“How can I, that girl standing there, my attention fix,” asked William Butler Yeats plaintively in the midst of the political upheavals of the early 1930s, “on Roman or on Russian or on Spanish politics?” Well, love and beauty in the Beijing spring weather notwithstanding, it is hard once again not to fix attention on Roman and Spanish politics or, more specifically, on the politics of the euro
At first all this might not seem to be a subject to fit into a blog called “China financial markets,” but aside from personal interest – I was born in Spain, and spent most of my youth there (and my family still lives there) – what happens to the euro will matter to China. Weakness in the euro will make a US export adjustment much more difficult, and this will increase trade tensions between China and the US. More intriguingly, the trade imbalance within Europe that is at the heart of the euro crisis is replicated globally, and is just as much at the heart of the global crisis. Both are going to be equally difficult to resolve.
On this subject I recently called a Spanish friend of mine who studied in the US and currently lives in China. He likes living in China a lot but has often thought about returning to Spain and beginning a career in politics. During the call I told him that if he ever wanted to do so, now was the time. There are two issues which I am certain will move to the center of the political debate in Spain within a few years, and if he were to stake out radical positions on both positions now, his prestige and visibility would quickly soar.
The first issue is Germany’s role in the crisis. I am convinced that over the next few years, fairly or unfairly there will be a crescendo of blame directed at Germany and German policies, and this ire will be magnified by the fact that many Germans seem oblivious to their role in the crisis. The German press in fact seems to delight in wagging a disapproving finger at the shameless profligacy of the south, and this can’t make southerners very happy.
Critics of Germany will argue that this moralistic posturing is thoroughly misplaced. European monetary policy, which was driven largely by Germany, was incompatible with German trade and labor policies that effectively suppressed German consumption, forced a large trade surplus onto its neighbors, and together made a southern European debt crisis almost inevitable.
The strong euro and burgeoning liquidity it brought on meant that much of Germany’s trade surplus had to be absorbed within the eurozone, forcing especially southern Europe into high trade deficits. These deficits were dismissed, very foolishly it turns out, and against all historical precedents, as being easily managed as long as the sanctity of the euro was maintained. A very false analogy was made with the US, in which it was argued that because European countries all use the same currency, trade imbalance within Europe are sustainable in the same way they are sustainable between states in the US.
But states in the US are not like states in Europe. Labor and capital mobility in Europe is very low compared to the US, and the Civil War in the US ensured that sovereignty, including most importantly fiscal sovereignty, resided in Washington DC, and not in the various state capitals. The US is clearly as much an optimal currency zone as any large economy can be.
This isn’t the case in Europe. In fact I would argue that the existence of a common currency in Europe, the euro, is only a little more meaningful than the existence of various currencies under the gold standard, and it was pretty obvious under the gold standard that balance of payments crises could indeed exist.
So why not also in Europe under the euro? As I see it, domestic German policies, perhaps aimed at absorbing East German unemployment, forced a structural trade surplus. The strong euro, along with the automatic recycling of Germany’s large trade surplus within Europe, ensured the corresponding trade deficits in the rest of Europe – unless Europeans were willing to enact policies that raised unemployment in order to counter the deficits. As long as the ECB refused to raise interest rates, southern Europe had to accept asset bubbles and rapidly rising debt-fueled consumption.
This couldn’t go on forever, or even for very long. Now southern Europe is paying the inevitable price, and of course the moralists are accusing the south of being shiftless and lazy, confusing the automatic balancing mechanisms in the balance of payments with moral weakness.
This is not to say that it is all Germany’s fault (although I’m sure I will be accused of making this claim anyway), but rather that the existence of the euro seriously exacerbated the problem by making it very difficult for certain countries to adjust to Germany’s domestic policies, which generated employment growth at home at the expense of Germany’s trading partners. There is no question that a long history of fiscal irresponsibility in southern Europe made things much worse, but the imbalance could have never gotten so large without Germany’s role, and since in a crisis it is always easier to blame foreigners, bashing Germans will become a very popular sport in much of Europe.
Abandon the euro
The second issue that will divide Spanish politics of course is Spain’s future within the monetary union. Spain simply cannot remain within the euro without making radical political changes. American economist Barry Eichengreen argued in his book on monetary policies during the 1920s and 1930s, Golden Fetters (a book I never tire of recommending), that the democratic enfranchisement of workers made a return to the gold standard impossible because workers, who had traditionally borne most of the burden of gold-standard adjustment through rising unemployment, would no longer passively accept those policies.
Spain is in just such a position. Although most Spanish politicians continue to insist that Spain’s joining the euro is irreversible and a symbol of its modernity, in order to adjust within the euro I suspect that Spain is going to have to suffer unemployment of 20% or more for several years. Spanish voters, correctly in my opinion, will not tolerate such an outcome.
The argument will be made by establishment politicians that to reject the euro will be seen as an indication of contemptible irresponsibility and will condemn Spain to developing-country status for the foreseeable future. Without the euro, Spain is a third-world nation, they will insist, and because many Spaniards are still sufficiently insecure about their status as “real” Europeans, this criticism will carry some emotional weight.
But the strength of this argument can only survive a few years of high unemployment. It was the same argument made, by the way, in France in the 1920s, when the value of the franc collapsed against other currencies, and the dour governor of the Bank of France, Emile Moreau, was forced to re-establish the link between gold and the franc in 1928 at a humiliating 80% discount to the pre-war parity.
I am not sure France’s subsequent experience justified the negative assessment. France struggled after the huge inflation of World War 1 to return to the pre-war gold parity and its economy suffered badly in the process. Bankers and the rich argued that maintaining the old pre-war parity was vital to France’s international standing, but to no avail. The cost was too high. France had no choice but to accept a devalued franc, while the rest of the world poured scorn on France for its spineless irresponsibility and predicted economic disaster.
But they were wrong. During the period of franc weakness France had regained its competitiveness and became one of the stronger economies in Europe, while those who had condemned France’s spinelessness were forced into their own humiliating devaluations after struggling mightily with unemployment and economic contraction. France also had a milder experience during the depression of the 1930s than other large economies, although as other countries devalued their own currencies against gold, France lost its competitiveness and slid into deeper economic contraction.
The virtues of irresponsible behavior
In fact by my reading it seems that during the 1920s many of those countries that were quickest to behave “irresponsibly” – to recognize that orthodox monetary policies were untenable – suffered the least during the subsequent years of the great economic crisis. This is not a vote for beggar-thy-neighbor devaluations, by the way, although it may seem like that. Rather it is a vote for recognizing when monetary conditions cannot be maintained, and then acting quickly to resolve them. The foreign exchange rate value of the currency matters.
Like France in the 1920s, the sooner Spain – and by extension the rest of southern Europe – admits that current monetary conditions are untenable, the less damage it is likely to suffer. The current system, in which fiscal authority is concentrated in Madrid and monetary policy is determined by the needs of the euro, will create insurmountable political opposition as many years of high unemployment turn the population to more radical solutions.
Spain will almost certainly have to choose. Either it gives up fiscal sovereignty – including, most importantly, taxation authority – to Brussels, or it gives up the euro. The alternative, several years of difficult adjustment borne mostly by workers, is politically unlikely.
Can Spain give up fiscal sovereignty? Actually that might be easier than many people think. Already there are strong separatist movements in many parts of Spain, and a number of regional governments might be happy to reassign sovereignty from Madrid to Brussels in exchange for real relief from the burden of adjustment. I would imagine that Catalunya and Euskadi (the Basque provinces) would not find it so difficult if economic conditions deteriorated. Other regions are also likely to consider it a viable prospect.
The problem with this strategy might actually be Germany. Although one can posit a scenario in which regions in Spain and other southern economies (for example Italy, with its own regionalist movements, especially in the north) reassign sovereignty to Brussels, unless Germany does the same the viability of a United States of Europe would be doubtful. It is hard for me to imagine, however, a situation in which Germany assigns fiscal sovereignty to Brussels. In that case the only real European entity with any chance of viability might be the United States of Germany.
Could this happen, and European regions assign sovereignty to Berlin? Maybe, but aside from the near impossibility of imagining France agreeing to a United States of Germany, if I am right about rising anti-German feeling in many parts of Europe, this will make it tough even for the smaller countries to swallow the prospect.
So these are the options as I see them. Spain might choose closer integration into Europe, including giving up fiscal and tax sovereignty, although it is not clear which European entity this would entail. Spain might choose to disenfranchise the working class, but the probability of this is close to zero, I think, and would be morally unthinkable. Or Spain might choose to give up the euro. This is just another restatement of Dani Rodrik’s “inescapable trilemma of the world economy”, by the way.
If you do decide to follow my advice, I told my Spanish friend, I wouldn’t bet too heavily on the first two outcomes. It would be much safer politically to become vociferously anti-German and to demand that Spain exit the euro. It might be a little sleazy, but it would lead to a very exciting political career, and isn’t a certain amount of sleaziness useful to a politician?
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