Special Report: Europe and the Euro (Part 1)

Posted by Brad McMillan, CFA, CAIA, MAI

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This entry was posted on Aug 13, 2012 12:25:09 PM

and tagged Europe, Politics and the Economy

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The media has focused a lot of its attention on Europe recently—and deservedly so. The meta-stories generally concern weakness in one country or another or the slow disintegration of hope for Greece. I wrote a couple of weeks ago about how I thought Europe would end up pulling itself together for political reasons—the fear of history, mostly—but I did not really delve into what would have to happen to make that the case.

In July, I spoke at the Commonwealth Live! networking tour. The conversations I had there, as well as the increasing sense that Europe is continuing to deteriorate, suggested that I should lay out how I see the evolution of the eurozone and how it might succeed or fail. This thought process will obviously adjust to conditions on the ground, and one reason for writing it down is to track the changes as we move forward.

Let’s start with a baseline question: what would it mean to solve the problem? That is, what would a stabilized Europe and eurozone look like? From an economic point of view, there would be four components:

  1. A common and commonly adhered to tax policy
  2. Common spending policies
  3. Common regulatory structures
  4. Generally similar levels of affluence, labor productivity, and capital stock

Looking at this list, it is immediately obvious to me that none of these components will be obtained in the short term—and very probably not in the medium term. How do I know this? Well, look at the U.S., which has a long-term monetary and fiscal union:

  1. Point 1 applies at the federal level, but certainly not at the state level.
  2. Point 2 also applies at the federal level, but not at the state.
  3. Ditto point 3.
  4. Ditto point 4.

The survival of the U.S. monetary union therefore depends on the predominance of the federal structure.

So, the solution to the eurozone problem extends beyond the economic to the political. The answer to whether the euro can survive depends on the creation of a federal structure that is based on a common culture and provides fiscal union. The differences between the U.S. states are ironed out by fiscal transfers and population mobility. The U.S. has been able to survive as a monetary union because the fiscal union supports weak areas and population mobility allows labor to move where it is needed. Balance can be maintained at the federal level even though imbalances persist at the state level. Europe, of course, does not have this balancing mechanism. Tomorrow I’ll delve deeper into balancing.

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