Bonds, Currencies, Emerging Markets, Stocks

The Eurozone Has Failed Both Politically And Economically

Karl-Friedrich Israel and Jeff Deist discuss the current situation in Greece from Karl’s perspective as a German. Old hostilities between the north and south in Europe are being inflamed, which calls into question the entire purpose of the Eurozone.

Would Greece be better off simply leaving the Euro and resurrecting the drachma? Would the less profligate Eurozone nations cheer this? And has the ECB failed as miserably as the US Fed in creating price stability?

Frankfurt_EZB-Neubau.20130909 European Central Bank Wikipedia

The European Central Bank (seat in Frankfurt depicted) is the supranational monetary authority of the eurozone. Courtesy of Wikipedia.

Jeff Deist: You have studied at length, conceptually, central banks around the world. Before we get into that further, I’d like to ask you as a German especially, what your opinion is of the ongoing crisis in Greece.

Karl-Friedrich Israel: One of the leading German economists has recently compared the Greece situation to the so-called Dutch disease.

Back in 1960 when the Netherlands discovered huge supplies of natural gas, they could exploit those resources and live off exploiting those resources and they became fairly wealthy and it allowed them to increase wages and prices within the economy faster than the actual productivity grew. And when the production of gas diminished after some time, the economy was pushed into a recession. They had to go through a painful adjustment process in which wages had to fall and prices had to fall, but after all, today they are a stable economy in Europe. To some extent, the situation is similar in Greece, but of course Greece has not been exploiting a natural research, but rather an unnatural resource, namely the euro, which is a central-bank controlled fiat money.

After the introduction of the euro, huge amounts of liquidity in the form of credit flowed into the Greek economy, which allowed them to increase wages and prices and welfare spending above their productivity level. And so that’s why today, they are not competitive in the international markets and that’s why they have problems.

JD: But it’s interesting, apart from just the mechanics of the debt that’s owed by Greece, there’s also the political angle of all this. I’m reading today in the Washington Post about this image of the cruel German returning. In effect, the ECB has become a political project of sorts, has it not? It’s actually serving now to inflame some of those old postwar tensions that existed between the north and the south in Europe.

KFI: Yes, that’s true. There are some interesting facts and this is not surprising that the Germans are discontent with the situation in Greece and Greeks are discontent with what is happening in Germany. The Greeks don’t like the German conditions that come with bailout money.

So for example, as I’ve mentioned, the wages are inflated in Greece. Let me give you some examples. In manufacturing, the average hourly wage is twice as high as in Poland and Poland is of course, not part of the eurozone, but there are other examples. Pension payments in Greece are on average higher than in Germany. It’s not surprising that Germans, when they hear those empirical facts, they cannot understand it. Why do Greeks get higher pensions than we do in Germany, and why do we have to give them all these loans? So in fact, the big project of European integration, in some respects turns out to be counterproductive.

JD: Well it reinforces nationalist impulses in some senses.

KFI: That’s true.

JD: Now if we go back to the founding of the euro itself and the ECB within the eurozone, at the time, was it really recognized that it was crazy to have a single currency among these nations which still allow them to produce their own central sovereign debt through their own central banks.

KFI: It is not crazy to have the single currency, but it is crazy to have a single currency which can be exploited by sovereign national banks. This is what Greece has done, for example, through the Emergency Liquidity Assistance (ELA) mechanism. So, Greece was essentially able to grant itself credit from this ELA mechanism because, in order to stop Greece, a two-third majority would have been necessary within the ECB Council. Back then in 2012, the six crisis-stricken countries, Ireland, Italy, Spain, Portugal, Cypress, and Greece, had more than a third of the votes. So it was very hard to stop them from granting themselves more credit. This has changed now because Latvia and Lithuania entered the eurozone in 2014 and 2015, so now it has become easier to stop this.

JD: But this makes Philipp Bagus’s point that the euro operates more as a political project than a real currency.

KFI: That’s true, absolutely true.

JD: As a German, I’d like your thoughts. Do you think the average hardworking German or Dutchman or Belgian feels aggrieved under the eurozone? In other words, do they feel as though they are subsidizing countries that are economically less productive, like the PIGS, Portugal, Ireland, Greece, Spain?

KFI: Yes, I think they do. In fact, there never has been a majority for the euro, at least in Germany. So there always has been quite some skepticism toward the eurozone and toward the integration of Europe through these monetary measures in Germany. And now, as I mentioned earlier, seeing that welfare spending is at least partly higher in Greece than in Germany, just reinforces this feeling of some Germans that we are effectively subsidizing the Greeks. We have to give them liquidity and they don’t seem to be willing to lower their standard of living, which of course, nobody wants to lower their standard of living, but this is what needs to be done.

JD: So, part of your work here this summer at the Mises Institute is discussing, confronting some of the prevailing arguments in support of central banks and central banking. Could you sort of lay out for us, as a devil’s advocate, what are some of those arguments and how do you refute them in your work?

KFI: I think one of the most important arguments at the beginning, was the argument of price stability. It is the idea that we need a flexible money supply that can be expanded in accordance to real economic growth, so that we have stable prices or a stable price level. This argument still today seems to be very important because when the ECB started to buy government bonds directly, there was opposition in Germany, and lawsuits against the ECB have been brought to the European Court of Justice.

They argued that those purchases of government bonds are against European law because direct government financing is prohibited, but of course, the European Court of Justice, which is based in Luxembourg, decided in favor of the ECB measures. They argued that no, this is within the legal boundaries of the ECB because it belongs to the category of monetary policy and they do that in order to stabilize the ruro, in order to stabilize the purchasing power of the euro. So we have this argument still today. What I would argue is that what is today called price stability is not stability at all. This can be seen by the very definition of price stability that the ECB proposed. Price stability for them means, an inflation rate close to 2 percent.

JD: Same as in the US. Our Fed’s target is 2 percent.

KFI: Exactly, which means that in thirty-five years, on average, the currency will have lost half its value.

JD: Right and what’s so interesting is this inflation is an expressed policy of the government we pay for, in effect.

KFI: Right.

JD: This isn’t just a symptom of mismanagement, it’s an expressed policy.

KFI: Right.

JD: From your perspective, in the shorter history of the ECB versus our Fed, have they succeeded in creating price stability within the eurozone?

KFI: No, they haven’t. Since the establishment of the Federal Reserve in the US, the US dollar has lost, according to official statistics, 98 percent of its purchasing power. And the developments are similar in other countries. This is the same in the eurozone today and it has been the same under the deutsche mark as well. The deutsche mark seemed to be stable just because it was relatively less inflationary than for example, the French franc or the Italian lira, but it still was inflationist and a big part of the purchasing power has been lost under the policies of the Bundesbank.

JD: Does the ECB have an employment mandate like the Fed?

KFI: There’s a difference here. The Federal Reserve operates under a so-called dual mandate, so they try to maintain price stability and economic growth and employment on equal footing.

So, they are to some extent inherently more inflationist than the ECB because the ECB has a hierarchical mandate which says, first of all, comes price stability and after that, real economic targets, employment and growth.

JD: When we look at the euro in terms of its endgame, some people talked about the Greek exit as the straw that would break the camel’s back and will begin the end of the euro. Do you think that’s true or do you think the euro has real staying power in the coming decades?

KFI: It seems as if the leading nations within the eurozone want to preserve the currency union. They don’t want to let Greece exit the euro. Angela Merkel right now is lobbying for more rescue credits for Greece in order to keep Greece within the union. A leading German economist has proposed that it would be better if Greece left the eurozone, introduced the drachma again, and then devalued the drachma against the euro so that they remain competitive. I’m not sure whether this is the best solution, but it is pretty clear that what needs to be done is price adjustment and wage adjustment. In which way, I don’t know, but prices and wages in Greece as compared to other countries, have to fall.

JD: Well, a lot of people including Nigel Farage, have suggested going back to the drachma, but diluting the drachma doesn’t create any wealth, it just transfers wealth from savers to, say, Greek exporters. So in and of itself, allowing the currency to float to its natural level in devaluing it would not make Greek people more prosperous, but I would suggest that it might give them more sovereignty and more say over their future.

KFI: That’s true. They might have more sovereignty and they might have an independent central bank that can inflate their own currency as they please, but I don’t know whether this is the best solution. The Greek government seems to be inspired by Keynesian policy and prescriptions. I don’t know whether the Greek people or the country would be better off if they had an independent central bank and their own currency.

JD: So, can you elaborate on your thesis, your findings, in terms of your study of central banks? If you could make one point to someone who was talking to you about the folly of central banking, what would that point be?

KFI: I’m studying central banking especially in terms of fiat money because fiat money is subject to political will. It can be extended at virtually zero cost. And I would argue that this is the very danger of fiat money. You provide central banks with a very powerful tool which seems, according to historical experience, to corrupt people.

JD: And this is the point made by your mentor, Guido Hülsmann in his book about the ethics of money production, that there’s not just economic consequences to fiat currencies, but there’s deep seated cultural consequences to fiat currencies. For example, people act more upon high time preferences and they don’t save for the future as much.

KFI: I think it’s not only economics that is important here to understand, but the dynamics of central banking and the fiat money. In my research, I focus more on the economic arguments, but I see that there are a a lot of other arguments from other areas of the social sciences and ethics. I oftentimes ask myself what is the more powerful argument against or for central banks? Is it an economic one or is it an ethical one? And at times, I think the ethical argument might even be more powerful with which to persuade people.

Karl-Friedrich Israel is a 2015 Mises Institute Summer Fellow and a PhD candidate at the University of Angers in France. The focus of his research is to identify and confront the prevailing arguments for central banks.

Note: The views expressed on are not necessarily those of the Mises Institute.

[This article is adapted from a July 17 Mises Weekends interview, available here in Mp3 format.]

Courtesy of Mises Institute


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