The EU: Every Country For Itself

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What then is to be done? The tentative suggestions of this chapter may appear to the reader inadequate.  But the opportunity was missed at Paris during the six months which followed the Armistice, and nothing we can do now can repair the mischief wrought at that time. Great privation and great risks to society have become unavoidable.  All that is now open to us is to redirect, so far as lies in our power, the fundamental economic tendencies which underlie the events of the hour, so that they promote the re-establishment of prosperity and order, instead of leading us deeper into misfortune.

Chapter VII: Remedies
The Economic Consequences of the Peace
By John Maynard Keynes, 1919

Observe that all wide sight and self-command
Deserts these throngs now driven to demonry
By the Immanent Unrecking. Nought remains
But vindictiveness here amid the strong,
And there amid the weak an impotent rage.

Part The Third
The Dynasts
By Thomas Hardy, 1908

For those students of history, the prophetic words of John Maynard Keynes echo down the halls of history.  Of course, the object of his concern stood foremost in front of the globe at the end of World War I: the terms of the peace.  For the terms of the peace in 1919 would shape the European economy for years to come.  Of course, as Keynes understood, the economic terms of the peace created an unsustainable state of affairs.  Keynes analysis proved prescient as the Treaty of Versailles led to the bankruptcy of Germany and the economic collapse across the rest of Europe, setting the stage for the rise of totalitarianism and, ultimately, World War II.  And while the sustainability of the individual pieces of the treaty could be debated, the aggregate impact could not.

Similarly, one can look at today’s state of affairs in Europe.  This state of affairs stands the direct result of the creation of a common currency in the late 1990s, which redistributed economic growth across the continent.  It aided the strong currency, industrial oriented countries such as Germany and Austria, by weakening the relative value of their currencies.  Thus, it provided a tailwind to their exports and their global manufacturing position.  It harmed the weak currency countries of Southern Europe, such as Italy, Greece, Spain, and Portugal, by strengthening the value of their currencies and raising their labor costs.  Thus, it provided a strong headwind to their economies, making much of their production uncompetitive globally and harming their long term economic growth.

Numerous economists predicted ultimate disaster, as the European countries appeared ill-suited to the type of currency union enjoyed by the United States.  In fact, Milton Friedman famously wrote the following in 1997 (The full article can be read at https://www.project-syndicate.org/commentary/the-euro–monetary-unity-to-political-disunity :

“The drive for the Euro has been motivated by politics not economics.  The aim has been to link Germany and France so closely as to make a future European war impossible, and to set the stage for a federal United States of Europe.  I believe that adoption of the Euro would have the opposite effect.  It would exacerbate political tensions by converting divergent shocks that could have been readily accommodated by exchange rate changes into divisive political issues.  Political unity can pave the way for monetary unity.  Monetary unity imposed under unfavorable conditions will prove a barrier to the achievement of political unity.”

The Euro: Monetary Unity to Political Disunity
By Milton Friedman, August 28, 1997
Project Syndicate

And if one examines the economic results for countries like Spain, Italy, Portugal, and Greece, the data support an unqualified thumbs down on the Euro.  These countries’ economies stand 20% to 40% smaller today than if the Euro did not exist for them.  And given the poor economic results under the Euro, the expected political reaction, with no real economic recovery since 2009 for many of these countries, comes as no surprise.  The voters in countries that got the short end of the stick with the Euro started down the logical path: repudiation of the terms of the current economic deal.

The recent elections in Italy and the current government in Greece, stand as a foretaste of the slow dissolution of the EU. For the UK, their decision to maintain their currency prevented the types of punishment that Germany imposed on Greece.  In fact, the actions of Germany in handling Greece’s bankruptcy probably hastened the UK exit, as it became clear how a German dominated EU would dictate policy to the UK.  The Brexit negotiations confirm this view, as Germany and France attempt to extract the maximum economic price to punish the UK for its ‘brazen’ exit.  (One wonders what Keynes would comment on this.) Fortunately for the UK, they possess their own currency and the ability to ultimately halt the massive transfer of wealth from the UK to the EU without tangible benefits for the UK.  For Italy, the Chinese proverb “May you live in interesting times.” hangs overhead.  Clearly, the EU, as constructed, will provide a continued drag on Italy’s economy.  But the likely new construct appears fuzzy. It stands somewhere in between full exit and the current status, involving an effective “partial” exit that vastly improves Italy’s economic growth.  And this likely stands as a mid-ground setting the stage for full exit from the Euro later, given the only true solution to Italy’s economic growth issues lie in a restoration of its currency, the Lira.  While certain financial institutions believe Germany will use the ECB to threaten Italy with bankruptcy if it attempts to exit or change the terms of the current economic deal, should Germany go down that path, the political reaction to such a move likely would only reinforce the current populist government in Italy, encourage them to recreate the Lira, and hasten the country’s exit from the EU.  Other countries such as Spain and Portugal would be tempted to follow Italy to regain control over their economies and improve the fate of their citizens.

For a model of what this might look like, Italy, Spain, and Portugal need only look a few hundred miles East to see the salutary benefits of access to the EU markets coupled with possessing their own currency. Central Europe retained the zloty, koruna, and forint.  Thus, these countries retained control over their economies.  As a result, they have grown at rapid rates with free access to the Western European markets coupled with significant investment from the EU. For countries like Italy, the short term pain of leaving the Euro pale in comparison to the benefits of regaining control over the economy with the ability to depreciate the currency and restore global competitiveness.  Economic growth could resemble the 1980s and 1990s once more.  For Italy and other Southern European countries, creating a deal similar to the one Sweden possesses, with access to the EU but its own currency the krona, would provide the type of breathing room they need to restore economic growth.  While Germany will fight, using whatever means possible, to preserve the benefits of the current economic arrangement, the cost to other countries’ economies sits at a politically unacceptable level.  The new parties in power stand as a testament to the laws of economics.  These laws can be ignored, but only at great peril as the bill always comes due.  And the longer politicians attempt to forestall the inevitable, by kicking the can down the road, the higher the cost.  For the European Union, the Euro bill has come due. The costs outweigh the benefits for many countries and their citizens.  With their citizens demanding changes and electing politicians who will implement them, time has run out. And the can cannot be kicked anymore.  For countries such as Germany and Austria, it will be a rearguard action with the occasional counterattack as they attempt to slow down the oncoming train.  But, despite their best efforts, that train continues to gain momentum given economic reality. And, as that reality takes center stage, for the European Union, it will be Every Country For Itself.  (Data from public sources coupled with Green Drake Advisors analysis.)

 

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