17 January 2011

Was the Euro a Bridge Too Far?

I am a fan of the European Union, but the analysis, Can Europe Be Saved?, by Paul Krugman in the 16 January issue of New York Times Magazine, is a good summary of what is going wrong in the European project. 
The worldwide financial meltdown has pushed several of the EU members — Greece, Ireland, Portugal, and Spain to the cusp of a debt deflation, raising the specter of national bankruptcy.  At the heart of the problem is the euro, and the inconsistencies resulting from the mismatch between monetary centralization and fiscal decentralization. 
There is simply no question that the progressive economic integration of the Western European countries that began with the Coal and Steel Community in 1950 has been good economically and politically for Europe and the World.  But as Krugman shows, the adaption of a common currency — the Euro — in 1999 without a concomitant commitment to a unified fiscal policy set the stage for an inevitable crisis.  
Some observers, like my friend Marshall Auerback, have long warned about the problem posed by the mismatch between monetary and fiscal integration, but their dissents were lost in the enthusiasm of the rush to adopt the Euro.  Add in the rapid expansion of the Eurozone to the east after the Soviet Union collapsed and the stage was set for trouble.  
The global financial crisis beginning in 2007 brought that problem to a head when sovereign debt crises emerged in several of the weaker EU members.
Krugman analyzes four alternatives for muddling through the sovereign debt crisis, 
  1. Toughing it out via tight fiscal (and monetary) policies;
  2. Debt restructuring; 
  3. Devaluation (some kind of monetary decentralization);
  4. Fiscal Centralization.
Krugman explains well why options #1 and 2 are unsatisfactory as long term solutions, so, in reality, it seems to me that only his last two options offer a long term resolution to the crisis — Option #3 or monetary decentralization implies dumping the Euro as a single unified currency, allowing local devaluations, and in effect, returning to the EU status quo ante with some variation of national currency relations that existed in 1998, or Option #4, keeping monetary the integration but adding full fiscal integration.  Moving backward is never attractive politically or intellectually, and Krugman explains the downside of Option #3 (as he did with  Options #1 & 2). But he does not explore possible negative ramifications of Option #4.  In effect, Krugman leaves the reader with the impression that full-scale integration would be the best — and perhaps the only — outcome over the long term.
I am not so sure.  
Full scale fiscal integration — effectively creating a United States of Europe — has long been the dream of many EU proponents, but it assumes all the EU members can move beyond the legacy of Europe’s fractious history: the memories of its wars and the deeply ingrained cultural differences among its peoples.  If the people of Europe can not move beyond the remnants of this cultural DNA, the idealistic dream of a  fiscal union could mutate into a nightmare.
The model for that nightmare may well be a variation of what happened in Yugoslavia, where history and dormant resentments collided horrifically in the 1990s to unravel the union enforced by Marshall Tito.  The resulting chaos created a pressure cooker in the Balkans not seen since the late 19th and early 20th Centuries.  
One could argue that some of the cultural differences between Serbia and Croatia, for example, were less than those between France and Germany, or between Sweden and Italy, or between the Netherlands and Spain, or between Denmark and Greece.  Serbia and Croatia are populated by Serbo-Croatian people speaking the same slavic language.  To be sure, Serbia and Croatia have different Christian religions Orthodox & Catholic) and alphabets (Cyrillic & Latin).  But differences in religion and alphabet also exist in the EU.
On the other hand, Serbia and Croatia  had very different histories (but not so for Serbia and Montenegro).  Serbia was part of the Ottoman Empire while Croatia was part of the Austro-Hungarian Empire.  Western (particularly the northern) European countries also have different histories of being independent nation states that emerged out of feudalism (which enshrined the principle of reciprocal powers), with unique languages.  The feudal and national experiences were been far less developed for the countries making up the former Yugoslavia, having been provinces ruled by multi-ethnic empires.
Prior to its dissolution into civil war, Marshall Tito had forged a unified Yugoslavia into the most prosperous economy in the old Communist block, people were educated, and there was much intermarriage among nationalities.  Indeed, Tito himself was half Slovene and half Croat.  To be sure, he was a ruthless leader and a virtual dictator who used the whip hand to contain local animosities, but few people would have predicted that Yugoslavia would collapse into a violent civil war after Tito died.  
It is now clear that animosities remained beneath the surface, and one of the main factors breaking up Yugoslavia was the resentment on the part of the relatively richer Slovenes and Croats over having to transfer some of their scarce wealth to the relatively poorer Kosovars, Macedonians, Montenegrans, and Serbians.  Those economic resentments (which were fanned by opportunistic outsiders as well as insiders in the 1980s and 90s) resurrected memories of past wrongs and atrocities, launching a downward spiral to disintegration, violence, and destruction not seen in Europe since World War II.  
No doubt, Tito’s death in 1980 and the loss of his organizing genius was a major factor in the loosening of the bonds holding Yugoslavia together.  Significantly, there is no statesman of comparable stature to forge a fiscal federation out of the EU, much less to make it endure.  And EU governments are democracies that ultimately respond to popular emotional pressures, like ethnic resentments and the “otherness” of people who are somehow different.
I have spent 75% of my time living in Mediterranean over the last five years, and my conversations with many European friends, from all walks of life in both northern and southern Europe, make it quite clear to me that there is a widespread latent resentment among the inhabitants of the richer countries of the north over the the requirement to transfer money to relatively poorer countries in the South.  That said, the overwhelming majority of Europeans from all parts of the EU favor the EU, and I would categorize these kinds of complaints as griping.  I have seen no hints of threats or any tendency toward violence associated with these resentments.  Until recently, it was common hear comments like, “It is a great time to be a European."
There is no question that a new and very different Europe and a new Europeaness is evolving, but that very newness may make it vulnerable to too massive a change.  The history of the EU’s integration from the the tentative steps taken in 1950, suggests a pathway of incremental change is best. Indeed, it was the jump to a common currency that became become a source of the most serious crisis facing the EU itelf.  
A full fiscal union would involve an even greater jump and a more drastic subordination of national identities than the monetary union.  If significant minorities of people in the rich countries felt they were being treated unfairly by the imposition of a supranational authority, including the requirement to transfer funds to the poorer countries (via taxing and spending programs much like New Yorkers help to subsidize the poorer states in the south through the federal tax and spending system), opportunistic politicians may be tempted to fan the fires of national resentments by emphasizing the “otherness” of the poorer countries in southern or eastern Europe.  This kind of demagoguery would be particularly potent during times of economic stress and insecurity.  
If you think this line of argument is too much of a stretch, given the postwar history of Europe, just look at the link between the fanning of resentments to the most recent incarnation of paranoid political extremism in the United States.  Might a similar process put a political sequence of action and reaction into place that eventually intensifies to a level that kills the EU goose that laid the golden egg?  
Krugman ignores the implications of the dangers posed by this kind of interplay of chance and necessity in his assessment of Option #4.  Had he considered them, Option #3, or retreating from the Euro (but keeping the customs union, open borders, free movement of capital and labour, and the harmonization of standards and regulations, etc), while painful in the short term, might look a little better when viewed over the long term.  A return to  a degree of sovereign currencies in an EU context (perhaps in some kind of form of tiered Euros, coupled with some quasi-fiscal coordination?) may pose a better chance for putting the EU political economy on a more sustainable evolutionary pathway toward integration over the long term.  Moreover, given the already widespread use of modern electronic funds transfer capabilities ranging from ATM machines to international bond sales, the major inconveniences of working with separate currencies would be relegated to the past.