The Euro zone is a monetary union, or a group of independent states that agreed in 1992 (with the Maastricht treaty) to adopt the same currency, starting from 2002.  Having the same currency is equivalent to adopting a regime of fixed exchange rates within the union or, in other words, it is equivalent to adopting the gold standard within the union.  For the individual states this has entailed not only loss of control over their exchange rates, an important tool of economic policy, but also over their monetary policy and, as a consequence, over their fiscal policy. Three enormously penalising constraints are hidden in one apparently simple agreement.  No wonder that this monetary union has turned out to be an unmitigated disaster. I will examine the loss of monetary and fiscal policy first, then the loss of floating exchange rates, and then finally how these self-imposed constraints played out in real life: by giving rise to a perverse boom and bust cycle called ‘Frenkel cycle’.


In order to achieve and maintain convergent exchange rates between the member states, the monetary policy of the Euro Zone has been centralised.  The member states have had to give up their ability to create money, which has been taken over by the European Central Bank (ECB) and the national central banks are no longer independent, they have become branches of the ECB.  While monetary policy is exclusively in the hands of the ECB, fiscal policy remains in the hands of each individual national government, therefore fiscal policy is separated from the currency.  From this point of view the Euro zone states are like the US states, but without the benefits of having a federal government to support them.  This has created a peculiarly dysfunctional situation, in which the member states have individually retained all their financial responsibilities, but at the same time have lost the most important instrument to fulfil them: monetary sovereignty.

In order to understand the implications of this arrangement, it is useful to make a comparison with the US states.  The main similarity between the two monetary unions is that the individual states are in both cases users, not issuers of the common currency.  However, there are two key differences:

  1. A) US states are not responsible for major expenditures such as defence, social security, health care, natural disasters, and economic disasters like the bail outs of financial institutions.  In the USA all of those responsibilities fall under the purview of the issuers of the national currency, the FED (the central bank of the USA) and the Treasury.  The Fed is actually prohibited by law from directly buying Treasury debt, but it can always buy it back from the secondary market to keep interest rates low.

It is true that the ECB can do similar operations to keep interest rates down, and it has done so more and more after 2012.  However, individual states have no control over the ECB. For all practical purposes, the Euro is a foreign currency for them.

  1. B) While the US states can and do rely on fiscal transfers from Washington, which controls a budget of more than 20% of GDP, the Euro zone member states have only an underfunded Parliament with less than 1% of GDP


The US states are required to submit balanced budgets.  When a US state runs a budget deficit, it faces the possibility that credit rating agencies will downgrade its debt, meaning that interest rates will go up.  This could cause a vicious cycle of interest rate hikes that increase debt service costs, resulting in higher deficits and more downgrades.  Default on debt becomes a real possibility. Economic downturns cause many state and local governments to experience debt problems, triggering downgrades.  This forces them into austerity.


Euro zone members are in the same situation (but with the additional problem that they don’t get any transfer payments form the central government): unable to create money, their Treasuries have to get from taxation or from the financial markets all the money that they spend.  The consequence is that they have no control over their interest rates and that they are constantly at risk of default, both circumstances tending to keep interest rates high, with constant risk of snowballing debt and constant pressure from the financial markets, especially when there is an economic downturn.

To reduce the possibility of downgrades of their credit ratings, the Euro zone states agreed under the Maastricht treaty, which instituted the single currency, to adopt restrictions on budget deficits and debt issue.  The guidelines were that member states would not run budget deficits greater than 3% of GDP and would not accumulate government debt greater than 60% of GDP.  This means that they have to implement austerity measures all the time, in other words, they have lost control over their fiscal policy.  However, these criteria have been persistently violated, because they entail a structural permanent stagnation of the economy.

The paradox is that, given the peculiar arrangements of the Euro zone, in which the member states: a) are responsible for major expenditures (defence, social security etc.), b) don’t issue their currency, c) don’t get transfer payments from the central government, these economic parameters are actually far too lax.  It is true that with these criteria government spending is insufficient to keep a healthy level of aggregate demand (= to maintain a healthy economy), but since these states are essentially spending and borrowing a foreign currency, the Maastricht criteria permit deficits and debts that are inappropriate.  This can easily be understood from a comparison with the US states: none of the US states’ debt even reaches 20% of GDP, less than 1/3 of Maastricht criteria. A mixture of austerity, default on debt, and Federal government fiscal transfers keeps US state budget deficits more or less under control.   By contrast, Euro states had, in the run up to the 2008 crash, much higher debt ratios (most of them between 80 to 120% of GDP), with only Ireland coming close to the US states ratios at around 30%, followed at a distance by Spain (40-50%) and Portugal (65%).

It is true that none of these debt ratios would be too high for a sovereign government that issues its own currency: Japan’s debt ratio is 200% and its interest rates have been close to zero for two decades.  But they are far too high for nations that use a foreign currency.


The FED routinely purchases US government debt as necessary.  The ECB is prohibited from such automatic cooperation with member states.  This is a design feature, to ensure that no member state would be able to use the ECB to run up budget deficits financed by ‘keystroke’ created money, but it is also a necessity, to keep their trade deficits in check. This lack of support from the central bank results in the financial markets acquiring an inordinate amount of power to decide interest rates.  Only fairly recently (since October 2012), has the ECB intervened more and more often to keep interest rates down, but this has always been conditional on the member states adopting austerity measures.   This is an often overlooked consequence of having a single currency:  imposing austerity is necessary not so much in order to keep government debt and interest rates under control (as the ECB can ultimately take care of this problem by buying the government bonds of the member states), but by the more stringent need, for those countries with an overvalued currency, to keep trade deficits under control.  This is because the countries with a less efficient economy run persistent trade deficits with their more efficient partners and, in absence of the re-balancing mechanism provided by the devaluation of their exchange rates, the only way to reduce their trade deficits is to reduce their internal aggregate demand.  In other words, they need to reduce the spending capacity of their peoples as the only way to prevent them from buying imported goods, because the value of their currency cannot adjust to rebalance trade.


It is now time to introduce the other main aspect of a currency union: fixed exchange rates. The Euro is a ‘one size fits all’ currency for the 17 countries of the Euro zone, and it is undervalued for the more efficient countries (Germany, The Netherlands, Finland  = the Centre ) and overvalued for the less efficient ones (Portugal, Ireland, Italy, Greece, Spain and France = the Periphery).


The exchange rate is a ‘price’ (= the price of the currency of a country) mechanism which, when allowed to fluctuate, permits countries to stay competitive in the international markets.  This is how it works: if the products of a country are not very competitive, in other words if their prices are too high compared to the competition (and this can be due to various reasons, but mainly low productivity or comparatively high wages) the country will end up importing more than it exports, thus running persistent trade deficits.  The consequence is that its currency will be in high supply in the international money markets (as the country pays for its imports) and over time it will tend to depreciate.  This will make its products more competitive as they become cheaper for consumers with stronger currencies.  At the same time, foreign goods will become too expensive for its population, and there will be a substitution of imports in favour of locally produced goods.  The combined effect of reduced imports and increased exports will tend to eliminate the trade deficit.  The reverse happens if a country’s products are too competitive (its currency will be in high demand, it will appreciate, and its products will become more expensive for foreign buyers). The exchange rate is the only instrument governments have nowadays to defend themselves against the shocks caused by globalisation (In the past they could also use tariffs and quotas to contain imports, but these instruments have been eliminated). If, for example, the competition from emerging markets greatly reduces a country’s exports, currency devaluation can be of great help in defending its industry.

On the other hand, in a monetary union, which is a regime of fixed exchange rates, if a country has an overvalued currency, the impossibility of currency depreciation is bound to lead to a process of de-industrialisation:  firms will gradually disinvest from tradable goods (that is, goods that can be imported and exported) which are exposed to competition from cheaper imports, and increase their investments in non-tradable goods.  The most obvious example of non-tradable goods is the construction of buildings, which by their nature are not subject to foreign competition.  Therefore the first consequence of fixed exchange rates for less competitive countries is de-industrialisation and an unbalanced (no longer self sufficient) economy, with an excess of non-tradable goods.  The other related consequence is the appearance of persistent trade deficits, which over time pile up into a stock of debt with foreign countries, which has to be serviced.  The only way for a country to contain de-industrialisation and trade deficits would be to reduce wages in order to reduce the costs of production and thus reduce the price of its products in order to increase exports, and most Euro zone countries, pushed by the EU authorities, have adopted this policy.  However, when every country pursues this policy at the same time, it results in a race to the bottom which further depresses internal aggregate demand, leading the economy, already depressed by austerity, into a downward spiral, with further contraction of GDP and further de-industrialisation.


In 1992 (the date when the Maastricht treaty was signed) began the preparations for the introduction of the single currency.  During this time the less efficient member countries had to engage in restrictive monetary and fiscal policies in order to bring their currencies into some kind of convergence towards a middle-of-the-road rate of conversion of their currencies into the newly created Euro, with the result that the new currency was overvalued for the countries of the Periphery and undervalued for the countries of the Centre.  This caused an erosion of the industrial base in the Periphery, on an unprecedented scale.  Just to give an example, the proportion of tradable goods produced in Portugal fell from 22% of GDP in 1992 to 14% in 2008.  It is a very rapid process of de-industrialisation, which has no parallels in the past.


To sum up the structural problems caused by a monetary union:  the loss of control over the creation of money and the fixing of the exchange rate results in the necessity for the member states to constantly implement austerity measures and to cut wages in order to keep both budget deficits and trade deficits in check.  In other words, there is a structural tendency in-built in a currency union towards a state of permanent economic stagnation or even depression.  The only member states able to escape this dire necessity are those with net trade surpluses.  However, within a union a county’s surplus is another country’s deficit:  the remaining states, unable to use either monetary or fiscal policy to stimulate their economies, are condemned to a state of permanent stagnation and de-industrialisation.


There are, in theory, two solutions to avoid this unsustainable situation and make a currency union work.  They are two alternative ways of obtaining the same result, recycling money from the  countries with trade surpluses to those with trade deficits:

1) creating a fiscal union to act as the spender of last resort with a ‘federal’ budget of at least 20% of GDP, financed in part by money created by the ECB, in part by transfers from the rich countries to the poorer ones.  This is how the USA operates.

2) the countries which are running trade surpluses could take it upon themselves to adopt loose monetary and fiscal policies and thus act as spenders of last resort for the entire union, by increasing  the salaries of their workers and their government spending, thus generating demand for the goods of their partners, and also generating internal inflation, which realigns their real exchange rate vis a vis the other member states.

However, EU policy does not favour price and wage inflation and, moreover, Germany (the main country with a trade surplus) never showed any inclination to follow this policy anyway.  Quite the opposite: its mercantilist trade policy has resulted in persistent pressure on the other partners to keep wages and government spending down.


Against a backdrop of stagnation and de-indstrialisation in the periphery, German policy makers and business leaders, instead of cooperating with their partners along the lines described above (solution 2), chose early on to engage in competitive wage devaluation, in order to enhance both their profits and their position within the Union.  In 2005 the Social Democratic government passed a comprehensive reform of the labour market (known as Hartz reform) that made possible for employers to reduce wages, benefits and job security.  This reform was indirectly subsidised by the government (in violation of the treaties) with an increase in social spending to integrate the wages of many low paid workers.  At the same time German industry upgraded its machinery to increase productivity.  As a result, in spite of reasonably high (although decreasing) living standards, Germany has become a low cost producer in Europe, allowing it to run consistent trade surpluses with the other Euro Zone partners in the run up to 2008.  Effectively Germany was able to keep its budget deficit low and its private sector debt low (about 50% lower as a ratio of GDP compared to the Euro zone average) by relying on its neighbours to keep the German economy growing through exports, while at the same time its neighbours were building up unsustainable debts.  This is a zero sum game, and it lasted long enough to do serious damage only thanks to financial deregulation.


As neither of the two possible solutions described above was implemented, and as Germany acted to exacerbate the imbalances for its own advantage, the only reason why this currency union has lasted so long, was due to a major factor coming into play: the freshly deregulated financial markets.  They provided a temporary fix, up to the crash of 2008.  The integration and de-regulation of the financial markets across the Euro zone, which started with the signing of the Maastricht treaty, permitted the instauration of a perverse mechanism:  banks giving reckless loans across countries, made possible both by the fact that there was no risk of currency devaluation (which is equivalent to debt devaluation, or partial default) between the countries of the Euro zone, and by the fact that the common institutions made the recovery of the bad debts by the banks much more likely. Essentially the financial system provided a subsidiary (though unsustainable) recycling mechanism in absence of fiscal transfers or accommodating policies from the Centre.  The money accumulated in Germany as a result of trade surpluses was recycled by French and German banks into (reckless) loans mainly to private citizens of the Periphery, loans that were used mainly to buy German goods or to inflate housing bubbles.  This is the only way that the system could have functioned relatively smoothly for a number of years.  Without these loans the countries of the Periphery would soon have run out of money.



This perverse mechanism is not new, as it has taken place again and again, starting from the early 80’s, in many countries that experienced financial collapses.  It is called ‘ Frenkel cycle’ after the Argentinian economist who first studied it extensively, and it is the Third World version of the Minsky cycle  (described also in the book ‘Modernising Money’ p. 129-139).

The Minsky cycle is a boom and bust cycle generated endogenously in developed countries, due to excessive creation of credit money and financial instruments which act in a pro-cyclical manner, creating bubbles in times of economic growth and high expectations and then a sudden credit stop when expectations become more pessimistic, causing the bubbles to burst and the economy to enter a deflationary spiral.  The financial collapse of 2008 is an example of it.

The Third World version of this, the Frenkel cycle, is caused by an exogenous factor, the pegging of the currency to a stronger one (for example Argentina pegged its peso to the dollar).  This pegging has the same effects of a monetary union, and it means that a country, in order to make itself attractive to the financial markets, gives up control over its exchange rate, thus eliminating the risk of devaluation.  Fixing the exchange rate involves, as we have seen, giving up control over monetary and fiscal policy as well (with all its consequences for government debt and interest rates). Coupled with the de-regulation of the financial markets, this sets the stage for a perverse sequence of events:

1) Credit flood and booming phase – the country is now attractive (or creditworthy), for the financial markets, because it has a fixed exchange rate, thus eliminating the risk of devaluation for its creditors.  As a result, a flood of cheap credit comes from the international financial markets to the country in question, mainly in the form of mortgages and consumer credit.  Interest rates go down, aggregate demand goes up, resulting in high employment, high level of tax revenues for the government, but also rising prices, and often the starting of a housing bubble.

2) Distortion of the economy/de-industrialisation – over time this flood of money causes inflation in the country.  As its exchange rate cannot be adjusted (= it cannot be devalued to compensate for the higher prices which drive up production costs and the prices of its exports), its currency becomes overvalued, this causes de-industrialisation and consequent loss of GDP, which often gets compensated by a construction bubble (most notably this happened in Spain and Ireland).   As a result of these distortions to the structure of the economy, the credit money now finances mainly imports (in the Euro Zone imports of German goods) and the housing bubble.  Trade deficits increase (in Portugal & Greece they were about 10% of GDP per year), foreign debt starts to pile up and interest rates start to rise.  It becomes evident that the debt is not sustainable as there is no expected GDP growth to service it.  (The only sustainable foreign debt is when it serves to finance infrastructure or other investment which increases productive capacity, resulting in an expected increase in future production and income, out of which the debt can be serviced).

3) Snowballing debt and financial collapse – The combination of high foreign debt and high interest rates start to set off a snowballing effect on the level of debt.  Creditors start to get nervous and sell their positions.  As soon as a major external event (such as the 2008 financial collapse) happens, a credit crunch with a deflationary spiral (=a rush to sell assets in order to repay debts, which results in lower and lower asset prices) sets off, leaving people and banks with negative equity (=market value of assets lower than the relative debts).

4) Bank bail outs, austerity and economic collapse – As the economy is full of people/businesses with negative equity, the banks become full of bad loans and potentially bankrupt. Typically the country bails out its banks with money provided by the IMF (in the Euro zone a combination of IMF, ECB and a mutual public fund called ESM), so the creditor banks recover all their money and escape all responsibility for their poor risk management, while the debt, which was born mainly private, becomes public.  The IMF takes on the role of debt collector of last resort and imposes austerity to get its money back from the taxpayers.  Austerity causes economic stagnation and, if prolonged, outright depression, with snowballing of the public debt and further asset deflation, as the county is forced to sell off its assets in a vain attempt to stave off default.  There is no alternative to this policy for as long as the exchange rate is not allowed to float again (or for as long the country stays in the Euro).  Going back to a floating currency is the only solution, as it allows the indebted country: a) to re-denominate the debt in its devalued currency, thus giving foreign creditors a haircut), b) to resume exporting, in order repay the remaining foreign debt and c) to create debt-free (or Positive) money in order to stimulate an economic recovery while keeping interest rates on the public debt at a low level.  The longer a country delays this step, the longer it will remain trapped into the austerity/de-industrialisation/deflationary spiral, with the necessity to sell off both public and private assets in order to pay for its snowballing debts.  It is lethal to stay in this phase of the cycle.

5) Back to a floating exchange rate – eventually the country goes back to its un-pegged currency, but in the meantime assets (both private and public) and industries will have been lost…


Phase 1-2 (2002-08) – In the run up to 2008, aggregate demand in the Periphery of the Euro zone was generally sustained with debt money coming from the Centre, in part financing government debt (mainly in Greece), but for the most part financing private debt. In most of the Periphery, not unlike what was happening in the USA and the UK, private debt was very high.  In some cases in fact, such as Spain and Ireland (and Portugal to a lesser extent), private debt was much higher than government debt, which was very contained, for the simple reason that the money necessary to run the economy was provided by the financial markets in the form of cheap consumer credit.  In these countries private debt money kept the economy in a booming condition, with high tax revenues, hence low government debt.  In Greece both public and private debt were high.  Generally speaking, where private debt was low (such as in Italy and Portugal to a lesser extent) then government debt was very high – at least one of the two had to be high, in absence of positive (=debt free) money created by the central bank. In Italy there was no boom and bust cycle, the country entered a prolonged phase of stagnation, as the decreased production in tradable goods, due to an over valued currency, was not compensated by an increase in non-tradable goods (in the form of a housing bubble).

Phase 3 (2009-12) – In the aftermath of the financial collapse of 2008, the countries with low government debt (Ireland and Spain), had to bail out their banks, thus converting private debt into public debt.  As a result, all countries now were faced with high public debt, and in the public discourse (dictated by the media), public debt became the culprit of all ills.  The countries of the Periphery, all with increasing trade deficits and high public debts started to be considered unsafe, and a wave of market panic was unleashed, with downgrades and interest rate hikes. This did not happen to states with much higher debt to GDP ratios, like the USA or Japan.  (These countries never face strong market reactions, and even when the rating agencies occasionally downgrade their debt, their interest rates don’t tend to be forced up, because they have their own floating currencies). However, it needs to be highlighted that the financial markets did not react simultaneously against all member states, because there is a desire to hold Euro-denominated debt, as the Euro is a strong currency and much of the world wants to buy European exports.  So markets ran out of Greece and Ireland first, and then of the other countries of the Periphery.  Since Germany is the strongest member and by far the biggest exporter, it benefited the most from a run against the Periphery as the interest rates on its debt decreased, while the interest rates on the other countries’ debt increased.  Normally if a country was considered too big to fail its interest rates would not increase as much.  So the countries that were targeted first and foremost were the small ones.  But the main thing to be noted is that the ECB did nothing until October 2012 to defend the weaker countries (or the larger ones) from default scares and predatory interest rate hikes.  Unlike the Bank of England or the FED, the ECB stood by, let the debt grow and made sure that austerity measures were implemented across the board.

Phase 4 (2012- present) Only when the situation became completely unsustainable did the ECB governor Mario Draghi come up with the famous ‘whatever it takes’ speech in July 2012 (4 years after the financial collapse!) and later in the year the ECB started buying government bonds of the member states when needed, thus ensuring substantial decreases in interest rates.  However, the financial help that the ECB has been giving since then, comes only in very small doses, barely sufficient to keep the economies of the Periphery and the monetary union itself from falling apart, and this help is conditional upon ever more austerity (indispensable, it’s worth reminding, to contain trade deficits) and privatisation measures being passed.  The only result achieved by this type of intervention is keeping the EU countries longer and longer in stage 4, and the suspicion arises that strong interests behind the ECB are inspiring this policy, so that the financial markets and transnational corporations may continue profiting from further de-industrialisation, from the selling off of competitor businesses and from privatisations of public assets/infrastructure/services that are of interest to them.

This may not be the only factor at play: the hegemonic power, the USA may be pushing behind the scenes to keep the union together (for geopolitical reasons), hoping that the succession of crises will force the member states to finally become a proper federation (in the image of the USA), while at the same time Germany is pulling in the opposite direction, in pursuit of its own interests.  This may be an additional explanation for the devastating stalemate. Time will tell.

Phase 5 – when?  –  CONCLUSION

The current stalemate, with all its damaging effects, is nothing but the expression of a dis-union in terms of political will that has always been the trademark of the European states.  Whatever solution will be eventually implemented (probably a dissolution of the monetary union), this will be the result of a political decision.  But it is important to understand that in strictly economic terms a currency union by its very nature cannot work unless there is a recycling mechanism (formal or informal) from the more competitive regions to the less competitive ones.  No doses of austerity and wage repression can solve these inherent structural problems. In reality austerity and wage repression only aggravate the problems, but they also operate a transfer of wealth from the majority of society to the rich elite that controls money and debt in the West.  Therefore what is at play is not just conflict between nation states, but also between social classes.