The Death of Money (17 page)

The second part of the efficient labor pillar of the Berlin Consensus is
labor mobility.
As long ago as 1961, Robert Mundell highlighted its importance to a single-currency
area in his landmark article “A Theory of Optimum Currency Areas”:

In a currency area comprising many regions and a single currency, the pace of inflation
is set by the willingness of central authorities to allow unemployment in deficit
regions. . . . Unemployment could be avoided . . . if central banks agreed that the
burden of international adjustment should fall on surplus countries, which would then
inflate until unemployment in deficit countries is eliminated. . . . A currency area . . .
cannot prevent both unemployment and inflation among its members.

Although this article was written almost forty years before the euro’s launch, the
implications for the Eurozone are pertinent. When the terms of trade turn adverse
to the periphery and in Germany’s favor, either the periphery will have unemployment
or Germany will have inflation, or there will be a combination of the two. Since Germany
indirectly controls the ECB and has so far been unwilling to tolerate inflation, rising
unemployment in the periphery is inevitable.

Mundell, however, also pointed out that the solution to this dilemma is capital and
labor factor mobility across national boundaries. If capital could shift from Germany
to Spain to take advantage of abundant labor, or if labor could shift from Spain to
Germany to take advantage of abundant capital in the form of plant and equipment,
then the unemployment problem could be solved without inflation. EU directives and
use of the euro have gone far toward increasing the mobility of capital. However,
Europe has lagged behind the rest of the developed world in mobility-of-labor terms,
partly due to linguistic and cultural differences among the national populations.
This problem is widely recognized, and because steps are being taken to improve labor
mobility within the EU, prospects for growth are greater than many observers believe.

This brings the analysis to the final element of the Berlin Consensus—a
positive business climate
. What economists call regime uncertainty is a principal differentiator between long,
anemic depressions and short,
sharp ones. Monetary policy and fiscal policy uncertainty can negatively impact an
economy, as was seen in the United States during the Great Depression of 1929 to 1940,
and as is being seen again in the depression that began in 2007. But policy cannot
improve an economy if businesses are unwilling to invest capital and create the new
jobs associated with such investment. Once the panic phase of a financially induced
depression is over, the greatest impediment to capital investment is uncertainty about
policy regimes related to matters such as taxes, health care, regulation, and other
costs of doing business. Both the United States and the EU suffer from regime uncertainty.
The Berlin Consensus is designed to remove as much uncertainty as possible by providing
for price stability, sound money, fiscal responsibility, and uniformity across Europe
on important regulatory matters.

In turn, a positive business climate becomes a magnet for capital not just from local
entrepreneurs and executives but also from abroad. This points to an emerging driver
of EU growth harnessed to the Berlin Consensus—Chinese capital. As the Beijing Consensus
collapses and Chinese capital seeks a new home, Chinese investors looks increasingly
to Europe. Chinese leaders realize they have overinvested in U.S.-dollar-denominated
assets; they also know they cannot divest those assets quickly. But at the margin
they can invest new reserves in diverse ways, including euro-denominated assets. China
was in no hurry to prop up a flailing Eurozone in 2011, but now that the EU has stabilized,
they find the euro an attractive alternative to dollar-denominated assets.
The
Washington Post
reported on this phenomenon in 2013:

As Chinese companies and entrepreneurs have moved to invest more overseas, they have
been drawn increasingly to Europe, where a two-year surge in foreign direct investment
from China has eclipsed the amount flowing to the United States. Over the past two
years, Chinese companies invested more than $20 billion in the European Union, compared
with $11 billion in the United States.

The Wall Street Journal
reported in July 2013 that the Chinese State Administration for Foreign Exchange
(SAFE), which manages China’s reserves, “
was an early investor in bonds issued by the European
Financial Stability Fund . . . and has invested regularly since then in the bailout
fund.” A sound euro is an important attraction for Chinese capital because a stable
currency mitigates exchange-rate risk to investors. Indeed, capital inflows from China
provided support for the euro—an example of a positive feedback loop between a sound
currency and capital flows.

Increasing capital inflows to the Eurozone were not limited to those coming from China.
The U.S. money-market industry has also been investing heavily in the Eurozone. After
panicked outflows in 2011,
the ten largest money-market funds in the United States almost doubled their investments
in the Eurozone between the summer of 2012 and early 2013.

The Berlin Consensus is taking root in Europe, based on the seven pillars and directed
as much from the EU in Brussels as from Berlin, to mitigate resentment of Germany’s
economic dominance. The consensus is powered by a virtuous troika of German technology,
periphery youth labor, and Chinese capital. It receives its staying power from a farsighted
blend of low inflation, sound money, and positive real interest rates. The new Berlin
Consensus has the potential to replicate the
Wirtschaftswunder,
Germany’s “economic miracle” reconstruction after the Second World War, on a continental
scale.

German chancellor Angela Merkel was born during German reconstruction in the 1950s,
grew up in Communist East Germany, and had firsthand experience with German reunification
in the 1990s. Few political leaders anywhere have her experience in facing such daunting
development challenges. She is now turning those skills to the greatest development
challenge of all: growing the European periphery and preserving the euro at the same
time.

■
The Euro Skeptics

Europe may have the will to preserve both its unity and the euro, but does it have
the means? Events since the 2008 financial crisis have raised considerable doubt in
many quarters about Europe’s capacity to deal with successive crises, notwithstanding
the overriding political objectives of
the Berlin Consensus. A close examination reveals that these doubts are misplaced,
and that the euro project is considerably more durable than the critics suppose.

Foreign exchange and debt markets have existed in a state of continual turmoil since
the global sovereign debt crisis erupted with the announcement of default by Dubai
World on November 27, 2009. Any visitor to Dubai in the months leading up to the default
could see the real estate bubble forming, in the shape of a skyline with miles of
empty office buildings and luxury condos for sale. Investors assumed that Dubai, with
oil wealth provided by rich neighbors in Abu Dhabi, would muddle through, but it did
not. Its collapse became contagious, spreading to Europe and Greece in particular.

By early 2010, serious fraud had been uncovered in Greece’s national accounting, enabled
by off-the-books swaps provided by Goldman Sachs and other Wall Street banks. It became
apparent that Greece could not pay its debts without both massive structural reforms
and outside assistance. The sovereign debt crisis had gone global and would soon push
Ireland and Portugal to the brink of default, raising serious doubts about the public
finances of the much larger economies of Spain and Italy.

Fears about sovereign finances spread quickly to the banks in those countries most
affected, and a feedback loop emerged. Since the banks owned sovereign bonds, any
distress in the bonds would impair bank capital. If the banks needed bailouts, the
sovereign regulators would have to provide the funds. But this meant issuing more
bonds, further impairing sovereign credit, which hurt bank balance sheets more, spawning
a death spiral of simultaneously imploding sovereign and bank credit. Only new capital
from outside sources, whose own credit was not impaired, could break the cycle.

After three years of on-again, off-again crises and contagion, the solution was finally
found in the troika of the IMF, the ECB, and the EU, backstopped by Germany. The IMF
obtained its funds by borrowing from nations with healthy reserve balances, such as
China and Canada. The EU raised funds by pooling member resources, largely from Germany.
Finally, the ECB created funds by printing money as needed. The troika members operated
under the central bankers’ new mantra, “Whatever it takes.” By late 2012, the European
sovereign debt and bank crisis
was largely contained, although rebuilding bank balance sheets and making the required
structural adjustments will take years to complete.

Despite this turmoil, the euro held up quite well, to the surprise of many analysts
and investors, especially those in the United States. In July 2008 the euro reached
a peak of $1.60 and remained in a trading range between $1.20 and $1.60 during the
sovereign debt crisis. Throughout the turmoil, the euro
always
traded at a higher dollar price than where it began in 1999.

The euro has also increased its share of global reserves significantly since its issue
date. The IMF maintains a data time series showing the composition of official foreign
exchange reserves broken down by currency.
Data for the first quarter of 1999 show that the euro comprised 18.1 percent of global
allocated foreign exchange reserves. By the end of 2012, after three years of crisis,
the euro’s share had
risen
to 23.9 percent of global reserves.

Such objective data is at odds with the histrionics produced by the Euro skeptics,
and that helps explain why, by early 2013, the prophets of Euro-doom were mostly mute
on the subject of a Eurozone breakup. The skeptics had committed a succession of analytic
failures, easily seen even at the hysteria’s height in early 2012. The first analytic
failure involved the zero-sum nature of cross exchange rates.

Beginning in 2010, the United States initiated a
cheap-dollar policy, intended to import inflation from abroad in the form of higher
import prices on energy, electronics, textiles, and other manufactured goods. The
cheap-dollar policy was made explicit in numerous pronouncements, including President
Obama’s 2010 State of the Union address, where he announced the National Export Initiative,
and former Federal Reserve chairman Ben Bernanke’s Tokyo speech on October 14, 2012,
in which he threatened trading partners with higher inflation if they did not allow
their currencies to strengthen against the dollar. Since the United States wanted
a cheap dollar, it wanted a strong euro in dollar terms. In effect, the United States
was using powerful policy tools to strengthen the euro. Why this obvious point was
lost on many U.S. analysts is a mystery, but a permanently weak euro was always contrary
to U.S. policy.

The second analytic failure had to do with the tendency to conflate the simultaneous
crises in debt, banking, and currencies. Analysts looked at
defaulting sovereign bonds in Greece and at weak banks in Spain, then breezily concluded
that the euro must weaken also. This is superficial: economically, there is nothing
inconsistent about weak bonds, weak banks, and a strong currency.

Lehman Brothers is a case in point. In 2008 Lehman defaulted on billions of dollars
in bond obligations. This default meant the end of the bonds but not the end of the
dollar, since the currency in which bonds are issued has a different dynamic than
the bonds themselves. A currency’s strength has more to do with central bank policy
and global capital flows than with the fate of specific bonds in that currency. Analysts
who treated European banks and bonds and the single currency as subject to the same
distress made a fundamental error. The euro could do quite well despite the fate of
Greek bonds and Irish banks.

The third analytic blind spot was a failure to recognize that capital flows dominate
trade flows in setting exchange rates. Too much emphasis was placed on Europe’s perceived
lack of export competitiveness, especially in the Eurozone periphery of Ireland, Portugal,
Spain, Italy, Greece, and Cyprus. Export competitiveness is important when it comes
to growth, but it is not the decisive factor in determining exchange rates. Capital
flows to the euro from the Federal Reserve in the form of central bank swaps with
the ECB, and from China in the form of reserve allocations and direct foreign investment,
placed a solid floor under the euro. If the two largest economies in the world, the
United States and China, did not want the euro to go down, then it would not go down.

The fourth blind spot had to do with the need to lower unit labor costs as part of
the structural adjustment required to make peripheral Eurozone economies globally
competitive. Euro skeptics suffer from the legacy of misguided Keynesian economics
and the sticky-wage myth, technically called downward nominal wage rigidity. Keynesians
rely on a theory of sticky wages to justify inflation, or theft from savers. The idea
is that wages will rise during periods of inflation but will not decline easily during
periods of deflation; they will tend to stick at the old nominal wage levels.

As a result, wages fail to adjust downward, employers fire workers, unemployment rises,
and aggregate demand is weakened. A liquidity trap then develops, and deflation becomes
worse as the cycle feeds on itself, resulting in impossibly high debt, bankruptcies,
and depression. Inflation
is considered advisable policy because it allows employers to give workers a nominal
raise, even if there is no raise in real terms due to higher prices. Workers receive
raises in nominal terms, while wages adjust downward in real terms. This is a form
of money illusion or deception of workers by central banks, but it works in theory
to lower real unit labor costs. As applied to Europe, the Keynesian view is that the
quickest way to achieve the needed inflation is for member nations to quit the euro,
revert to a former local currency, and then devalue these currencies. This was the
theoretical basis for the many predictions that the euro must fail and that members
would quit to help their economies grow.