Too Good to Leave, Too Bad to Stay - Adam Price on the Euro


Adam Price is a former Plaid Cymru MP and now a Research Fellow at Harvard’s Kennedy School of Government. His report on the economic crisis in Europe’s small economies, The Flotilla Effect, was published this month by Jill Evans MEP, Vice-President of the European Parliament’s Green/EFA Group. 

Europe needs a half-way house between the Euro and national currencies, writes Adam Price

What's the difference between plane crash and economic crash investigators my Harvard mentor Ricardo Hausmann, is fond of asking? Air investigators spend months sifting through the wreckage to work out what caused disaster so as to avoid the same mistake recurring. In an economic crash, however, we clear the runway, pump the engine full of gas and scratch our heads when the same thing happens a few years later. We call it the business cycle to make ourselves feel better about our seeming inability to learn from our mistakes. So it is with the current Euro-crisis: the obsession with the crash’s fiscal consequences has masked its monetary causes. And so a whole Continent is condemned to a repeat performance even if the Euro survives its current travails.

Most of Europe has made its mind up on who is to blame for the current mess: it’s those feckless Mediterraneans and the wayward Irish. Listening to German politicians, in particular, is to be served up an economics lecture written by the Brothers Grimm in which over-spending governments are devoured by evil speculators. The problem with this account of “the PIGS and the Wolves” is that it is a fairy story, with little real basis in fact.

Far from being fiscally profligate, for most of the last decade and a half the Irish had been positively parsimonious by European standards, running a surplus in every year from the mid 90s to 2006 and reducing public debt by two thirds. By contrast between 2001 and 2007, household debt as a share of GDP doubled in Ireland and trebled in Greece (whose public debt ratio though high was reasonably stable over this period even when factoring in copious amounts of creative accounting). Spain too saw a massive upsurge of corporate borrowing in the run up to the crisis – up by a quarter, while public debt halved in just six years.

Europe’s political class, as the formerly hawkish Ken Rogoff has argued, has turned a private debt problem into a public debt problem. This work of economic alchemy continues to cloud policy-makers’ judgment as to the monetary, not fiscal, origins of the current crisis. Essentially, higher inflation in the Euro-zone periphery combined with a single Euro-zone interest rate meant real interest rates were lowest in the most over-heated economies –precisely the opposite of what policy would ideally prescribe. These low rates meant foreign banks could find more willing lenders in the Euro-periphery than at home – “crowding in” private investment and stoking up the borrowing binge.

Irresponsible politicians and bankers undoubtedly made a bad situation worse but the source of the problem was systemic, arising from a basic flaw in the very constitution of the Euro. With monetary union and its banishment of monetary sovereignty there simply was no means available of staving off localised bubbles. The swifter the recovery the faster this economic centrifuge begins to spin again – even with the fiscal sticking plasters of the Stability Facility, Euro-bonds, short-selling bans and dawn raids on the hated rating agencies.

So what’s the answer? Leaving the Euro – even on a temporary basis – is not only a legal and logistical minefield, a depreciating drachma or punt, would mean the current debt mountain mushrooming to even more nightmarish proportions (as the debt is held in Euros).

Luckily, there is a monetary “Third Way” involving the re-introduction of a form of national policy while remaining in a single currency. To combat future inflationary bubbles national governments beyond Europe’s cordon sanitaire could be encouraged to establish new national units of account (NUA) indexed to inflation. The idea of an inflation-proof unit of account is not itself a novel idea – the grand old man of English economics, Alfred Marshall, suggested it over a century ago, and in Chile it actually exists. The Unidad de Fomento, created in 1967, is the main unit of account for long to medium-term financial contracts (car loans, mortgages, corporate borrowing and government securities) while the peso is used for wages and prices.

A country with a NUA would be able to conduct its own monetary policy by adjusting the interest rate on NUA-denominated bonds – an insurance policy against the type of localised boom that derailed the Irish and all the rest. All this sounds a little contrary to the very essence of monetary union but it’s not that dissimilar to the system of regional discount rates used widely by the 12 Regional Reserve Banks in the United States until the 1930s. Creating a genuine monetary union, as America’s central bankers soon realized, requires patience and flexibility: building a durable Union means sometimes, not strengthening, but loosening its bonds.