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Why the Euro Will Fail

What is the fundamental flaw in the European Monetary System?

February 13, 2002

What is the fundamental flaw in the European Monetary System?

Under the rules of the euro road, sanctions exist to discourage any single country from running budget deficits. In particular, the 12 countries in the euro zone must keep their deficits below 3% of their gross domestic products or be subject to very hefty fines — as the deficit-spending Germany is now painfully aware.

The purpose of such a policing mechanism seems at first self-evident. Budget deficits are inflationary. Any one country that runs chronic deficits will ultimately weaken the underlying individual fixed exchange rate parities between the other countries’ currencies upon which the euro was originally based.

However, the failure Europe’s system to clearly distinguish between a “structural” budget deficit and a “cyclical” budget deficit is a potentially serious flaw.

A structural budget deficit exists when a country is operating at full employment, but its government still spends more than it receives in tax revenues. In such a case, the country is clearly living beyond its means — and must either raise taxes or cut spending to bring the structural budget deficit back into balance. This is precisely the kind of budget deficit that the euro deficit cops want to discourage.

In contrast, a cyclical deficit is that portion of the budget deficit that results when a country’s economy is at less than full employment, that is, in a recession. In such a case, recessionary forces reduce tax revenues through lower income and profit taxes. “Automatic stabilizers” in the form of increased welfare and unemployment benefits also kick in — and exacerbate the expenditure side of the ledger.

Now here’s the counterintuitive punch line: In the presence of a cyclical deficit, the appropriate remedy is not to raise taxes — or cut spending to eliminate the deficit. In fact, such a contractionary “remedy” will actually worsen the cyclical budget deficit — by deepening the recession. Instead, a country facing a cyclical deficit should either increase spending or cut taxes to stimulate the economy back to full employment.

Historically, world leaders have had a hard time grasping this crucial distinction — often with disastrous results. Consider, most famously, President Dwight D. Eisenhower’s situation back in the recessionary days of the late 1950s. The United States was running a large budget deficit — but it was totally cyclical in nature.

Eisenhower’s Vice President Richard Nixon was deeply concerned that a stagnating economy would make him vulnerable in the upcoming 1960 Presidential election. He thus vigorously advocated an expansionary tax cut to stimulate the economy. Mr. Eisenhower, however, wanted to balance the budget before he left office and rejected such a tax cut for fear it would balloon the deficit.

Absent any stimulus, the economy limped into the Presidential election season, John F. Kennedy seized on the slogan, “Let’s get the country moving again” — and Kennedy squeaked by Nixon in one of the tightest Presidential races in history.

The irony is that — if Eisenhower had listened to Nixon and cut taxes — the result would not only have been strong economic growth. Eisenhower also would have left office basking in the glow of a budget surplus of about $5 billion. This is because the additional economic growth would have generated billions of dollars of additional tax revenues and eliminated the cyclical deficit.

Interestingly, a very similar fate befell President George Bush in 1992. Prior to the election, the budget deficit had soared to over $200 billion. Part of this deficit was purely structural in value. But as the Bush economy sank further into recession, the cyclical portion of the deficit ballooned. Rather than engage in a stimulus, Bush demurred — and wound up losing to Bill “It’s the economy, stupid” Clinton.

On Tuesday, February 12, 2002, the euro cops debated this very question with respect to that supposed paragon of fiscal responsibility, Germany. After three straight quarters of contraction, Germany’s budget deficit has risen to 2.7% of GDP — perilously close to the 3% cap. If it violates that cap, Germany would face fines of up to 10 billion euros — a new kind of reparations that might have similarly disastrous consequences.

After all, Germany’s deficits are clearly due far more to a stagnating economy than any profligate spending. But, although the European Commission stayed away from delivering a formal warning to Germany, it still expects Germany to work towards a balanced budget by 2004.

That means that, although the immediate pressure of a fine is off the table, Germany may yet be forced to adopt contractionary policies that will both worsen its recession at the same time that they swell its cyclical deficit.

More broadly, this kind of excessive deficit “cure” is a recipe first for economic stagnation and then for political turmoil. Indeed, from the perspective of many euro bashers, it’s bad enough that a common currency takes away an individual country’s ability to engage in discretionary monetary policy to address rising unemployment. It’s far worse if the budget deficit policing mechanism for the euro actually worsens any recession. Accordingly, the euro’s budget cops would do well to heed the crucial distinction between structural and cyclical deficits.