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The Euro at 20: Dysfunction by Design by Sven R. Larson

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The Euro at 20: Dysfunction by Design

The Eurotower in Frankfurt am Main by Marco Verch, CC BY-2.0.

In the first part of our evaluation of the euro 20 years after it was minted, we demonstrate that this currency, the largest economic experiment in modern history, has failed. It was born from excessive confidence in the ability of government to reconfigure the economy to its own liking; it is ailing thanks to the same excessive confidence. Only an end to said confidence can bring the experiment to an end.

The euro itself is only part of the failure. An entire structure of government institutions, laws, and even constitutional provisions were erected around it in order to secure its success. It all looked impressive two decades ago; today, the structure itself, from the European Central Bank (ECB), to the so-called Stability and Growth Pact, is a package of sordid evidence that even under democratic governments, central economic planning is a bad idea.

All it took was one recession

It only took one economic recession with widespread budget deficits across the euro zone for the ECB to abandon tight money and price stability. However, the policy surrender of the Central Bank is only part of a systemic failure of economic policy across the European Union. The other big failure became apparent when the EU put the Stability and Growth Pact to work during the recession a decade ago.

As a direct result of its economic failure, the European Union today is economically stagnant, with high and persistent unemployment, perennial government budget problems, and rising inflation. Rather than climbing to the economic top of the world, the EU consistently lags behind the U.S. economy in terms of employment and growth on gross domestic product, GDP. 

These metrics are often overlooked in terms of their importance for our daily lives. If the euro zone had enjoyed the same economic growth rates from 2009 to 2019 as the U.S. economy did, then by the end of that period the Europeans would have had almost 9% more money to spend, adjusted for inflation. 

That is no small potatoes for families living paycheck to paycheck. It can be the difference between a vacation at home and travel to see friends and family. It can be the difference that allows a young couple to buy their first home. Higher growth results in lower unemployment, as is evident in American labor-market statistics

Plainly, high economic growth can be a life-changing factor for many people. It also means more tax revenue: government can provide more funding for health care, education, social benefits, law enforcement, and infrastructure, without raising taxes.

Over the past 20 years, the euro-zone economy has not even averaged 1.5 annual percent GDP growth. The U.S. economy has managed to grow almost a full percentage point faster. With its low growth rate, the euro zone has effectively been trapped in a state of economic stagnation, and a major reason is the economic architecture of the EU itself. 

EU relied on prominent economic theory

When the Union was constructed, its constitution and accompanying statutes assigned concise, even rigid goals to specific forms of economic policy. To start with fiscal policy—taxes and government spending—it was given the role of stimulating economic growth. The member states of the European Union were supposed to keep interest rates low by balancing their government budgets. Low interest rates make it more affordable for businesses to invest and expand.

Monetary policy, under the jurisdiction of the European Central Bank, was going to keep inflation low by means of tight money supply. Lastly, the role of promoting full employment was assigned to labor-market policies in the individual member states, which would secure flexibility and a great deal of latitude for employers. This in turn would guarantee strong labor supply and wage stability.

This economic architecture did not come out of nowhere. It was derived from an economic theory known as New Classical Macroeconomics, NCM. This theory emerged in the early 1980s and has dominated economics since then; the authors of the EU Constitution, first the Maastricht Treaty and then its Lisbon Treaty sequel, clearly paid attention to the wisdom of New Classical Macroeconomics. 

The theory says that government cannot affect the business cycle and should instead concentrate on promoting long-term economic growth. Government makes its best contribution to the economy by keeping interest rates low by means of a balanced budget. 

Unfortunately, there was one part of the NCM that the European Union failed to incorporate. For the theory to work, government must be so small that its finances never disrupt the business cycle. Yet as we saw during the Great Recession, which hit the world economy in late 2008, large governments in Europe—many with large deficits already going into the recession—upset the plan for a new way to govern the European economy. 

Flawed design

To see how the recession exposed the flawed economic structure of the EU and its currency union, we first need to understand how that very structure is built. In addition to the ECB, its central feature is the Stability and Growth Pact, which is written into the EU Constitution. Its core features are a cap on government debt at 60% of GDP and a similar cap on the annual deficit at 3% of GDP. 

Every EU member state is bound by these caps, but they have thus far only been meaningfully enforced within the euro zone. There is an important reason for this: the Stability and Growth Pact is an auxiliary institution to the European Central Bank. When governments balance their budgets, they minimize the risk that investors, on the sovereign-debt market, might lose faith in sovereign debt. If they were to lose that faith, they would sell off the debt, and almost automatically shed large amounts of euros. This would cause interest rates to rise and the euro to lose value against other currencies. 

To counter such a rise in rates, the ECB would have to break its vow not to print money to help debt-ridden governments. Therefore, it is essential to the stability of the euro that governments balance their budgets. If they do, implies NCM, the outcome would be high economic growth and low unemployment. 

That did not happen. A review of Eurostat public-finance statistics shows that every year through 2017, a majority of EU member states ran a budget deficit. Those deficits were often in excess of the 3% cap imposed by the Stability and Growth Pact. 

During the Great Recession, which emerged in late 2008 and bottomed out in 2010, almost every member of the EU ran a deficit. For the Union as a whole, budgetary shortfalls equaled 6% of GDP in both 2009 and 2010.

In 2009, Ireland, Greece, and Spain all ran deficits in excess of 10% of GDP. Latvia, Lithuania, Portugal, and Romania all exceeded 9% while the French, Polish, and Slovakian deficits climbed above 7% of GDP. 

This led the EU to enforce the Stability and Growth Pact, hence the austerity era. Governments with runaway deficits cut spending and raised taxes in varying combinations, all with the goal of bringing their budgets into balance. In some countries, like the Czech Republic and the Netherlands, the austerity packages were relatively mild; in others they were very serious with far-reaching economic consequences. 

Flawed policies

It was during this period that the European Union demonstrated how inept its economic architecture actually is. Two policy goals came into direct conflict with one another:

  • On the one hand, the ECB was supposed to manage a common currency for most of the EU member states, with its prime goal to keep money tight and inflation down;
  • On the other hand, the EU mandated its member states to exercise fiscal responsibility and keep their debt in check, thereby securing strong economic growth. 

The deep recession led to economic stagnation, even shrinking GDP, and excessive budget deficits. The Stability and Growth Pact, which was designed to promote growth, now demanded that governments resort to fiscal tightening in the midst of a deep economic slump. Higher taxes and, to a lesser degree, cuts in government spending exacerbated the recession by depressing consumer spending and business activities.

In other words, the economic policies that were thought to promote economic growth were now holding back the economy. Due to persistently slow growth, the expected budget recoveries took their sweet time. As the fiscal problems dragged on, investors in the sovereign-debt market began losing faith in some of the most debt-ridden governments. As a direct result, interest rates on government bonds began rising; at one point they exceeded 20% in Greece.

Deteriorating confidence in government debt could rapidly translate into a global sell-off of the euro. To prevent this, the ECB decided to enter the scene with accommodating monetary policies and purchases of government debt. 

The Central Bank’s commitment to buying government debt reversed the worst of the crisis. Interest rates subsided and eventually fell. However, this was a temporary fix, not a permanent policy solution. As governments across the EU fought their deficits, taxes went up to where they were directly harmful to the economy. According to Eurostat data, if taxes on the EU economy had been the same in 2014 as they were a decade earlier, its households and businesses would have kept an extra €250 billion—in that year alone.

The ECB walked itself into a trap

Since the improvement in government finances came at the cost of economic growth, the ECB was now trapped in a monetary policy for which it was not constructed. Governments across the euro zone had shown that they were unable to maintain fiscal balances without help from the Central Bank. 

To not mince words: the ECB had walked itself into a trap, set by the Stability and Growth Pact, where its monetary expansion was necessary to prevent investors from abandoning the euro.

Despite the money printing, budget problems have prevailed. We don’t even have to look at the recent pandemic: as of 2019, according to Eurostat, ten EU member states ran budget deficits and had done so for at least three consecutive years. Seven of those were euro-zone members: Belgium, Finland, France, Italy, Latvia, Slovakia, and Spain. These were years when the global economy was operating at the height of the business cycle, and yet almost half the euro-zone member states were unable to fully fund their governments.

The dysfunctional economic design of the European Union and the euro zone is not just visible from the practical viewpoint. There is quite a bit of academic research exposing it (references are listed below). Some contributions demonstrate how the incentives to budget balancing in the Stability and Growth Pact have also discouraged long-term economic growth (Beetsma and Debrun 2004, Della Sala 2005, Moro 2008). It has also been shown that tight focus on budget balancing leads to unsustainable budget problems over time (Buti et al. 1997, Combes et al. 2014). 

After 20 years with the minted currency, the euro zone and the EU as a whole have been trapped in a policy gridlock of balanced-budget enforcement and monetary expansion. The result is slow economic growth, high unemployment, and persistent government budget problems. This policy gridlock is hard to break; one suggested solution is to centralize more fiscal policy to the EU itself. This was predicted already when the euro zone was born (Buti and Martinot 2000), and subsequent arguments have been made both against this idea (Mackiewicz 2007) and in its favor (Palley 2017). 

The problem with more EU powers is that they increase government involvement in an economy that evidently has already had an overdose. The only rational way forward is to gradually decentralize EU powers, to let member states conduct their economic policies as they see fit, and to eventually dissolve the euro zone itself.

Sven R. Larson is a political economist and author. He received a Ph.D. in Economics from Roskilde University, Denmark. Originally from Sweden, he lives in America where for the past 16 years he has worked in politics and public policy. He has written several books, including Democracy or Socialism: The Fateful Question for America in 2024.

References:

Beetsma, Roel, and Xavier Debrun. “Reconciling Stability and Growth: Smart Pacts and Structural Reforms.” IMF Staff Papers 51, no. 3 (2004): 431-456.

Buti, Marco, Daniele Franco, and Hedwig Ongena. “Budgetary Policies during Recessions Retrospective Application of the ‘Stability and Growth Pact’ to the Post-War Period.” Louvain Economic Review 67, no. 4 (1997): 321-366.

Buti, Marco, and Bertrand Martinot. “Open Issues on the Implementation of the Stability and Growth Pact.” National Institute Economic Review 174 (2000): 92-104.

Combes, Jean Louis, Alexandru Minea Lavinia Mustea, and Mousse N Sow. “The Euro and the Crisis: Evidence on Recent Fiscal Multipliers.” Revue d’Économie Politique 124, no. 6 (2014): 1013-1038.

Della Sala, Vincent. “From Resource to Constraint? Italy and the Stability and Growth Pact.” Italian Politics 21 (2005): 123-138.

Mackiewicz, Michal. “Making the Stability Pact More Flexible: Does It Lead to Pro-Cyclical Fiscal Policies?” Fiscal Studies 28, no. 2 (2007): 251-268.

Moro, Domenico. “The Stability and Growth Pact in the European Monetary Union.” Proceedings. Annual Conference on Taxation and Minutes of the Annual Meeting of the National Tax Association. 101 (2008): 248-259.

Palley, Thomas. “Fixing the Euro’s Original Sins: The Monetary-Fiscal Architecture and Monetary Policy Conduct.” PERI Working Paper Series 431 (2017): 1-20.

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