The Euro: Federation or nothing

If today it is clear that the Federal government in the US has the responsibility and means to maintain full employment, one could argue that this was not always the case; in fact, the US Federal Government developed most of the programs and agencies by which it now intervenes in the economy when faced with a crisis similar to the one the Euro Area is now going through: the Great Depression. The US economy went on a free fall from 1929 to 1933, with the product falling more than a quarter and unemployment reaching a whopping 25%, similar to the levels reached by some of the periphery countries of the Eurozone in the present recession. Then, like now, the crisis affected some states more than others. In addition, despite some other obvious parallels, two other similarities in particular spring to mind: the youthfulness of both central banks - FED and ECB- and the fixed exchange regime (Gold Standard and the Euro).

Not surprisingly, current migration patterns: away from the periphery countries to the northern countries in the EU, resemble the great migrations of the Great Depression. But most important, for the sake of the argument defended here, is that economic governance was not all that different. If one can abstract for the moment of the obvious political differences- the US had a constitution and a democratic elected government-; on the economic side, the US federal government, as we know it today, with its multiple agencies and responsibilities, was pretty much in its infancy.

The Great Depression is often called a “defining moment” in the twentieth-century history of the United States. Its most lasting effect was a transformation of the role of the federal government in the economy. The long contraction and painfully slow recovery led many in the American population to accept and even call for a vastly expanded role for government, though most businesses resented the growing federal control of their activities. The federal government took over responsibility for the elderly population with the creation of Social Security and gave the involuntarily unemployed unemployment compensation. (…) All of this required an increase in the size of the federal government. During the 1920s, there were, on average, about 553,000 paid civilian employees of the federal government. By 1939 there were 953,891 paid civilian employees, and there were 1,042,420 in 1940.

 The series of programs and projects that were enacted after 1933 with the specific objective to bring the economy back from the brink would become known as New Deal. One of the most iconic pieces of legislation enacted at the time was the Glass–Steagall Act, which among others things created the Federal Deposit Insurance Corporation (FDIC), to address the banking crisis that afflicted the US at the time; in the same way that the recent approved Banking Union legislation in the EU is suppose to address the banking crisis in the Euro area. Furthermore, with the creation of the  Tennessee Valley Authority (TVA), one of the most controversial projects at the time, the federal government intervened directly in the economy to foster economic growth in the Tennessee Valley, which covers 7 states, that had been particularly affected by the Great Depression. Although the same problem is evident in Europe, with the peripheral countries suffering disproportionately with the Great Recession, no specific program of public investment has been designed to assist this countries and in its absence, it's hard to see how they will ever get out of the depression. 

Creating a Federal or Central government in the Euro area is the only solution if the Euro is to survive with the same number of members. In the short run, mired in recession the Euro area needs a "New Deal" to bring the economy back to life.  In the long run, however, the Euro area needs and effective system of financial equalisation, similar to that of the US, that takes on the role of the several national governments. The EU already works as a transfer union with a budget worth about 1% of the union’s GDP. Despite being too small, the budgetary process is already a constant source of disagreement. Every time there's discussion on the seven-year financial framework, the net contributors are set against the net recipients, with the former wishing to contribute less and the later always demanding to receive more. In the US the budgeting process is already crazy; just imagine if the net contributor states and net recipient states had to discuss how much each one had to pay/receive? Not only that, it gives as well the net contributors countries an effective power over the net receivers. 

In addition, despite some success stories, decades of Structural funds, the vehicles used by the EU to combat regional disparities, have not reduced regional disparities. Part of it is due to weak institutional framework on the part of the recipient countries but mostly has to do with the fact that more funds do not mean higher growth. A point is reached where returns begin to decline and additional funds do not lead to higher growth. Portugal is a case in point, as more than 25% of the €96 billion EU funds were spent building motorways that now are largely empty. It now has four times more kilometres of motorway per inhabitant than Britain and 60 per cent more than Germany. This boom has not only created severe imbalances in the economy but it also contributed to corrupt the country as the disbursement of the funds depends largely on the local governments and administrative machine, who try to maximize their short term gains without any regard for the future. A whole industry, full with advisers, lawyers and the like has flourished just to help companies and individuals to maximize the capture of funds despite the economics of the projects. Accountability is weak or non-existent as it relies on local laws and judiciary.

This is precisely opposite to the view expressed by Wynne Godley of how the government should work through common public provision and fiscal system:

"Another important role which any central government must perform is to put a safety net under the livelihood of component regions which are in distress for structural reasons – because of the decline of some industry, say, or because of some economically-adverse demographic change. At present this happens in the natural course of events, without anyone really noticing, because common standards of public provision (for instance, health, education, pensions and rates of unemployment benefit) and a common (it is to be hoped, progressive) burden of taxation are both generally instituted throughout individual realms. As a consequence, if one region suffers an unusual degree of structural decline, the fiscal system automatically generates net transfers in favour of it. In extremis, a region which could produce nothing at all would not starve because it would be in receipt of pensions, unemployment benefit and the incomes of public servants."

The transfer union should work mostly through the fiscal system, even if sometimes some programs might be designed to help specific regions. With a Central or Federal Government most of the transfers would occur automatically without any necessity for negotiations; and where specific programs are necessary, money would be disbursed through federal agencies, which would also be responsible for implementing and monitoring the programs. Money disbursed by an EU Federal or Central government should be governed by EU law, not local law as it is at the present. This would, off course, lead to the creation of a federal bureaucracy with much needed government jobs.

Anything short of a New Deal won't solve the problem and it would be better for the most affected countries to regain monetary sovereignty as Wynne Godley predicted it would happen if unemployment ever reached Great Depression levels:

"It should be frankly recognised that if the depression really were to take a serious turn for the worse – for instance, if the unemployment rate went back permanently to the 20-25 per cent characteristic of the Thirties – individual countries would sooner or later exercise their sovereign right to declare the entire movement towards integration a disaster and resort to exchange controls and protection – a siege economy if you will. This would amount to a re-run of the inter-war period."

It is puzzling that this has not happen yet. Part of it must be due to the origins of the crisis, and in particular the role of the Euro in it,  have not been fully grasped. Otherwise, how can countries sustain unemployment rates in excess of the 20% and watch their societies crumble without even considering the exit of the single currency as a possible escape route? The current narrative of the pre-crisis profligacy seems so entrenched that the only acceptable alternative is austerity. However, if the affected countries were to make all the "structural reforms" advised the unemployment would be driven to 50% or more.  The obvious fact the article below points out is that before the Euro Greece muddled through despite all of its idiosyncrasies:

"Until January 2001, Greece offset its utterly uncompetitive economy and unsustainable national debt by retaining its own currency, the drachma, which simply lost purchasing power each year. It was inflationary, unsustainable, but Hellas muddled by. Then, having moved most of its state debts off its balance sheet (aided by Wall Street’s brightest), Greece persuaded the rest of the European Union that it was fit to join the single currency, the euro. It has been downhill ever since. Grants flowed from Brussels for more or less anything. Much of that cash went astray, but the effect of suddenly having very low interest rates prompted a rash of speculative, highly leveraged investments to be made.

 Eleven years later, Greece’s banks are all effectively bust. No structural reforms have been made. And the Greek state cannot even service the debt on its interest. Unable to maintain competitiveness via currency deflation, the economy (led by the tourist industry) has crumbled. Real unemployment (government statistics are unreliable) is about 30 percent. Youth unemployment is 55 percent. To stay in the eurozone (and receive more bailouts), Greece must privatize the state-owned industries, fire half its civil servants, slash state pension provisions, and institute all the structural reforms needed.

That will push unemployment up to 50 percent. The soup kitchens of Athens cannot cope now. Under that scenario, society would crumble.

Mass emigration is already underway. Others are leaving the cities and heading back to a subsistence existence in the villages. The two old parties are hemorrhaging support to new extremist groups (including the Nazi Golden Dawn party). Will democracy survive?"

The same was truth of other Euro Area countries, such as Portugal, Spain and Italy. Maintaining their national currencies allowed Portuguese to be Portuguese, Greeks to be Greeks, Spanish to be Spanish, Italian to be Italian, Irish to be Irish, but also French to be French and still have a life. With the single currency, however, to have a life, it seems, they all must become German. The over indebted countries of the Euro Area are destined to suffer austerity without end and in the absence of a system of fiscal equalisation (federal government), as Wynne Godley predicted, this countries might suffer from a terminal decline and ultimately mass emigration:

"If a country or region has no power to devalue, and if it is not the beneficiary of a system of fiscal equalisation, then there is nothing to stop it suffering a process of cumulative and terminal decline leading, in the end, to emigration as the only alternative to poverty or starvation."

Unfortunately, due to a combination of ultra low fertility rates and mass emigration the population of some of this countries is already shrinking and some of them risk becoming totally unsustainable in the very short run. Although the demographic situation  is alarming in almost all the Euro Area countries, the mass migration from the debt stricken countries to the rich countries of the north is making the situation worse for the peripheral countries, where a growing older population is resting on the shoulders of an ever shrinking working age population and improving, at least temporary, the demographic situation of richer countries like Germany.

  

In the absence of a Union wide Social Security, this emigration pattern is just making the Social Security of the over indebted countries even more unsustainable that they already are while at the same time bringing some respite to the richer countries of the Union. Labour mobility within a monetary union suffering from an asymmetric shocks and without a fiscal equalisation mechanism, might lead to unsustainable migration movements, that put pressure both on the countries of origin and the receiving countries. In the US, let's not forget, there's a Federal minimum wage that effectively puts a floor on migration but in the Euro area there's no such floor and so there's nothing to prevent these countries from becoming emptied of young people. For the periphery countries, Portugal, Spain , Greece and to a less extent Italy, countries with high youth unemployment, the situation might become dramatic in a not so distant future if mass emigration doesn't subside.  

Portugal is a case in point as in the 60's it had the youngest population in Europe but due to low fertility and especially to high emigration, in particular since it joined the EU in 1986, has today one of the oldest population in Europe, if not the oldest as recent mass emigration numbers are not correctly reflected in the statistics collected. If the Portuguese public pension system would in normal times face challenging circumstances due to the already skewed demographics, with the the mass emigration of the recent years, it risks a complete collapse and with it the meltdown of its society.

Although the creation of a Federal government would be the obvious solution for the present Euro Crisis, this might not be in the best interest of all the individual countries. For the weaker countries, a monetary union, with or without a Federal Government, looks increasingly irrelevant if they are to survive at all as nations. In the face of the demographic nightmare they face, for some of the countries in the Euro area it would be better to get out of the monetary union altogether, so they could regain monetary sovereignty and try to jump start their economies to stop the exodus and in that way avoid the meltdown of their societies. Off course, there will be costs and these will not be small, but the cost of inaction is increasing by the day. Some of the countries cannot even afford the time that would take to negotiate and establish the Federal government. In any case, even in the best scenario, it is difficult to envisage the Euro area members integrating their pension systems and as a result, bankruptcy of the weaker countries could hardly be avoided. On the contrary, emigration might even intensify inside a Federal union and make a bad situation worse.

The expectation of many of the poorer countries in the EU is that at some stage they will converge with the richer countries of the Euro, as if making part of the club by itself will somehow lead them to have the same income of the other members but, as the last few years have shown, this is not guaranteed. In fact, some of the poorer countries have started to diverge again. Ultimately, they will not converge in the same way as Mississippi and other states in the US have not converged with the richer states of the union, even though they are the beneficiaries of an equalisation mechanism. In it's absence, this countries would be better off to reverse to their previous status as sovereign nations- similar to the UK or Sweden- that would give them a better chance to converge.