When fears about the Euro were not always so well developed
Recent developments in Europe have created
fears that Greece will soon exit the Euro. The spectacular way that the Euro has failed has led
some to wonder why the Euro came together in the first place. Interestingly, the concern about a systemic Eurozone crisis
did not really register when the Greek crisis started. Perhaps there were some musing that the crisis could spread, but it seemed that people believed that there would be a rescue package and that the crisis would pass. Size would come to the rescue, and an economy larger than that of the United States, the EU would end the threat of financial contagion.
If only they were right.
We now see massive capital outflows from the periphery and a frighteningly fast flight to quality within the Eurozone. But wasn't size supposed to blunt these impacts? While this narrative of "strength through fragility" seems hopelessly naive now, it's interesting to note that even in May/June of 2010 Foreign Affairs published
an article by Richard Rosecrance extolling the benefits of size and larger currency arrangements in an era of turbulent capital flows. Rereading the essay, many of the key passages remind us how hindsight is 20-20, and that the narrative of the day can often push policy in the wrong direction.
The essay starts with a description of the Asian financial crises that roiled markets in the late 1990's as a justification for larger economic zones and currency areas;
But eventually the
trading-state model ran into unexpected problems. Japanese growth stalled during
the 1990s as U.S. growth and productivity surged. Many trading states were
rocked by the Asian financial crisis of 1997-98, during which international
investors took their money and went home. Because Indonesia, Malaysia,
Thailand, and other relatively small countries did not have enough foreign
capital to withstand the shock, they had to go into receivership. As Alan
Greenspan, then the U.S. Federal Reserve chair, put it in 1999, "East Asia
had no spare tires." Governments there devalued their currencies and
adopted high interest rates to survive, and they did not regain their former
glory afterward.
Russia, meanwhile, fell
afoul of its creditors. And when Moscow could not pay back its loans, Russian
government bonds went down the drain. Russia's problem was that although its
territory was vast, its economy was small. China, India, and even Japan, on the
other hand, had plenty of access to cash and so their economies remained
steady. The U.S. market scarcely rippled.
Small trading states failed
because the assumptions on which they operated did not hold. To succeed, they needed
an open international economy into which they could sell easily and from which
they could borrow easily. But when trouble hit, the large markets of the
developed world were not sufficiently open to absorb the trading states' goods.
The beleaguered victims in 1998 could not redeem their positions by quick sales
abroad, nor could they borrow on easy terms. Rather, they had to kneel at the
altar of international finance and accept dictation from the International
Monetary Fund, which imposed onerous conditions on its help. In the aftermath
of the crisis, the small trading states vowed never to put themselves in a
similar position again, and so they increased their access to foreign exchange
through exports. Lately, they have proposed forming regional trade groups to
get larger economically, by negotiating a preferential tariff zone in which to
sell their goods and perhaps a currency zone in which to borrow cash.
The story of the Eurozone has shown us that increasing lending through large currency zones is a fool's errand.
Private capital flows to the periphery destroyed the PIGS' competitiveness even though they were being quite fiscally conservative. The ability to borrow easily in good times has actually worsened situations, as at the first sign of debt troubles capital can quickly move out of the periphery states, again forcing them to "kneel at the altar of international finance and accept dictation from the International Monetary Fund." Comically, Greece has been forced to accept "onerous conditions" from Germany for their help in the bailouts. While larger currency areas may secure cheaper funding in the short run, long run capital prospects don't improve. In a sense, the larger currency area is a form of manufactured stability. It allows volatility to be restrained in good times, only to become fearsome in times of crisis. It's a blowup strategy, with all of the risk in the far left tail.
Moreover, a common currency area actually prevents a country from pursuing the other solution to sudden financial shocks: higher trade in goods. While the Asian economies faced the problem that "the large markets of the developed world were not sufficiently open to absorb the trading states' goods", Greece is facing the exact opposite problem. Past capital flows have left the economy
severely overvalued and other markets may be willing to buy Greek goods,
if only Greece could devalue its currency! To worsen the problem, fears about Greece's debt situation lowers global equity values, further reducing global demand for Greek goods! A common currency area takes away from the external devaluation adjustment mechanism and therefore only aggravates the problems that small countries face in financial crises.
The fact that there is no adjustment mechanism makes the larger market available to each state less useful. According to Rosencrance:
The 27 states that now
compose the European Union will soon be accompanied by almost ten others,
making Europe stretch from the Atlantic to the Caucasus. Member states have
benefited from participating in an enlarged market extending beyond their
national borders. The absence of tariffs in the EU allows greater cross- border
commercial cooperation, which promotes specialization and efficiency and
provides consumers in the member states with cheaper goods for purchase. Over
time, as economists such as Andrew Rose and Jeffrey Frankel have shown, such
trade zones increase their members' trade volume and GDP growth. There are also
administrative advantages: southern and eastern European states with less
advanced economies have found help and tutelage from veteran EU members and
have not been allowed to fail (even if their fiscal policies have been reined
in).
But when Germany is running a massive current account surplus vis-a-vis virtually every other member of the Eurozone, the cross-border commercial cooperation is a joke. The cheaper German goods for purpose are only that way because of past capital flows that rendered periphery states uncompetitive. Given the horrendous costs of internal devaluation and the low likelihood that it would restore problems with
capital structure, any possible microeconomic efficiency from trade is being swamped by disastrous levels of youth unemployment and civil unrest. When there's no transfer union, these asymmetric effects of trade flows on the different countries become incredibly important. We can no longer say "Europe is benefiting", we instead see the periphery on the verge of a full-fledged financial contagion.
It is also interesting to note that Rosencrance also makes an institutional argument here. Through the interaction of the "responsible" core states with the "irresponsible" periphery states, the periphery states will be brought up to the core states' level of institutional maturity. However, large capital flows promoted by a common currency rendered these kinds of supply side reforms unnecessary, and this institutional shift never happened. And as the Eurozone drama is unfolding, it is quite possible that some periphery states will be allowed to fail as the "help and tutelage from veteran EU members" abandons them.
In addition to these new harsh economic realities, the political realities of the situation don't seem to match up with Rosencrance's arguments either. According to the essay:
The peaceful expansion of
trade blocs today, moreover, is likely to bring outsiders in rather than keep
them out. It has done so in Europe and to some degree in North America and Asia
as well. Self-sufficient trade blocs are impossible and will not be sought
after. The key to a successful trade group, in fact, is that as it grows, it
attracts sellers from the outside.
What would China, India, and
Japan do if the United States and the EU formed a trade partnership? They would
not find an Asian pact a satisfactory rejoinder to the transatlantic
combination. Since the major markets of the world are located in Europe and
North America, Asian exporting nations would have to continue to sell to them.
And if Japan eventually joined the partnership, the stakes for China and India
would rise. China and India might not be significantly challenged if they could
substitute domestic sales for exports. But even they, as big as they are, could
not do so entirely. However important Chinese consumption becomes, it will not be
able to sop up all the goods that China currently exports to technologically
advanced and luxury markets in Europe, the United States, and Japan. To avoid
falling behind, Beijing and New Delhi would need a continuing association with
markets elsewhere.
What all this means is that
the patterns of global politics and economics that have prevailed for the last
half millennium are increasingly outmoded. During that period, eight out of the
11 instances of a new great power's rise led to a "hegemonic war."
With a potential Chinese challenge looming in the 2020s, the odds would seem
stacked in favor of conflict once again, and in other eras it would have made
sense to bet on it.
Yet military conflict is not
likely to occur this time around, because even if political power sometimes
repels, today economic power attracts. The United States does not need to fight
rising challengers such as China or India or even to balance one off against
another. It can use its own market capacity, combined with that of Europe, to
draw surging protocapitalist states into its web.
During the Cold War, the
economic force of the West eventually surpassed and subverted even the heavy industrial
growth of the Soviet economy. In the 1980s, the attractions of North Atlantic,
Japanese, and even South Korean capitalism were a critical factor in Soviet
leader Mikhail Gorbachev's decision to renew his country's economic and
political system -- and end the Cold War. They also helped stimulate Deng
Xiaoping's reforms in China after 1978.
Now that the formula for
capitalist economic success has become widely understood and been replicated, Western
economic magnetism will stem not just from the triumphs of individual economies
but from their development as an increasingly integrated group. The expansion
and agglomeration of economies in Europe -- and perhaps also across the
Atlantic -- will serve as a beacon for isolated successes such as those in
Asia.
The argument here seems to be that larger scale economic integration would be a virtuous cycle and therefore serve to moderate international conflict. As a result of integration in certain regions, other states will be forced to integrate with them, creating a unified global trade and financial regime. However, if large economic regime are important to this process, doesn't this just heighten the fragility embedded in the international system? This is especially vivid for the Euro now as, if anything, the collapse of the Eurozone would severely discredit the argument that open, integrated, western economies are the correct way forward. The failure of agglomeration would serve as a deterrent to the "isolated successes such as those in Asia."
A look back on such essays about the Euro serves as a reminder on how limited our capacity for prediction really is, and how the common narrative at any given time can hide the fragilities that persist in complex systems. The reasons behind large scale political developments such as the EMU are often opaque and create economic regimes whose faults are only revealed to us later. It is for this reason that our awareness of fundamental fragilities within economies is incredibly important. We do not know what we are truly doing, so we must strive towards a system that is robust to our errors.
