The consequence of fiscal austerity in parts of a monetary union3 May, 2012, 15:39. Posted by Zarathustra
Tags: Euro Crisis
Yesterday’s European PMIs and unemployment have, I think, painted a very clear picture of what austerity is like for the Europe as a whole. Just as Walter Kurtz described, the idea that the core of Europe can decoupled from the periphery is wishful thinking.
For the Eurozone, it is almost becoming a cliché to say that the design of the single currency is fatally flawed. One can frame the problem in different languages. For example, the lack of fiscal union, the lack of political integration, you name it. The fact that this single currency is used by 17 different countries with their own parliaments means that every country would hope to do something which appeal to their voters. That was how the Latin Monetary Union collapsed, essentially with countries cheating. That’s not hard to imagine. So we have seen governments collapsed all over Europe in the past year or two.
But what exactly is a “fiscal union” that actually solves the problem?
Imagine a closed economy, country A. There were two provinces in this country, the North and the South, with their own local government treasuries as well as a central treasury, with one single central bank issuing currencies. Let us assume that the South was permanently richer: the south was productive, they mad goods and export to the North, and thus running a persistent trade surplus with the North. As a result, the local government of the South ran budget surplus at the same time.
For the North, however, it is a complete mirror image: they were poorer, and instead of making goods, they were importing from the South, thus running a persistent trade deficit, and the local government of the North, inevitably, ran a budget deficit at the same time.
With the North running persistent trade and budget deficit, the South has to essentially help to plug that whole to maintain the state of affairs. Because they are in the same country, that does not appear to be a problem politically. So essentially the South has to use their own surplus to “subsidise” the North to import from the South. Yes, the South simply just give the North money to spend, and this is fiscal union.
Now, if the South was suddenly pissed off by the North, and decided that they would no longer give money away to the North for free, but to give loans and impose fiscal austerity. So the North had to raise taxes and cut spending. With that, other components of GDP like consumption and investment would have to fall, and not surprisingly the North will import less from the South, thus giving negative impact to the South’s GDP. At the same time, bear in mind that with government in the North tightening fiscal policy, the economy shrinks, and that does not help actually reducing budget deficit relative to its economy. And of course, with its negative impact on the South’s economy, the South’s government budget will deteriorate as well.
Perhaps the North would succeed one day in balancing the budget after crushing its people’s living standard and performing “internal devaluation” of wages and prices so that they are much more competitive now, and now they have a balanced budget and balanced trade with the South. But first of all, they have crushed the whole country, both North and South, into a depression. And as a closed economy, if the North finally ran balanced trade, all trade surplus for the South would have gone as well.
If we imagine for a moment that the Eurozone is indeed a closed economy, it is clear from the above thought experiment that the Eurozone cannot have all countries running budget surplus at the same time, and fiscal austerity in parts of the monetary union will cause contraction in the whole of the monetary union, and the so-called fiscal union will basically involves Germany giving money away to the peripheral countries for free, which they are not going to do.
Of course, Eurozone is not a closed economy. If the Eurozone as a whole can run a large trade surplus with the rest of the world, it is at least possible theoretically that all countries run budget surplus (or at least have balanced budget) at the same time. But of course, If the Eurozone were to run a large trade surplus with the rest of the world, the rest of the world will not be particularly thrilled. Think China, for instance.