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Part II -The real reason for euro zone collapse: heterogeneity of euro states

, October 17, 2012, 0 Comments

The first article of this Two part Series

Historical differences in economic institutions jeopardized the Euro currency

Is it not strange that Europeans do not have the same vision of economy? Just as in India, there are different political sensibilities in Europe: liberals, socialists, communists, nationalists, ecologists. Is Indian democracy – much bigger than Europe – more capable of obtaining a consensus?

The answer is affirmative because we have a federal state. But there is another explanation. In fact there are big differences in economic systems of the states in Europe, much more than in India. For instance, let us consider European financial measures to be applied at a national level: encouraging credit or taxing the national economies to reduce national public deficits.

Because of different historical trajectories, the banking systems, the housing loan system (based on real warranties, or on mortgage on buying price, or mortgage on estimated selling price), the tax system (including VAT, corporate taxes, separate taxation of the rich and the civil servants…), the savings system, the social protection system (beweridgian or bismarckian, or both, or private) etc… are different.

As a consequence, when you suggest a global tax level in all Europe, it will not have the same impact everywhere, accept if you build a unique tax system… which would be a huge work and a big battle since every nation would wish to impose its system.

When you want to encourage credit at a European level, each country needs to adapt it and it is hard to obtain the same result everywhere, would you try to be as equal as you wish.

We cannot perceive it from India: in India economic conditions are different but the credit, banking or tax system is the same, built as one during the British rule or at the time of Independence. You would be surprised to see how systems are so different on such a small territory in Europe(even among one nation sometimes), and how neighbouring countries can be ignorant of the reality of the system in other European countries!

Consequences of these differences can be very serious, let us take the example of inflation rate, the main obsession of the ECB, the reason why debt is such a huge problem. Some countries have export oriented economies and the companies there need credit to invest and have a better performance abroad, whereas others, like France, have a younger domestic market and need credit for consumers.

In a country where you have a greater elderly population nearing retirement and who can save more than in a younger nation, it is normal that you need to have higher real interest rates to remunerate savings than in a country where people are young and need to borrow in order to build their lives and to consume.

Northern European nations (Germany,Sweden, the Netherlands, even Poland) have older populations than France,Italy or Spain, or even Greece. Yet, more credits mean more inflation, especially if the credit system is not fast enough.

In my opinion, one of the main mistakes of the ECB leaders is to think there should be only one same low inflation rate all over Europe(they wish economies were more homogenous, so they do as if it was!).

What they don’t see is that there is no problem in higher inflation rates in Italy or Spain, compared to Germany: it is still low but adapted to the (younger) structure of the economy that needs credit to work.

In India all the country is young; the “natural” inflation rate is obviously higher than in Europe! And it doesn’t prevent our economy from being fit!

Apart from the reason why credit is needed in those European countries, the other point is the liquidity of the credit system. In a country where the credit system is well developed and quite liquid, in a system where business law is well developed and where companies can recover their credits form other companies fast enough, it is normal that you have lower inflation rate since there is no friction in the system of credit and payment among companies.

Unlike Northern Europeans states, it is well known that in France, Italy or Spain, justice (including for companies) is very slow. For these reasons, inflation rate is structurally lower in Northern countries (no need for companies to inflate prices to compensate the problem of short term payments).

Moreover credit – and in the recent years, consumer credit[i] multiplying consumption in the US or Europe in the recent years – has  been developed earlier and faster in Northern European states than in southern countries. As a consequence, the credit system is much more efficient and liquid.

For all these reasons, the “natural” inflation rate is structurally higher in southern Europe. Let us insist: there is no problem with a higher level of inflation in itself[ii]: it is still low but adapted to the structure of the economy that needs credit to work.

Those divergences in a different “natural” inflation rate (that should be accepted among EU countries) are hard to consider from India where the whole country is more homogenous in one way: young, and same credit system, everywhere!

Such consequences can be important for the Euro zone.

Principles of the euro zone are that there is a unique independent monetary policy from the ECB aiming at containing inflation, but different national budgetary policies from each state as long as they respect the two rules of the Stability and Growth Pact: no public debt should be over 60% of GDP; no public deficit should be over 3% of GDP.

When the Euro zone was experiencing prosperity identical rules for all countries were fine. But in turmoil, things have changed. For instance, the fact that there is only one ECB interest rate to fight against inflation in the Euro zone while there are 12 inflation rates! The interest rate is an average one.

If fixed for average level, it will be too low for countries that are not much indebted and that need money from their credit and banking system to finance investments of their companies. It is not low enough to prevent indebted countries to slow their credits and borrowings in an economy that runs too fast and overheats.

Another point for instance: the 60% of GDP in debt of countries. Some countries have efficient fiscal systems, other do not. Some countries have fiscal systems that are efficient in prosperous times but that collapse in terms of returns when the economy gets worse. Is this unique 60% goal appropriate[iii] when countries have different efficiency in collecting taxes?

The fact that there is no head at the supranational level makes another problem. How would you measure the goodwill of the governments towards Europe? While some are from the left wing, others are from the right wing, and then it changes.

Some governments change very often, others just do not have governments for months. Some are led by presidents and others by the parliaments. Some have short term elections, others, longer reform perspectives.

And those changing national leaders come to Brussels to speak for their country and try to make a common decision while political views and leaders inside countries keep changing. In India, the Federal government gives the direction for all India, even if there can be differences among states: no state can go in a different direction as long as the Federal level is concerned.

In Europe,Greece can go into the opposite direction,Italy can change 2 or 3 times its direction because of short term elections, while France radically changes its direction depending on the personality of the President.

As you can see, heterogeneity of the European national economies and institutions not only makes it hard to make decision to have effective economies everywhere, but also jeopardizes the Euro currency in times of crisis, increasing both inflation in indebted countries and recession in low activity countries.

It explains why Germany– more afraid of inflation because of its old population and its historical trajectory – want to convince Spain from not using the ECB facility for as long as possible.

Federalism or the collapse of Europe?

Then, since differences in the economies is the root cause of the problem, the only way to overcome this heterogeneity without cancelling it – while respecting the historical trajectories and institutions, and be efficient at a supranational level – seems obvious: federalism, federal solidarity and federal rules for Europe.

Unfortunately, it is not possible in the foreseeable future, all the more because the crisis does not seem to be abating.

Does that mean that the Euro zone will not survive? Does that mean that Indian investments in Europe are endangered? I don’t think so. The weakness of Europe comes precisely from the strength of each country. Each European country has a solid history – political and economic.

Of course, as Indian investor, one must avoid sectors touched by the consumption crisis (over national discourses for electoral objectives, one can see that all European governments are heading towards austerity – easier to do nationally, even if the financial markets wish concerted recovery measures so hard to obtain with such different national governments) but the sectors which are protected from cyclical consumption turmoil are not endangered.

Financial sector in most countries is sound and even in very good health, not suffering from the crisis. I would even say that investments in Greece are not endangered in the longer term.

I am sure that the political strength of each country, its wish to be a strong part of Europe can hold together the system in the short term and can make miracles in terms of decision making towards more economic solidarity, not because it is politically moral but because it is economically more efficient than the end of the Euro currency.

Recent months’ political reactions all over Europe have proved this point.

European federalism is not for tomorrow, but collapse of the Euro currency is not for tomorrow either. We, Indians, should not fear for our investments in Europe.

The first article of this Two part Series

[i] Southern countries like France,Italy and Spain are Latin and catholic countries. Following Weber’s thoughts, we must here highlight that wealth was looked down upon the catholic religion. Being indebted was even worse. At least, you needed to have saved a bit of money to borrow on that money to complement the needs. This is the reason why consumer credit was discredited, then introduced only in the latest years, while it had been current in the US or Great Britain.

[ii] Out of the economic institutional differences, historical conditions can explain why Austrians or Germans are so concerned with the inflation rate. In the collective German memory, even unconsciously, high inflation refers to those terrible years after the 1929 crisis when Germany was the European country which suffered the most from inflation ; it led to Hitler’s access to power thanks to his promises to save the German people from economic disaster.

[iii] The first countries which did not respect the 3% public deficit limit were Germany and France at a time when the economy was growing. Some argued that those leading countries gave a bad example, and it showed the problem of the system: no fines for the countries that were not respecting the Stability and Growth Pact. Other economists mentioned that a proper system would have been to oblige governments to lower their deficit to 2% for instance in growth years to save for worse years where the limit could go higher to 4% of public deficit for instance. This identical limit whatever the year was not adapted, according to them.

About author
Laurence Dupré is Associate Professor of Economics and Management at Université Paris Est Marne-la-Vallée, member of the Research Center CEMI-EHESS and has been financial analyst at Fortis Securities France. She graduated at University Paris 1 Panthéon-Sorbonne, was a post-grad student at Trinity College Dublin, and a Phd student at Ecole des Hautes Etudes en Sciences Sociales, Paris. Her domain of research is mostly BRICS financial markets, cross-cultural communication and behavioral finance. ...more