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Monday, 4 July 2011

Fear and Loathing in the Eurozone

Gonzo Economics

The journalist Hunter S. Thompson popularised a style of journalism that came to be called “gonzo”, operating on the theory that “fiction was the best fact”. If Thompson were still alive today and inclined to cast an eye outside of the USA towards Europe he’d probably be wondering how exactly to make the car crash that is the Eurozone sound like fact.

In fact the history of currency unions is replete with examples of spectacular failures and if the euro experiment does fail it won’t be for lack of prior example. Yet history also shows that collapse is not inevitable, assuming strong leadership and a common purpose. So we’re probably all doomed.

It's All Greek

The current travails of the Eurozone have been precipitated by the insolvency of Greece, a peripheral European nation with a financial record that one could, if one was feeling particularly kind, describe as “patchy”. Although, in truth, “utterly hopeless” would be more like it: as Reinhart and Rogoff have carefully documented this is a nation that since independence in 1829 has spent more years in default than not, and has had to reschedule its debt on no less than five occasions. If one were being cynical, you’d think that the European grandees who allowed Greece entry to the Eurozone were ignorant of history.

Generally, though, history is pretty imprecise about whether or not currency unions are useful or not. Indeed Greece was a member of a previous attempt, the nineteenth century French initiated Latin Monetary Union which at one point covered eighteen countries but which fell apart due to a lack of strong, central management. So no modern day parallels there, then.

Although more recent failures include a Scandinavian Monetary Union and an East African Currency Union not all currency unions have failed. In fact there are three very successful ones still in existence today. One of them is known as the US dollar, while the others, the German and Italian currencies, have been subsumed into the euro. All three of these examples share one, obvious thing in common: they are the outcome of political union rather than the cause.

Optimal Currency Area Theory

Of course, as we’d expect, economists have a theory about whether currency unions should work. Indeed, economists have a theory about everything, including lots of things they don't know very much about.  Actually, as we should also expect, they have two theories – which don’t agree with each other. Perhaps less expectedly these theories were both dreamt up by the same economist, giving a modern twist to the old joke that an economist is someone who can start an argument in an otherwise empty room.

The difference in theories revolves round whether countries in a currency union should have floating or, as in the Eurozone, fixed exchange rates. Version one of Robert Mundell’s optimal currency area theory (OCA) asserts that floating rates are better for countries. The idea is that rates can vary to absorb so-called asymmetric shocks where one country is subject to more pressure than others. In essence, a country can devalue against its neighbours and competitors if it needs to.

Fixed or Floating

In version two a fixed currency is propounded as better, because a shock in one area can be absorbed by moving money from other areas. The idea, of course, assumes that shocks are distributed randomly, so that all areas take a hit at one time or another, rather than being permanently located in one small olive growing region of South-Eastern Europe.

To be fair to Mundell, his views changed over time based on his experience, which is behaviour to be recommended rather than disapproved of. Sadly most commentators ignore his later view in favour of his former one, as this paper by Ronald McKinnon observed. McKinnon clearly comes down in favour of fixed rates and European integration, a la Mundell version 2, seeing the benefits of a common currency as powerfully positive. However, he does make an important caveat:
“A country could not participate in either a common-currency regime or a common monetary standard if its own public finances were too weak. If its government needs to retain control over issuing its own currency in order to extract more monetary seigniorage from the financial system—possibly through inflation—than a common currency regime would permit, then no fixed exchange rate regime is feasible or advisable.”
The Inflation Tax

“Seigniorage” is the technical term for the value a government can extract by controlling the issuance of its own currency: in essence a government can inflate away its debt by happily printing more money. That’s why it’s also known as the “inflation tax”. The alternative is proper tax collection; and the point is that if a country can’t pay its way by collecting taxes then the outcome for it if it joins a currency union is likely to be very, very bad indeed, because it loses the ability to print money and devalue: in effect Mundell model 1 is no longer available to it.

Unfortunately Greece’s ability to collect its taxes is, well, not great. Here’s the International Monetary Fund’s answer to the question “Are the rich going to pay taxes and be taxed more?”:
“Yes. Tax evasion, particularly from high-income groups, is rampant. The government plans to address this with the help of a strong anti-evasion effort and a significant strengthening of tax administration.”
Which hasn’t worked too well, it seems. The problem, as Mundell anticipated, is that if the shocks to the system are not random and are specifically and continually related to one country the concept of currency union begins to fall apart. In particular, if specific countries are characterised by lack of price flexibility and rigid labor laws restricting wage adjustment in response to lack of competitiveness the only alternative is to transfer money from one region to another: and potentially to keep on doing it, till the voters squeak.

Political Union or Bust

Well, if you have a currency union without political union you don’t have to be a genius to figure out that the psychology of the people doing the giving is not going to be uniformly positive forever. Unrest in consensual Finland, of all places, is proof of that.  So we have a country that should never have been allowed into the Eurozone, that’s unwilling or unable to make the necessary fiscal adjustments and which is being funded by countries whose populations are increasingly restive. Yet the politicians and central bankers of the region don’t seem to have any kind of real plan.

But maybe they do, because this is probably as much about playing for time as it is about the reality of avoiding a Greek default. If Greece leaves the Eurozone speculation will turn to the other peripheral countries – Ireland and Portugal – and then possibly beyond them to Spain and Italy. The calculation here seems to be that the longer a Greek exit from the euro can be avoided then the more likely it is that the world’s banks and the other Eurozone economies will be strong enough to survive the resultant fallout.

As for the long term survival of the Eurozone, that probably depends on a degree of political integration. We should not forget that the genesis of this strange union lay in a determination to avoid another European civil war on the scale of the last two. That’s a worthy aim, but in the meantime the consequences of politicians understanding neither economics nor history are likely to be as painful as one of Hunter S. Thompson’s hangovers.

Related books:

Fear and Loathing: On the Campaign Trail '72What Has Government Done to Our Money?Bust: Greece, the Euro and the Sovereign Debt Crisis (Bloomberg (UK))Greece's Debt Crisis: Overview, Policy Responses, and Implications - CRS Report


  1. Great article. It looks like the Euro zone made a huge mistake in admitting so many weaker economies so soon. It will be interesting to see how they deal with the problem over the next few years and how they manage the exit of one or more of the members. It is curious to see how the potential exit of a member is looked on as such an enormous event when the initial plan made it clear this was possible with its various rules for retaining membership.

  2. A very unique article. I am a big fan of Hunter S. Thompson and am familiar with his different pieces. When I needed a title loan for my car i was able to get cash fast which helped me.