Shortly before the year 2000, famed economist Milton Friedman predicted that the euro member countries would succumb to systematic flaws and fail within ten years. [Editor's Note: Friedman's original remarks were made in Q&A Session that followed a keynote address to the Bank of Canada.]
He might not have been too far off. To paraphrase Friedman:
A “one size fits all” monetary policy doesn’t give the member countries the flexibility needed to stimulate their economies.
A fractured fiscal policy forced to adhere to rigid EU rules doesn’t enable member governments to navigate their country-specific problems, such as deficit spending and public works projects.
Nationalism will emerge. Healthier countries will not see fit to spend their hard earned money to bail out their less responsible neighbors.
A common currency can act as handcuffs in perilous times. Exchange rates can be used as a tool to revalue debt and improve competitiveness of one’s economy.
I want to focus on these four bullets.
Bullet No. 1
What did Friedman mean when he called the eurozone monetary policy “one size fits all?” Put simply, the member countries in the EMU can’t cool down their economy, nor stimulate it as needed, when they have no direct power over monetary policy.
This is a key fundamental problem for European Monetary Union members. The fact is, their economies may be, and will likely be, operating at different speeds from one another. Therefore, what’s good monetary policy for Germany could be bad monetary policy for Spain. Yet through the European Central Bank, there is one central power in control of interest rate setting policy. And it will tend to set that policy based on how the bigger and stronger economies are behaving.
What tends to happen, in this case, is that countries that are performing poorly, without the luxury of cutting interest rates, will find other ways to stimulate their economies. And they do so through fiscal policies, like cutting taxes and increasing government spending.
Typically, there is a natural economic mechanism that keeps these fiscal policies in check: It’s called the financial markets.
When countries cut too much and spend too much, which threatens their solvency or financial position, global investors penalize them by selling their currency and selling their government bonds. After all, who wants to invest in a country that may not be able to generate enough revenue to pay their bills and pay you back?
With that, when the currency falls and government interest rates rise, it makes it more expensive to trade and more expensive to borrow.
In the case of the EMU members, they never had that penalty, until recently.
These countries found that they could keep pushing their economies along through very liberal fiscal policies, and never suffer consequences because the markets continually valued the euro currency and eurozone interest rates based on the strongest eurozone countries: France and Germany.
Bullet No. 2
Given the discussion above, on the incentive for countries to use (and possibly abuse) fiscal policies to stimulate economic activity, the European officials that conceived the monetary union built in limits on the extent to which countries could spend or carry debt. They limited budget deficits to 3% of GDP. And they set a ceiling on how much debt a member country could have at 60% of GDP.
That may sound like good policing procedures on paper, but in fact, it creates more problems. It further handcuffs these member countries.
When a country is in recession, deficit spending and government spending can be an effective way to achieve economic recovery. And they may need to run a bigger deficit for a period of time to bridge the downturn in their economic cycle – i.e., until the economy naturally returns to organic growth.
These limits set in the EMU rule book, the Maastricht Treaty, in theory, restricted a country's ability to work through these economic downturns using fiscal policy. That creates more problems, as Friedman forecasted.
Bullet No. 3
Given bullets one and two, countries within the monetary union are bound to run into economic problems. And Friedman argued that the citizens of stronger countries would have a hard time spending their hard-earned money to help, or bailout, these countries that run into problems.
Technically, of course, a bailout is illegal under the Maastricht Treaty, which governs the eurozone. However, Germany has lent money to Portugal, Ireland, Greece, and Spain. And German citizens are starting to balk at giving any more support.
In Germany's regional elections this year, in effect acting as a referendum on more lending, chancellor Angela Merkel's party (the CDU) was defeated in the country's most populous state, suffering its worst score since World War II.
Bullet No. 4
Finally, the easiest way to solve indebtedness and a weak economy is through currency devaluation. It inflates away the debt and makes exporting easier – typically a key driver in emerging from recession.
But members of the euro don’t have that tool.
Like monetary policy, the common currency is out of the control of each member country’s government. For Greece, this is precisely why exiting the euro (and the eurozone) and re-adopting the Drachma becomes such an appealing idea for the Greeks.
My partner Bryan Rich published the script for this fallout in the euro earlier this year in an e-book titled It’s Curtains for the Euro
. You can download it for free at GlobalInvestorMonthly.com
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