Greasing the European Union

When you grease your car it reduces friction and makes it run better. Many machines need grease. The question these days seems to be whether or not the EU needs grease. And by that we mean Greece!

I don’t usually like to implicate others in my madness but I should thank my colleague Michele Fratianni for years of discussion about the EU.

We start with the idea that the EU is like a machine. It can work well or it can work poorly. To understand what contributes to EU performance one needs to know more about it. Wikipedia says the EU is “a politico-economic union of 28 member states that are located primarily in Europe.” That little group of words is correct but it is also subject to a wide degree of interpretation. One of the key points is that the EU is a union with most of the political clout residing in the individual countries. While a central EU institution (like the EU Parliament) might decide to impose a law or regulation on its members – that law or regulation would have to go through 28 national governments separately to become EU law. If the USA were such a union, Obamacare would have had to pass in the 50 legislatures and be signed by 50 Governors. If one country failed to pass it then it would not have become USA law.

So the first point is that the EU is not a highly centralized form of government. It has central bodies but the main clout remains in the 28 countries that comprise the member states. For more information about the EU see http://europa.eu/about-eu/institutions-bodies/index_en.htm

Much of what has transpired under the rubric of the EU has been a movement toward a single market space for its members. The underlying belief is that freer trade among the 28 countries would make them all better global competitors. Notice that 28 countries believe this – or they never would have joined the EU and they never would have passed hundreds of rules and regulations in their national governments. These hundreds of new rules and regulations essentially make it easier and less costly for a business to operate in Europe. They eliminated numerous barriers to trade among the 28 countries.

While the EU has been growing since the end of World War II, one of those barriers was not fully removed until 1999. If you are going to make the EU a single market then it hardly makes sense to have marks and liras and lats. Wow – what a mess trying to do business with all those piles of currencies!

The euro was thought to be an important part of reducing trade barriers. And so far – 19 of the 28 countries have joined in a European Monetary System with its own Central Bank that emits euros in much the same way as the US Fed emits dollars. And therefore, the ECB has become a very strong centralizing policy institution. While its rules were adopted by representatives of the EU nations – monetary changes do not have to go through each of the governments. Thus the ECB is truly a supra-national body.

I don’t want to get hung on that last point. My main point here is that the EU is here to help! It is a voluntary organization solidified by formal treaties meant to improve economic outcomes for every country from tiny Latvia to super power Germany.

If I can now direct my remarks to the 19 countries in the EMU – one specific thing to note is that these countries willingly gave up their own currencies. That means also that they gave up a policy tool. These countries can no longer adjust the values of their own currencies. They can try to influence the ECB to change the value of the euro – but there are no longer any dracmas to depreciate. When countries encounter into slow growth, they will sometimes depreciate their currency as a means to make their goods look more competitive in the global marketplace. These 19 countries, including Greece, no longer have that tool available.

Thus there are many tears being shed for Greece these days. But let’s face it—this is a bit silly. Depreciating ones currency might be something to use for small day to day adjustments but it doesn’t make reality go away. Competitiveness is basic. A kid wins the state track meet in the 100 meter dash because she worked harder and smarter for years. Maybe a competitor had another teaspoon of sugar the day of the meet, but it is fundamentals that determine the winners year in and year out. The exchange rate is like the sugar. It is not the solution.

Worse yet, currency depreciation is self-defeating. A continuous depreciation may help the trade balance and growth for a while, but the depreciation of the currency means that imports are priced higher and cost more. To the extent that depreciating countries import materials and capital goods, they because less productive. Worse is when speculators see a declining currency value in a country without any solutions – and they flood the markets with even more of the sad currency. This makes the depreciation even worse and causes panic

Greece is in trouble because it tricked the EU. It pretended to want to be a good member. Everyone knew that Greece and several other countries were not as solid as others when they joined. But the implicit bargain was that they would give up the dracma and try to be more competitive – more like the other countries. Well they didn’t. They acted more like Zorba the Greek than Ms Merkel.

I looked at some numbers. I compared European countries competitiveness before and after 1999 when the European Monetary Union began. If European countries losing their own currencies attempted to sharpen their competitiveness after 1999, then we should have seen improvements in their trade balances. And we do see some improvements between 1999 and 2007 (before the world financial crisis muddied the water). Trade improvements came for Germany, Austria, and the Netherlands.

Unfortunately, despite small initial improvements these next countries had vast deterioration in their balances of trade with the world – Greece, Ireland, Italy, and Spain. For example, the balance in current of account for Spain before 1999 was a deficit of less than 1% of GDP. By 2007 this deficit was about 10% of GDP. The story is the same for the other countries mentioned. In the case of Greece, the current account deficit was almost 14% of GDP in 2007.

Don’t cry for Greece. Greece accepted a gamble – a gamble that could have paid off handsomely. But they conned the game. They now need to decide what they want. They can have their dracma back and hope its depreciation solves their competitiveness problems. Or they can get down to the serious business of governing a country within the EU. Either way I think the EU will be fine.