The Myth of Market Convergence in the EMU

The EMU (shared currency across 17 member states of the EU) was created to remove the risk of devaluation and to embed the single market in Europe. It was assumed that market convergence in interest rates would lead to economic convergence. This was the fundamental mistake of the Euro.

A core insight of comparative political economy, working within a historical institutional framework, over the past twenty years is that ‘varieties’ of capitalism exist. What this means is that institutional and political differences between nation-states (and regions) produce divergent economic and employment growth patterns. Italy would never become Germany even within a currency union.

This reality was completely overlooked by financial markets. A one size fits all monetary policy did not lead to economic convergence (economies are always a complex relationship between labour market institutions, the state and market). It simply fuelled reckless investment, leading to credit and housing bubbles in Ireland, Spain, Portugal and Italy. In Greece it led to reckless fiscal policy by a successive corrupt governments. 2 years ago, the difference between Greek and German bonds was 2 basis points. It is now 22 points.

This is not to say that the problems in Ireland, Greece and Spain can be traced to external monetary policy, associated with the EMU. Domestic policy choices (particularly the laissez-faire approach to the housing and banking market) in all of these countries contributed to the crisis. But the general point is that convergence in interest rates fuelled rather than removed economic divergences within the Eurozone. This can be traced to institutions, culture and politics.

To pay the price for this ‘myth’ of convergence, the ‘GIICPS’ (Greece, Italy, Ireland, Cyprus, Portugal and Spain) are now being forced into radical retrenchment of the public sector whilst domestic bank lending has dried up. Hence, a simultaneous recession in the private and public sectors. None of which will solve the core problem of the Eurozone: a continued divergence in the economic and employment performance of north and south Europe.

Private cross-border capital flows have dried up in the Eurozone, leading to a significantly changed role for the ECB. The ECB is lending money (based mainly on German deposits) to Italian and Spanish banks. In turn these banks are using this money to buy the debt of their domestic governments. These banks are also imposing high interest rates in their lending to domestic small and medium-sized enterprises. It costs a Spanish SME four times the rate to borrow than a German SME.

Financial markets control the democratic states of weaker EMU countries. This can only be reversed by these countries either pulling out of the Euro currency or creating a fiscal transfer system within a United States of Europe. Both options will cost the German taxpayer. The German government needs to be honest with the electorate about this. But neither an exit from the Euro or a United States of Europe will solve the employment and economic crisis of Ireland, Italy, Greece, Spain, Portugal and Cyprus.

It is time for policymakers to approach comparative political institutional scholars rather than neoclassical economists for solutions. A one size fits all ‘market’ solution will simply fuel political discontent within Europe.

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