The Euro Crisis for Poets

It occurred to me recently that I hadn’t seen an explanation of the euro crisis that (1) my sister could understand and (2) was thorough (i.e., actually an explanation). So I’m going to attempt to make one here.

So, first, what is the euro crisis? Simply put, it’s a sovereign-debt crisis. Sovereign debt is the debt issued by sovereign countries, like the U.S., Greece, etc. Right now, several European countries are having trouble meeting their obligations to their own citizens (i.e., paying pensions) and foreign investors (i.e., paying interest and principal on debt). Normally, they could just issue more debt (i.e., roll the debt over) to meet these obligations. But now, investors are getting nervous that they’ll ever pay what they owe back. So they’re charging higher interest rates, which itself is compounding the problem of the countries’ indebtedness—and so on and so forth in a vicious cycle. This is a sovereign-debt crisis. So that’s what that is. But the euro crisis has some unique features. And to understand them, we need to understand the euro itself.

The first concept we need to understand is the concept of exchange rates. What’s an exchange rate? By definition, it’s the price of one currency in terms of another. You surely know how at the Toronto airport, there are various kiosks offering you 1 Canadian dollar for $1.25 US, and so on and so forth — those are all exchange rates.

Next question: What determines exchange rates? Well, today we have ‘floating’ exchange rate internationally, which means simply that we have a free market in currencies — i.e., everybody can buy and sell currencies freely at whatever price they can get. And that means, in turn, that the ‘price’ of any currency — its exchange rate — is determined by supply and demand. So, then, what determines the supply of and demand for a currency? Well, let’s imagine a world with just two currencies — the dollar and the euro. The ‘demand’ for the euro (which in practice means people trying to buy euros on foreign exchange markets) comes from Americans, who use dollars for all their normal domestic transactions, who want to buy goods from euro-zone countries. Firms in the Eurozone all, of course, pay their employees and creditors in euros, and so you need to give them euros if you want to buy their goods. In turn, the ‘supply’ of the euro (which in practice means people trying to sell the euro on foreign exchange markets) must necessarily come from residents of the euro-zone who are selling their euros in exchange for dollars. I.e., the supply of euros is another term for the demand for dollars, and it is driven by people who want to get dollars to buy American goods.

So, now remember the basics of supply and demand. As the demand for any good increases, its price must increase, too. More people desiring more of a good means that the sellers can get away with raising their prices — and if they don’t, there’ll be a shortage of the good. An increase in the supply of a good, in turn, lowers its price, as the suppliers all compete to undercut each other in order to sell off their excess inventories.

So now, put those two previous paragraphs together: If Americans desire more goods from euro-zone countries, they will go to foreign exchange markets to buy more euros, and bid up the price of euros in terms of dollars — the euro will appreciate, which means (in this two-currency world) the dollar will depreciate. If euro-zoners desire more goods form the U.S., they will go to foreign exchange markets and demand more dollars, bidding up the price of dollars in terms of euros — the dollar will appreciate and the euro will depreciate.

So next question: What could cause Americans to desire more goods from euro-zone countries (or vice versa)? Well, theoretically, it could be some weird, random cultural thing — i.e., France’s cultural soft-power increases, and Americans suddenly develop a new taste for authentic French goods. But in practice, the major determinant here is the relative productivity of the trading countries. Put very simply, if Germany is really good at producing high-quality goods relatively cheaply (which is the English-language definition of ‘productivity’), then lots of foreigners are going to want to buy those goods. If America goes through a horrible economic turmoil that consequently reduces its ability to produce desirable goods that can compete in global markets (i.e., its ‘productivity’ decreases), then fewer people are going to want to buy American, which means they’ll have less need to buy dollars, and more interest in selling dollars to buy other currencies, which will cause the dollar to depreciate.

And as you might sense, there’s a cool, important balancing function provided by markets here: If a country gets awesomely productive, such that everybody else wants to buy its goods, then the demand for its goods and its currency will increase, causing its currency to appreciate. In other words, its currency will get more expensive for everybody else, which means that its goods will get more expensive for everybody else, too. It will also mean members of that country will be able to buy other countries’ goods more cheaply. So that will counterbalance things — increasing the newly-successful country’s imports and reducing its exports. As a result, the floating exchange rates keep countries in a sort of equilibrium — exporting and importing approximately the same amount, such that no country permanently runs enormous ‘current-account’ surpluses or deficits, and no one country completely dominates global export markets.

So that’s how exchange rates work. And in these few paragraphs we basically have all the theory we need to understand the monetary side of the euro crisis, and the tradeoffs involved in a ‘currency union.’ Now we just need to put the pieces of the puzzle together.

So: In 2002, a bunch of the countries of the European Union, which had previously had their own, individual sovereign currencies, decided to come together under a single ‘currency union’ — the euro, which was to be issued by a single central bank, the ECB. It was adopted for some pretty obvious advantages: the Eurozone is tightly economically integrated, meaning lots of trade happens over national borders, but doing currency conversions was a hassle for ordinary businesses; a single, convenient currency could also help promote tourist travel across those borders, which is an economic good; and there was a symbolic value to bringing further unity to a continent that had seen so much devastating war and genocide during the 20th century.

But the very curious and troubling thing about the Eurozone is that it integrated under a single monetary regime countries with very different national characters and, hence, very different underlying real economies. Specifically, Germany is a much more productive country than Greece. But now, under the euro, they share the same currency, issued by the same central bank, whose value is determined by the same foreign-exchange markets. The fact that Germany and Greece have distinct local economies – and also, which we’ll get to later, distinct sovereign governments with distinct fiscal policies – means that the natural, equilibrating role of exchange rates that we discussed above gets completely neutered.

Think of it this way: As Germany gets more and more productive, the value of Greece’s currency increases, regardless of any changes in the Greek economy, because Greece and Germany share the same currency. The result is that countries end up with a currency that is out of sync with their real economies. Today, Germany has a currency that is weaker than the mark would have been in an alternative universe; and Greece has a currency that is stronger than the drachma would have been in an alternative universe. That’s because the value of the euro for each country is affected by economic conditions in the Eurozone as a whole, rather than economic conditions in its own domestic economy.

Now, you probably sense that this brings some instability, because it screws up the balancing function we talked about above. But it also brings some temporarily nice advantages. Germans, with their artificially weak currency, can persistently dominate export markets (i.e., because the weakness of other Eurozone countries prevents the value of the euro from rising to the point where it would make German manufactures uncompetitive in international markets) which brings it lots of growth, and high wages even in its manufacturing sector. Without the euro, such dominance would cause Germany’s currency to appreciate until its exports were only of average competitiveness in international markets.  And Greeks got to live the high life for a bit, enjoying nice foreign vacations, importing expensive wines, etc., because the euros they now carry are more valuable than the drachmas they would have carried otherwise.

And this is all pretty fine and well, for all parties, until some serious instability throws things off – in fact, in practice, the fun party lasted about 7 years.

So, what went wrong? How did the euro go from being a fun party to the thing in crisis, every day in the business section of every newspaper, for the past two years? Well, it’s actually very straightforward. In brief, there was that financial crisis you may have heard something about. As you know, this crisis caused a lot of turmoil and instability in financial markets, which then extended into the real economy via a credit crunch, causing many economies to slow their growth and suffer widespread unemployment. It also forced some governments to bail out major financial institutions. So combine all these factors: European governments’ expenditures go way up (due to bailouts, and social welfare and unemployment payouts), while its revenues go down (as the economy shrinks, the taxable portion of it shrinks as well). What do you get? Massive amounts of new debt (combined with few signs that the economy will bounce back quickly). Lots of debt. So much debt, in fact, that the international bond markets are unsure that these governments will ever be able to make good on their promises to pay the debt back. So what do international bond markets do? In order to compensate for the perceived risk that certain Eurozone governments will default on their obligations, investors demand higher interest rates on their loans. These higher interest rates, in turn, make the government debt burdens even worse, which makes investors even more nervous, etc., etc.

So the ‘Eurozone crisis’ is fundamentally just a regular sovereign-debt crisis – a downward spiral based on investors’ belief that a country won’t be able to pay what it owes. Debt crises used to be the domain of politically backwards Latin American countries. Now they are the purview of the first world.

What does this have to do with the Eurozone? Well, honestly, the problems of the euro itself – the currency union – are only tangentially related to how the euro crisis started. There’s a plausible argument to be made that the strength of the euro allowed weaker countries, such as Greece, to borrow more than they really should have, in the run-up to the crisis. Greece’s basic problem now is that it has to face up to the reality that it made pensions and benefits promises to public-sector workers that it simply can’t keep. Theoretically, being part of the currency union may have helped it make those false promises. But these are sort of tangential.

Rather, the real relevancy of all the monetary-union theory that we discussed above is that explains why this sovereign-debt crisis is peculiarly hard to get out of.

Normally, if your economy goes to hell, such that you risk a sovereign-debt crisis and other problems, there are a couple of things that will happen. First there’s a natural balancing: As your economy gets weaker, foreigners will be less interested in buying things from you, both because a weak economy means (tautologically) that your firms are less productive, and also because your financial assets will all look riskier. They’ll be less interested in what you’re selling and will try to sell off your currency. This looks bad at first, but it brings a blessing: Your currency depreciates, which suddenly allows your goods to be more competitive in international markets, giving a huge boon to your export-oriented industries; this also helps attract more tourists eager to take advantage of  Your Country on the Cheap. As your currency inflates and depreciates, the real value of your outstanding public debts decreases – which make them easier to pay off. And hopefully the boon to your export industries helps start a nice virtuous circle that can drag you out of your debt crisis. That’s all supposed to happen naturally for countries with separate currencies.

Beyond relying on this natural process, you can also use human artifice, via public policy. Your central bank can provide some monetary stimulus to your country or your government can do some fiscal stimulus. This is how it is supposed to work for sovereign countries.

But the Eurozone screws this up. Nobody can inflate and depreciate the currency for Greece, because the currency for Greece is also the currency for Germany, a country which is still really strong. The European Central Bank has to have a policy that makes sense for the Eurozone as a whole, rather than for the specific, idiosyncratic conditions of specific, idiosyncratic nations. So, today, Greece is saddled with enormous public debt, and has a strong need and justification for currency devaluation and monetary stimulus, but no ability to effect it. Greece has a limited ability to effect fiscal stimulus, too, because it has so much debt, and investors are unwilling to lend it even more money at an acceptable rate (which is the definition of a sovereign-debt crisis).

And this, dear readers, explains all the seemingly-contradictory commentary  we read in the newspapers—i.e., why half of writers are convinced the Eurozone needs to break up entirely, and half are convinced that they need further unification, with greater fiscal and political co-dependence.

The reason for this polarization is that both sides of the debate are taking different responses to a single truth—you cannot have a monetary union without a fiscal union. Insofar as you place distinct, idiosyncratic economies under a single currency union, you are depriving each of them of the ability to climb out of crises using monetary stimulus and currency devaluation. But crises happen, and countries must climb out of them. So if you’re going to have a monetary union, you have to make sure there is a way for suffering countries to get some fiscal stimulus. But those countries can’t do it on their own when they suffer a sovereign-debt crisis. So you need your currency zone to also be fiscally and politically unified, so that weaker countries can get funding for stimulus projects using the good credit of the stronger countries.

In a sense, there are two defensible equilibria: (1) a world of sovereign states with sovereign currencies and (2) a currency union with near-total political and fiscal unity. Half and half doesn’t work.


Here’s a helpful way to look at things: In a sense, the U.S. is like the proposed New Eurozone with fiscal and political unity. We have some really productive states—in the northeast corridor, California, the and Midwestern metropolitan areas. And we have some really unproductive states—Alabama, Mississippi, Louisiana, etc.. But because we have a single currency, and a single central bank (the Federal Reserve), the poor, unproductive states can’t simply devalue and inflate their currencies in order to help themselves out. Instead, they get artificial fiscal stimulus in the form of transfer payments and spending paid for by the federal government, hence by the country as a whole. New York pays relatively more money in taxes to the federal government; and Alabama takes relatively more money out through Medicare payments, infrastructure spending, military salaries, etc. So the U.S. is like what the Eurozone would be if Germany were to constantly and willingly make transfer payments to subsidize Greece.

Why do Americans from richer states put up with this? A few reasons: (1) Because we’re a political union, a lot of these transfer payments are concealed, such that voters don’t know about them (i.e., military spending, in practice, is a lot like a big transfer payment to the South, but we don’t think of it that way—we think of it as spending for The military); (2) Politicians don’t like to publicly beat up on the poorer, less well-educated parts of the country; and (3) Americans from richer states might actually just be okay with the transfer payments, since we conceive of ourselves as a nation – a single people.

And those three facts point to why turning the Eurozone into a political and fiscal union as well looks so unlikely: The transfers wouldn’t be quite so concealed. And people wouldn’t be happy about them. Rich Americans can be persuaded to feel good about paying out to poor Americans. It’s harder to sell rich Germans on the idea of paying out to “lazy Greeks.” Alas, even in the digitized, cosmopolitan 21st century, national cultural identities persist.


So where do I stand?

Well, I wish the euro never came into being in the first place. I’m pretty skeptical of the efficacy of fiscal stimulus (though this is, admittedly, a politicized opinion). Expenditures that are intended to be a short-term stimulus end up creating permanent constituencies, and are hard to be rid of. Consistently relying on fiscal stimulus leads to a host of long-term problems from a burgeoning state that becomes more and more entwined with business. Monetary stimulus is much better; but it requires that distinct economies have distinct currencies and central banks. Besides, over the past decades, financial innovation has radically lowered the transaction costs associated with doing business and travel across borders with distinct currencies. And so I’m skeptical of the idea that, in the 21st century, the euro zone’s currency convenience  is really bringing huge benefits. But it brings obvious costs. On the whole then, I think the world today would be a better place without the euro.

But even though the euro was a bad idea in the first place, now that it exists, the costs of exiting might be greater than the costs of staying. Germany might just have to accept that, in return for the benefits it gets from having a nice artificial boost to its export industries, it will need to more or less permanently subsidize Greece, just as New York today subsidizes Alabama. Unwinding the Eurozone could cause instability and uncertainty that would be more costly than the costs of this subsidy.

A final, radical note: I’ll go further than just saying that Europe would be better off without the Euro. Indeed, our comparison to the U.S. still holds: I’m not sure it’s obvious that America wouldn’t be better off with multiple currencies. Right now, we have a situation in the U.S. in which richer, coastal and heavily urbanized, states are doing a lot to fiscally subsidize the economically dysfunctional South. This monetary union and fiscal subsidy has arguably deprived the South of the opportunity to develop an economic niche in low-cost, export-oriented industries. It has also subsidized sclerosis, and arguably postponed the South’s dynamic transition to a 21st century economy. Maybe America would be better off today with separate currency regions. The idea of a ‘dollar-zone’ breakup is, of course, wildly implausible—never going to happen. But I think it’s pretty illuminating that this might theoretically be the best thing to do.

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