The Tragedy of the Euro by Philipp Bagus follows the creation of the European Monetary Union (the "EMU") to present day. As we will see, he characterizes the EMU as a tragedy of the commons--hence the title of his book.
Setting the Stage
Many economists knew before the creation of EMU that the different political systems would make a functioning monetary union improbable. They pointed out specific problems, and the European Union and European Central bank devised rules to deal with those problems. Unfortunately, many rules were ignored.
The southern Mediterranean states had high inflation and deficits upon their entry into the EMU. To be accepted under the rules of the EMU, these countries had to make their government's look better managed. Many were able to make their governments appear better managed than they were. For instance, Goldman Sachs (GS) famously helped the Greeks hide debt.
The northern states (e.g., Germany, Belgium and the Netherlands) had lower government deficits while the southern states (e.g., Spain, Portugal, Italy and Greece) typically ran higher deficits. Only a handful of countries produced more goods than they imported; and therefore only a handful had a current account balance. The southern Mediterranean states typically imported more than they exported. In the image below we see the current account balance of the Euro countries (graph from book).
(Lines about the 0 axis represent a trade surplus, while lines below the 0 axis represent a trade deficit.)
One can see that imbalances of trade existed prior to the introduction of the Euro, but they become increasingly imbalanced after the Euros introduction. The mechanics of these imbalances are outlined below.
The Monetary Problem
In the EMU, rules were developed to prevent the present situation. Since the common currency implied that the high-deficit countries could not simply print new money to make up for their revenue shortfall, the countries had to manage their budgets responsibly. Of course, the rules were broken and ignored leading to the present predictable crisis. The rules were ignored, for instance, when Greek debt was classified as "junk" and was still accepted as collateral by the ECB. Prior to this, the ECB had only accepted the highest collateral.
Philipp Bagus characterizes the EMU as a tragedy of the commons. A tragedy of the commons can typically be thought of as when a number of actors are incentivized to consume a common resource. They are incentivized because in consuming the resource they externalize the cost of the using resource onto each other.
For instance, countries establish fishing quotas for fear that all the fishermen are incentivized to catch as many fish as possible. The more fish they catch, the higher their share of the profit and the less their share of the "losses" for the shrinking fish population. If they owned the fish resource, they would account for a "depletion" expense when measuring their income. But since the fish are not "owned" by them, they themselves experience no "depletion" expense.
All fisherman want the largest bounty, so they compete to consume the resource since it costs nothing to them. The fisherman know that they have to catch as much fish as possible lest a competitor take a greater share than them. In that situation, the fishermen are able to externalize the cost of using the fish population on each other. Since the fish are not "owned" by anyone, there is no cost specifically to anyone for taking them out of the ocean. (This is true even while we can say philosophically that there is a cost to everyone.) Governments impose fishing quotas to solve the problem of overfishing.
It turns out that fishing quotas are much like EMU rule that countries can only run deficits up to 3% of GDP. Countries were supposed to be fined when they exceeded 3% of GDP but, as one might expect, that rule was also broken.
In the Euro system, it is the Euro's value itself which is the common good. As I understand it, and in a simplified form, new money is created in the following manner:
- A government would like to issue debt.
- That debt is auctioned and purchased by some bank.
- That bank, then, can present the government bond to the European Central Bank ("ECB") and use it as collateral to borrow from the ECB.**
- To borrow from the central bank typically means the creation of new money.
- The bank gets new money and then lend out the money collecting profit on the "spread." They might, indeed, lend it to a government.
**The ECB lends money based on other collateral also (and indeed, they just lowered their standards further). However, if they get a less-desired collateral, such as an Asset Backed Security, they only lend up to 84% of the amount of collateral, taking a "haircut" of 16%; while if the bank presents collateral in the form of a government bond, they take a smaller haircut. Banks are then incentivized to hold government debt since they represent sounder collateral to the ECB. As mentioned above, this is true even while Greek debt is considered junk by the rating agencies.
In this basic formulation one can see that the new money enters the economy where governments are issuing debt. Since the banks know the ECB will lend against the government debt, banks buy the government bonds.
Therefore, the governments who issue more debt--i.e., those which run larger deficits--get the new money first. As is well known in monetary inflation, those who get the new money first benefit before the prices have risen for all the other members. Further, the countries which issue more debt are also ones who typically import more than they export. Therefore, they are sending the new money abroad to the exporting countries (this can be seen by countries dipping further in the negative in the graph above). One country goes into debt, gets more goods from its trading partners (like Germany or the Netherlands) before prices have risen, and therefore benefits. The inflation also lowers the government's cost of borrowing by devaluing the currency which makes up those debts.
What occurs, specifically, is that the Greeks (and others) have been externalizing their cost of borrowing on the Germans and other northern states. What makes the euro zone a tragedy of the commons is that, because of the above mechanism, there is an incentive to run increasingly larger deficits since the cost of going into debt is externalize onto more prudent countries through monetary inflation.
Note: the ECB also has since bought Greek debt outright, which is the equivalent of making new money and sending straight it to the Greeks. So they are also increasing the money supply directly, and therefore continuing to facilitate the transfer of wealth from the geographic north to the south.
Why would the Germans agree to such a scheme? According to the author, politically the Germans would not have been allowed to reunify east and west without leaving the Deutschmark and joining the Euro. The Deutschmark's stability exposed the high-deficit countries as irresponsible and caused embarrassment to all European politicians outside of Germany (for instance, as England experience during the ERM). So the French and others wanted to get rid of the German national bank, since it traditionally didn't destroy its currency as fast as its neighbors.
The Tragedy of the Euro can be found for free here (pdf).
The book points out the difficulties facing the Europeans. I highly recommend Jesus Huerta de Soto's piece also because he describes why many people are anti-euro. He says, in effect, that just as the gold standard forced governments to keep a low public debt lest they lose their currencies connection to gold--so too, the Euro forces politicians to take the hard measures to cut public deficits and to keep them low.
Obviously the Euro does not enforce public expenditure as rigorously as the gold standard did, however it does prevent "economic nationalism." If countries such as Greece were able to print their own currency, they almost certainly would, and they would be suffering from a bloated public sector and high inflation. Indeed, they might also put up trade barriers to "protect industry." The EMU forces governments to act responsibly in a fashion similar to the gold standard.
I give the book 4.5 stars. The 0.5 off because he uses the word socialism too loosely as someone on Amazon (AMZN) also commented.