Wednesday, February 10, 2010

Crisis in Euroland

by Gary North

The euro is the focus of attention these days. This is because of a fiscal crisis in Greece, and looming crises in Portugal and Spain. Italy could follow.

What is the problem? Greece is running a huge deficit in the range of 12.7% of its Gross Domestic Product. The investment world regards a deficit of this magnitude as unsustainable. There are rumors of default.

Spain is running a deficit of 11.4% of its GDP. This is considered a threat to the nation's financial structure. There are rumors of default.

The United States government is expected to run a deficit of $1.6 trillion in an economy with about $14 trillion GDP. This means the deficit will be about 11.4% of GDP. Of course, this is seen by American economists as all right. After all, the United States is not Spain. Treasury Secretary Geithner assured the viewers on ABC News on Sunday, February 8, that there is no possibility that the rating on U.S. Treasury debt will ever fall below AAA. "That will never happen in this country." Unfortunately, he neglected to say whether it could happen in other countries, whose credit-rating agencies are not regulated by the United States government.

The euro is officially issued by the European Central Bank. This central bank acts on behalf of all 16 European nations that are part of the European Monetary Union. Non-members are Great Britain and Switzerland.

This system is now an aspect of the European Union, which has been in existence since December 1, 2009, when the Lisbon Treaty went into effect. Yet the legislatures of each of the member states of the EMU have independent fiscal policies. They do not control monetary policy, but they control taxes and spending.

Always before, monetary affairs have been conducted by central banks that represent central governments. The euro is an experiment in a central bank that officially operates on behalf of 16 nations.


In 2005, Milton Friedman commented on the problem facing the euro and Western Europe.

The euro is going to be a big source of problems, not a source of help. The euro has no precedent. To the best of my knowledge, there has never been a monetary union, putting out a fiat currency, composed of independent states.

There have been unions based on gold or silver, but not on fiat money – money tempted to inflate – put out by politically independent entities. (New Perspectives, Spring 2005).

His admission that there have been unions based on gold was significant. He did not pursue this, because he rejected the gold standard. He made his reputation as a monetary theorist for his opposition to a gold standard. He was a faithful disciple of the American theorist who was most adamantly opposed to the gold standard, Irving Fisher. Friedman's monetary theories were an extension of Fisher's.

Fisher believed in fiat money unconnected to gold. So did Friedman. Fisher saw a stable price level as the primary monetary goal. So did Friedman. Fisher was willing to accept central banking in principle, because he believed that central banks are more reliable than legislatures. So did Friedman. Fisher never came up with a theory of civil government or economics that showed how central banks could be trusted with control over fiat money. Neither did Friedman.

Friedman believed in the free market, but not a free market in money. He did not believe in a full gold coin standard that is enforced only by the law of contracts. On this point, neither do defenders of a traditional, government-run, government-guaranteed gold standard. The question always arises: How can citizens prevent the government from cheating? What protects them from a government's decision to allow commercial banks and central banks from confiscating the depositors gold? So far, there has been no answer, other than the usual one: defeat at the next election. But, because the confiscations happen during emergencies – major wars, economic breakdowns – the public meekly consents. Always. Friedman offered this criticism of the present arrangement in Europe. In an interview during the boom phase of the economy in 2003, he said this.
What's going to make the difference is the productivity of the different countries. But personally, as I say, I believe the Euroland is going to run into big difficulties. That's because the different countries have different languages, limited mobility among them, and they're affected differently by external events.

Right now for example, Ireland and Spain are doing very well, but on the other hand Germany and France are doing very poorly. The question is; "Is the same monetary policy appropriate for all of them?" Germany and France on one hand and Ireland and Spain on the other: it's very dubious that it is. That's why you're having increasing difficulties within the Euroland group. As you probably know Sweden, which had not joined the European Monetary Union, voted down doing so and will keep its own currency

He asked what he imagined was a rhetorical question: "Is the same monetary policy appropriate for all of them?" He answered no. That was because he was a fiat money economist.

The free market-based answer would be this: "There should be no monetary policy. There should be only the enforcement of contracts."

Friedman assumed that there must be economic policy. This begged the question: "Set by whom?" The various parliaments? The various central banks? A combination? He opposed a single central bank. He also opposed gold. He opposed a single European parliament. That put him in a dilemma. There is only one answer remaining: competing parliaments. This is what we have now. This system is not working.

In 1999, he wrote a letter to an economist. The economist used it and other sources to write a paper on Friedman's view of the euro. On March 9, 1999, he wrote:
As you know, I am very negative about the euro and I am very doubtful about how it will work out. However, I am less pessimistic about it now than I was earlier simply because I never expected that the various countries would display the kind of discipline that was required in order to qualify for the euro. The convergence in inflation rates, interest rates, and so on was greater and more rapid than I would have expected.
Still, he hoped the deal would not go through. He wrote on April 17, 1999,
What most troubles me as it does you is that members of the euro have thrown away the key. Once the euro physically replaces the separate currencies, how in the world do you get out? It's a major crisis. As a result, I would strongly agree with your view that the euro should be abandoned before January 1, 2002.

At the same time, the odds are very great that it will not be abandoned. The defects of the euro will take some time to show up; nothing happens very rapidly in this area. There are fewer than three years to go. Even if difficulties deriving from the euro occur in those three years, the political system is unlikely to react quickly enough to end the euro. As a result, I think it would be very desirable for some systematic thought to be given to devising some way to get out of the straitjacket of the euro after 2002. The least Italy should do is to keep intact the plates which are used to produce lira.
No nation got out. They all surrendered monetary sovereignty to the European Monetary Union and the European Central Bank.


The crisis over Portugal, Italy, Greece, and Spain – PIGS – continues to escalate. Because they have surrendered their monetary policy to the ECB, these nations are unable to inflate their way out of the fiscal crisis. This leaves the following options.

1. Default on some or all of their debts
2. Pay higher interest rates
3. Cut spending
4. Raise taxes
5. Withdraw from the EMU
6. Withdraw from the EU
7. Wait for a bailout by the ECB.
8. Choices 2-7

Read the rest of the article here.

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