The Eurozone Economic Model on its Twentieth Anniversary: Is it Working?

15 March, 2019 | Posted By: Jim Leontiades

Not very long ago the economic performance of the currency union known as the Eurozone appeared promising. Member countries clearly gained benefits from the adoption of the euro.

More recently signs are appearing that is cause for concern, Italy is in recession. Germany was very close to one only a few months ago and the Greek economy is shrinking. In a reversal of previously stated policy the European Central Bank has loosened credit in an effort to stimulate the economy. Is the Eurozone moving toward another recession before having completely recovered from the previous one?  

Over the past two decades, the Eurozone has changed substantially. The removal of currency barriers has been supplemented by the creation of institutions, laws regulations and other features reinforcing the union between member countries.   

There is no formal economic model for the currency union but there are a number of relatively stable features which are fundamental in influencing and understanding its economic performance. These can qualify as features of what might be termed its “economic model”.    

They are the following:

Absence of internal exchange rates: By definition, national currencies have been eliminated between the member states of the currency union. This has brought with it substantial benefits. However, it also has other economic implications. For example, trade deficit countries within the zone do not have recourse to exchange rate variation to help correct trade deficits. Their only remaining mechanisms for correcting such imbalances are austerity and internal devaluation (deflation). 

National Debt Rules: The Euro’s “Stability and Growth Pact” limits national debt to 60% of GDP and annual deficits to 3%.  Euro countries which exceed these limits are subject to sanctions. The aim is to avoid the risk of inflationary pressures and other problems which can be caused by high national debt. This limits the perils of excessive debt. It also limits the ability of member governments to use fiscal policy to counter economic downturns. 

The Tax system: The Euro system of taxation relies on the value added tax (VAT) as a major source of government revenue. VAT has certain advantages, particularly for countries with a common currency. But, it is a regressive tax, its incidence falling most heavily on those who spend the largest portion of their income on consumption, i.e. the lower income groups. Its “regressiveness” increases during recessions. Those with  lower incomes have less flexibility to reduce their spending.  

Persistent Regional Differences: Within any common currency region there will be a difference in relative economic performance and prosperity. The more prosperous regions act as magnets, attracting resources (investment and labour) from the less prosperous members, e.g. migration of Greek labour to Germany in search of jobs.

To offset this, central authorities will try to shift resources to the less prosperous regions. For example, in the USA the central government is able to mitigate this effect by investing substantial resources in the less prosperous states (e.g. Mississippi). This includes investment  in education, government installations, roads and infrastructure etc. The EU is less able to do this due to the small budget available to the EU Commission, some 1% of EU GDP compared to that of the USA central government’s 24% of GDP. This points to persistence in such differences with the possibility that the gap between more and less prosperous member countries will widen.

Export orientation:  Whatever economists may say to the contrary, there is a deep-seated feeling among many Eurozone countries that trade surpluses are good. The Eurozone enjoys a persistent trade surplus which is not evenly distributed. The main surpluses accrue to  Germany,  Italy, France and the Netherlands.

These  benefit from the “averaging “ of the exchange rate of the euro with the lower exchange rate indicated by the weaker trade performance of other member countries. For example, Germany, currently with a record high surplus at 8% of GDP has the advantage of an exchange rate lower than if it were trading outside the Eurozone as a single country. Member countries with a weaker trade balance, like Greece, are disadvantaged by a Euro kept high by German export success.

Dependence on the European Central Bank: The Eurozone has displayed a marked reluctance to use fiscal measures, such as.reduced taxation or government spending to combat a slowing economy. This has led to dependence on the European Central Bank and its president Mario Draghi as the main source of Eurozone actions to counter recession and deflation. His policies on interest rates, quantitative easing and credit expansion have more than once been instrumental in overcoming major economic problems.

Economic conservatism: A philosophical conservatism permeates much of the Eurozone’s economic thinking. Its conservative bent on fiscal matters is institutionalized in the EU’s “stability and growth pact” as indicated above. More generally, it is demonstrated as well in the frequently voiced opposition to a Eurozone central budget or a Eurozone-wide bank guarantee scheme. Inevitably, it also influences and constrains the policies of the European Central bank.

It is this point of fiscal conservatism that has been most keenly questioned and the issue on which Eurozone policy has been at odds with the economic views of some of the world’s leading economists. These have openly expressed less concern with national deficits and favour more emphasis on proactive government spending to offset recessionary tendencies.  Both views have advantages and potential problems.

Those arguing for a more proactive approach point to the Eurozone’s unsatisfactory economic growth. For some time now.  Europe has been identified as having the slowest growth among the world’s developed economies. Its inflation rate remains well below the ECB’s 2% target.  Unemployment, though falling, is still relatively high at 7.8% in the Eurozone as a whole. For some individual countries, unemployment remains at recession/depression levels e.g. Greece at 18.5% and Spain at 14% (youth unemployment at.39% and 32% respectively).

Who is right? The upsurge in government spending and debt advocated by critics advising a more aggressive fiscal stance has its own dangers.

Economists may argue but only time and economic performance will give the final verdict.  Perhaps 20 years is still too short a period to pass judgment.