It really doesn’t matter how powerful the political will of the European leaders might be; what matters are the people. For generals to lead, their armies must follow them—not act for their own selfish, amoral interests.
The cultural and sociological issues are not the only ones that make the survival of the euro a long shot. Hard-nosed economic reality does too. The Nobel Prize juries are not always right, but they are a pretty good judge, and they actually voted against the euro way back in 1969 when they gave the first Nobel Prize in Economics to Jan Tinbergen of the Netherlands. In extremely simplified laymen’s language, Tinbergen theorized and proved—in a social scientific way—that the financial managers of any government must have an equal or greater number of policy variables to adjust in order to manage the three economic outcomes that are important to a country’s financial and economic success: employment, inflation, and current account balance.
Countries normally have four policy tools that they can manipulate as they manage the economy: the money supply, interest rates, fiscal balance, and currency level (or value). According to Tinbergen, four independent variables, correctly managed
, should lead to continuing successful economic outcomes, and even three independent variables would be just enough. Unfortunately, the Maastricht Treaty, forged in the country of Tinbergen’s birth, allows the eurozone countries only one independent variable (the fiscal balance), not four, and even fiscal maneuverability was constrained. Money supply, interest rates, and currency value are all established centrally, one-size-fits-all, under the control of the European Central Bank.
To keep their economies on track, national governments were almost immediately forced to break the Maastricht constraints—Germany was one of the first! Is it any wonder that in the past 12 years, European fiscal balances have been all over the place? Playing with the fiscal stance by changing the effective tax take and moving government spending has been the only way in which the financial authorities can manage their economies, but in the future, by following Merkel’s tighter fiscal band, the individual governments will be almost powerless to manage them. Odds are that the situation will deteriorate further, not improve. While the total eurozone economy will theoretically be manageable, following Tinbergen’s reasoning, as the whole is the one size that all must fit, each individual country will move erratically away from the average or convergence. By logically applying Tinbergen once again, it can even be argued that, over time, this situation will drive countries further and further from convergence, and recent empirical data already exhibit that tendency.
As convergence is an imperative for a functioning currency union, failing to reach it will eventually doom the euro. The only way to solve this lack of convergence, most likely manifested by a growing division between the richer and poorer countries, in a picture very similar to the disparity among cultures, is the continual transfer of financial support from the wealthier countries to the needier ones within the eurozone. Although almost all eurozone politicians seem to wish it were not so, history has shown this to be the answer. The United States is an example of a transfer system, but, of course, so is any stable country, like Germany, France, or Italy. The richer parts support the poorer parts—they don’t lend them money, they give it to them, as the money is never paid back. All of this is done through the tax system and various nationwide transfer programs, and it is hardly ever the subject of debate. In the next few years, Europe must either develop similar structures or take a giant step backward, retreating to a loose association of individual countries, each with its own currency.
At the same time that Europe is struggling with this great leap forward, two long-developing but slow-moving problems are approaching a possibly cataclysmic conclusion at some point within the next 10 to 20 years. Europe’s debt is overwhelming it, and the continent’s population is declining. The social welfare system, originated more than a century ago by Otto von Bismarck as part of his grand plan to keep the Socialist/Communist threat at bay and eventually adopted throughout Europe, is slowly bankrupting the major economies. As population growth slowly grinds to a halt during the next 40 years, the cost of the now-generous social programs will become overwhelming in relation to the size of the economy and the number of workers within it.
Neither of these problems can be solved with the flick of a switch. Not only have these payments become the centerpiece of the social compact between the governments and the voters, but these rights and offsetting responsibilities underlie the class structure and the fabric of national identity. Any changes in this compact, one that has survived and expanded throughout the last century despite global wars, deflation, and inflation, will be traumatic to individuals and extremely disruptive to the social peace. Despite the negative impact, however, these changes must occur, as these programs as currently structured cannot be financed because the working-age population will continue to decline as a percentage of the total population.
In the last year or so, it has become increasingly clear that parts of the European economy either have reached or are approaching the Ponzi stage of the long-term debt cycle as described by Hyman Minsky in The Financial Instability Hypothesis (1992). Currently, in some parts of Europe, many interest payments on bank and government debt cannot be made out of available funds and need to be financed with further borrowings. According to Minsky’s hypothesis, economies move from stability toward instability over time. In stable economies, all borrowings, both the original capital and interest payments on it, can be repaid out of cash flow, corporate earnings, or government tax receipts. As the Minsky cycle moves toward a higher level of instability, only the interest can be paid; the capital cannot be and needs to be rolled over. In the worst stage, not even the interest on the loans can be repaid out of cash flow; it has to be borrowed, adding to the size of the outstanding loan. At that point, the Ponzi stage of the cycle, the system is extremely unstable, and some external event will eventually intervene, causing a chain of defaults and a collapse of the whole system.
Although not all banks and governments in Europe have reached this last stage, enough have done so to put the eurozone at risk of a string of defaults. What compounds the current problems beyond Minsky’s simple example are the recent efforts to shore up the eurozone by adding more debt and more guarantees by higher financial authorities within a system that has no central authority and minimal political legitimacy. Beginning in 2008, when individual banks ran into credit problems, they were forced to turn to their local central banks, which supplied liquidity, committing their credit to these weak banks. Although the situation improved slightly for a while, in the weaker countries, the local central banks soon needed support from the European Central Bank (ECB) to shore up their national credit, as their national risk overwhelmed their countries’ perceived taxing authority. These countries were threatening to go the way of Iceland (a non-eurozone country) in 2008, when the world financial crisis sparked a banking and economic meltdown leading to an IMF emergency bailout, as their governments could not support their own banking systems. By late 2011, the ECB was forced to step in throughout the entire eurozone, offering cheap and secure three-year credit to all the banks, against collateral. That collateral was often the very loans that would be used to refinance the Ponzi-like interest payments that could not be funded any other way.
This daisy chain of credit not only has involved the national governments in supporting private debt, but has also roped in the supranational ECB, which is now stuffed full of sovereign debt totaling more than 30 percent of the eurozone GDP. Individual countries, especially Germany, are also on the hook. The risk is not only very large but also highly centralized. Any significant default now puts the whole structure at risk.
This perilous financial situation depends on economies that have a declining workforce, a declining tax base, and low growth expectations. The shrinkage in the working-age population will continue to decrease the tax base of the European governments and, if services are to be maintained, will result in an increase in the tax burden on individual payers. According to a recent study by the UN, Europe has just turned the corner, beginning an annual shrinkage of the working-age population; it is currently decreasing at a rate of roughly -0.3 percent per annum, which will expand to about -0.8 percent per annum by 2040, for a total decline of slightly less than 20 percent over the next 40 years. Consider that the working-age population has grown by roughly 35 percent over the last 50 years and the magnitude of the shock is obvious (see Figure 4-2).
Figure 4-2 Annual Growth of Working-Age Population in Western Europe
With old age dependency ratios climbing from roughly 27 percent currently to about 43 percent over the same time span, the tax burden on the remaining workers will increase dramatically if the present retirement age and current level of benefits are to continue. Because of the longstanding social compact that makes any negative adjustment to the current privileges enjoyed by the citizens an anathema, either tax levels must rise or growth and labor productivity must increase dramatically. Although growth is the strategy that is being championed within the eurozone, the process of reducing administrative hurdles and restric
tive labor practices is proving to be a challenge similar to that of reducing benefits. The widely praised efforts of Mario Monti, the recently installed technocrat prime minister of Italy, have attacked only the most trivial corners of red tape, but have generated a dramatic amount of pushback from taxi drivers, notaries, and pharmacists, among others.
Far more significant than these protected backwaters are the large government corporations that produce more than 50 percent of many basic economic goods within the eurozone. This statist industrial policy, harking back to Lenin’s socialist New Economic Policy, when the government dominated the “commanding heights” of the Soviet economy, was adopted in varying degrees by the leading European states during the Depression and after World War II. Although there have been some privatizations and divestitures, railroads, airlines, electricity, oil production, steel, and many other heavy industries are still dominated or totally controlled by government companies.
The workers in these corporations are coddled and often hold the governments in their power, as Monti’s trials in Italy illustrate. As a result, many of these state-owned organizations operate at a loss and are notoriously unproductive, but for Europe to survive intact, it is crucial that they become more efficient and profitable. A lurch higher in productivity or profitability would lessen the tax burden on the average citizen and greatly ameliorate the financial plight of the European governments. As Table 4-1 makes clear, the government payroll and purchases sometimes total more than 50 percent of the GDP. Among the EU countries, only Luxembourg has government expenditures under 40 percent. Among the OECD countries (Organisation for Economic Co-operation and Development), the Western Europeans have the highest level of government participation in the economy, a heavy burden to carry, as statistics have shown a negative correlation between the size of government participation and GDP growth. The private sector is far more vibrant.