OCTOBER
2011

 

By
Larry DeBoer
 
Professor of
Agricultural Economics
Purdue University

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10-27-11

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Europe Is Caught In-Between


The biggest threat to our economy these days comes from Europe. The Greek government borrowed a lot of money that it cannot repay. If Greece defaults the resulting financial crisis could plunge the world back into recession.

One of the reasons for the crisis is that Europe is caught in-between. European countries aren't independent. But there is no "United States of Europe."

There is a United States of America, so let's make a comparison. Suppose Indiana had made the same bad choices as Greece. Suppose our state ran huge budget deficits and borrowed a great deal of money for no productive purpose. Then one day lenders realize that we can't repay, and they stop renewing our loans.

Very quickly Indiana would stop running a deficit. We would cut spending and lay off workers. We would raise taxes. This would create hardships for taxpayers, public employees and business people who sell products and services to the government.

But Social Security payments would continue. So would Medicare, Medicaid and federal welfare. Our federal safety net would be untouched. This would support our economy and ease our hardships.

There is no European safety net for the people of Greece. Greek pensions and medical care are funded by the Greek government's budget. The budget-balancing threatens people's health care and income security. No wonder there are demonstrations and riots.

Suppose Indiana's economy dropped into recession while the rest of the country was doing fine. Unemployed people in Indiana could leave the state in search of jobs. Unemployment in Indiana would drop, reducing the economic hardships on migrants and remaining residents.

For the most part, the European Union allows free labor movement among its member countries. Unemployed Greeks can migrate to Germany in search of work. But Greeks speak Greek and Germans speak German. The language barrier is one reason that labor mobility in Europe is not what it is in the United States. This is one reason that unemployment in Greece stays high.

Now suppose that Greece was an independent country with its own currency, the drachma. The economic crisis would cause the exchange rate of the drachma to fall, so each dollar would buy more drachmas. This would reduce the cost of visiting Greece. Tourism would boom.

But Greece uses the European euro. So does Germany. Germany is one of the world's biggest exporters. To buy German exports, the world must exchange their own currencies for euros. This keeps the demand for the euro high, so its value stays high. The economic troubles of little Greece don't have much effect on the euro's value. There is no tourism boom in Greece because Germany doesn't need a low-valued euro to sell its exports.

An independent Greece could use monetary policy to stimulate its economy. The Greek central bank could increase the supply of drachmas, reduce interest rates, and encourage borrowing and spending. This would help the economy recover.

There is no Greek monetary policy because there is no drachma. The European Central Bank sets monetary policy for Europe, based on the needs of the entire continent. Greece may be in recession but Germany isn't, and Germany is a much bigger economy. The bank doesn't expand the money supply to match the needs of Greece.

Further, had Greece been independent, lenders would have considered the possibility of drachma exchange devaluation or monetary inflation. Both risks would have discouraged lending to Greece. Lenders wouldn't want to be earning interest in drachma if the currency's value could fall. The scale of the Greek crisis might have been smaller. But Greece has the euro, and lenders knew that Germany wouldn't allow much devaluation or inflation.

The European financial crisis is partly the result of the in-between economic integration of Europe. It's not a United States of Europe. There is no continent-wide safety net, and cultural barriers inhibit labor mobility. Its members aren't independent countries either. They don't have their own currencies so they can't adopt independent exchange or monetary policies.

Europe will have to come up with a plan to prevent a more severe crisis. That may be a step toward more European integration. If the plan breaks down, though, the alternative might be European dis-integration.

 

 

Writer: Larry DeBoer
Editor: Olivia Maddox