Economics: the failure of European monetary union has been abject

ΠΗΓΗ: GUARDIAN

by Larry Elliott

When he was leader of the Conservative party, William Hague once likened membership of the euro to being trapped in a burning building with no fire exit. It was an apt description, as young people in Greecewould testify: in a country that has already contracted by more thanGermany did during the Great Depression, the jobless rate for Greeks under 25 is 55%.

Little wonder then that Antonis Samaras, the prime minister of Greece, is warning that his country has been pushed to the limit and that there is, as with Weimar Germany, the risk of democracy collapsing.

Little wonder, either, that Spain, only just behind Greece in the youth unemployment misery stakes, is wary of seeking the help offered by theEuropean Central Bank. Unlimited buying of Spanish bonds by the bank will come at a heavy price: more austerity for a population already buckling under the strain.

A study of hundreds of recessions dating from the 19th century shows that most are short, sharp affairs. They are like heavy colds, nasty but quickly over. Every now and then, however, the cold turns into something much more serious and the longer it lasts the more serious it gets.

It becomes more like a pandemic, affecting the immune systems of economies and spreading from one country to another. That is the situation in the eurozone today.

Activity is collapsing in Italy, is weakening fast in France, and has started to falter in Germany. Unemployment in the eurozone is at record levels as the recession starts to feed on itself. Collapsing demand leads to company failures, adding to the bad debt problems of already weak banks. These, in turn, call in loans and make credit harder to find. Government finances suffer, increasing pressure on finance ministries to find additional savings. Another chunk is taken out of demand, making it more difficult to cut budget deficits and the national debt.

Europe's malaise is affecting the entire global economy. It is hampering an already tentative US economy and may result in Mitt Romney becoming US president. It is leading to slower growth in China, which in turn is leading to heightened trade tensions.

The eurozone has experienced weaker growth in the past decade than Japan did in its lost decade of the 1990s. The gap between the rich and poor countries has widened rather than narrowed. Before long, one in eight working age people will be on the dole. Flows of inward investment to what is increasingly seen as an economic backwater are starting to dry up. The failure of monetary union has been complete and abject.

In business this would not matter all that much. Enterprises fail all the time. The commercial world – with the egregious exception of the "too big to fail" banks – is run on empirical principles: companies that work tend to survive and thrive, while those that don't fall by the wayside.

The single currency does not operate by empirical principles. If it did the plug would already have been pulled on it. It is a top-down project, with a lineage stretching back to the Enlightenment, in which technocrats come up with what they see as a blueprint for happiness: clear, rational and beautiful. When the blueprint does not deliver the expected results, that is not the fault of the plan.

As made clear this year by the ECB president, Mario Draghi, the future of the euro is not open to negotiation: Europe could have a second or even a third lost decade and it would make no difference to those who think it the last word in modernity.

A second lost decade is certainly in prospect. The International Monetary Fund's World Economic Outlook tells the cautionary tale of British economic policy after the first world war, which was similar in many respects to the way the eurozone manages affairs today. When the guns fell silent in November 1918 the UK found the national debt had ballooned to more than 140% of GDP and prices were double their pre-war level. The government had two priorities: to return the pound eventually to the gold standard at its 1914 exchange rate and to cut national debt.

The upshot was that both monetary policy (interest rates and the exchange rate) and fiscal policy (taxes and spending) were kept tight. Interest rates were raised to 7% in 1920 and throughout the 1920s the Treasury ran primary budget surpluses (excluding interest payments on the national debt) of nearly 7% of national output.

Just as in the eurozone today, great store was put on the notion of an internal devaluation. Britain had become less competitive but could price itself back into global markets through cuts in wages and prices. But as the IMF study notes: "The combination of tight monetary and tight fiscal policy, aimed at significantly reducing the price level and returning to the pre-war parity, had disastrous outcomes.

"Unemployment was high, growth was low, and, most relevant, debt continued to grow. Although the price-level reduction the UK was attempting to achieve was larger than anything likely to happen today due to internal devaluation, similar dynamics are evident."

In some respects, the policy regime in the eurozone today is far less draconian than in 1920s Britain. Short-term interest rates have been cut, the ECB has flooded the financial system with cash and it will buy sovereign bonds, albeit with strings attached.

In other ways, though, it is the gold standard with knobs on. The standard was, in theory at least, a self-stabilising mechanism, since those countries that ran trade surpluses accumulated gold. This led to an expansion of credit, which in turn led to higher inflation, a drop in competitiveness and a narrowing trade surplus. Today's euro has no such mechanism to force the biggest creditor nation (Germany) to run down its colossal surpluses.

The gold standard collapsed in the 1930s amid great economic pressure and Britain was the first country to leave. For those who view the euro with almost religious reverence, the idea that monetary union could go the same way is inconceivable.

Let's hope they are wrong. The best thing for Europe would be if the euro were smashed to smithereens, allowing countries to devalue and impose capital controls. It would still be painful but at least they have the ability to boost their economies and pay down debts more slowly. The alternative is to sit and watch the flames lick higher.