What went wrong with the euro?

David Aaronovitch: not guilty

Peter Oborne’s campaign against the pro-Europeans took another step yesterday with his online debate with David Aaronovitch.  The latter was one of the targets in his recent book “The guilty men”, and the Centre for Policy Studies hosted an exchange of views between them on its website.  (Read the exchange here.)

The terrible state of the Greek economy and the adverse consequences this has brought to many members of the eurozone forms the basis of Peter Oborne’s denunciation of people who thought it would have been a good idea for Britain to join.  Some of them have since recanted (see Danny Alexander on the subject here) but others stick to what they believed.  It is not an easy case to make, given the news everyday, but it is a case that remains worth making.  Things have gone wrong with the euro, sure, but they are not the things that are commonly portrayed.

We start with Greece.  It is clear that Greece has lost competitiveness compared with Germany over the past ten years, and has been unable to readjust by lowering its exchange rate.  (Graham Bishop suggests that Greek “compensation” (on an EU standard measure) has grew by around 6 per cent per annum, compared with 4.5 per cent per annum in the UK and 1.5 per cent per annum in Germany.)  But is that loss of competitiveness really the cause of the problem?

No, the real problem is that Greek consumption exceeded its output.  High wages are fine if they are earned, but not if they are not.  Thanks to the fixed exchange rate, Greece was unable to adapt to this unearned growth in compensation by devaluing its currency by the appropriate amount, but it was a failure of politics, not economics, that saw Greece spurn the other means of adjustment.

Such an adjustment would have meant confronting the money illusion, the fact that people tend to think about sums of money in absolute terms rather than relative to prices, but isn’t the point of politics not to give in to human nature but to mitigate its worst consequences?

In Greece, this did not happen.  The era of the drachma had made it relatively easy to devalue and inflate away the real value of debt, allowing for borrowing to maintain consumption levels beyond the actual level of production.  This habit continued for the first few years of euro membership, but in the end, though, the external discipline of euro membership has forced Greece to confront its excess consumption rather than, to coin a phrase, kicking the can down the road.

Membership of the euro forces a country that does not produce enough to recalibrate its material expectations of life.  What conservative could possibly disagree with that?

But it is not only Greece that has spent the last ten years consuming more than it has been producing, and using borrowing to cover the gap between consumption and production.  Step forward the United Kingdom, and take a bow.

British government borrowing grew from 29.7 per cent of GDP in 2002 to 36.5 per cent in 2008, before the crash hit.  (We will allow that extraordinary times required extraordinary measures after Lehman Brothers had collapsed.)  Those years were the good years, when Prudence would have been paying off government debt, not increasing it.  Private borrowing soared even more astonishingly, from 63 per cent of GDP in 1995, via 85 per cent in 2002, to 100 per cent now.

Overall, that means that the UK was consuming perhaps 4 per cent more than it was producing, and borrowing to cover the gap.  This during a time of peace and normality.  That was the moment when wisdom would have made savings, not borrowed unnecessarily.  The prosperity of that time, helping the British feel justified in having stayed out of the euro, was to a considerable extent an illusion.

Outside the euro, we have been able to devalue our currency to try to escape some of the consequences of this excess.  Since August 2007, the pound has lost 20 per cent of its value against the euro.  (Note that the policy of devaluation started a full year before the collapse of Lehman Brothers; Northern Rock was the trigger which revealed how bad was the British economic strategy at that time.)

But what does devaluation entail?  It means higher inflation and reduced living standards at home, it means creditors deprived of the full repayment of their loans abroad.  And a conservative welcomes this?

The problem of the euro is not one of economics.  It is one of politics.  The thought was that membership of the euro and the loss of the possibility of devaluation would force national governments to bring order to their national finances.  In effect, that is what Greece and Italy are doing now.  Nobody envisaged that the problem would get this bad before it was dealt with – the low interest rates of the eurozone seduced politicians into thinking that they had more freedom of action than they really did.  The failure was a failure of political thought, that did not adapt to the integrated economy that eurozone member countries were now part of.  It was not merely the design on the banknotes that had changed, it was also the whole framework of macroeconomic policy.

The political failing was to continue to fund consumption without earning the money to pay for it, and to think that that was all right.  The Greeks thought it and they were wrong, the Italians thought it and they were wrong, and the British thought it and they were wrong.

I don’t think any British supporter of the euro should feel the need to apologise to those eurosceptics who thought that the rise in house prices was a good thing, that Britain was on a separate and attractive economic path, that boom and bust had been abolished.  British economic policy was just as misconceived as that of Greece or of Italy; the difference now is that those latter two countries have friends in the eurozone who are going to try and help them out.  Can Britain make the same claim?

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