Special Report: Europe and the Euro (Part 3)

Posted by Brad McMillan, CFA, CAIA, MAI

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This entry was posted on Aug 15, 2012 10:54:10 AM

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Europe, the Euro, and Political Integration

As I discussed yesterday, in order for the European whole to operate like the U.S., all the players need to subordinate to the federal level. Let’s use political union as shorthand for the first three points I made two days ago: common tax, spending, and regulatory policies. Political union can only come about from common government. As I noted, we see this at the federal level in the U.S. Below that level, differences can and will always exist, as we see in the American states, but there needs to be an overarching structure to provide a common foundation for the components of political union. The creation of such a structure is what Germany is demanding.

Creating a federal structure will come more easily to some countries than to others. For example:

  • Germany, like the U.S., is already a federal structure and therefore has experience with this type of government.
  • France is and always has been a much more centralized structure and can be expected to have more difficulty.
  • For some countries, such as Spain, a federal structure might actually ease some of the current problems by giving the regions another level of identity and autonomy within the federal euro structure.

The devil, as always, will be in the details. Harmonizing tax and regulatory structures will require enormous compromises. Harmonizing spending policies—and tax collections—will be even more difficult.

If you look closely at Greece, for example, the tax rates on the books do not seem to be the problem; the collection of those taxes does. The spending decisions made by Greece are also radically different from those made by Germany; those made by the other Club Med countries differ only in degree, not in kind, from Greece. These are the kinds of cultural, federal decisions that will need to be made—and enforced—by a federal structure. And it will require a cultural change. For it to work, at some level, Greeks need to become Germans and pay their taxes and work until 67.

The other component of what makes the U.S. work is labor mobility. Again, this requires a common culture to a great extent. Setting aside the obvious language issues, for a true European federal structure to evolve and last, a European culture will need to evolve. Regional differences can and will persist, but the cultural identity will need to have a solid common base—one where a Greek person can go to work in Finland and still feel, to some degree, at home. (At least to the extent that, say, a Californian feels at home in Michigan.)

The last piece of the puzzle here is productivity, and this ties in directly with labor mobility. For Greece to be competitive, for example, wages need to fall by about 20 percent to be comparable with Germany. Greeks can either stay home and absorb that loss or relocate to areas with higher wage levels. Because this is not happening—and has not happened in the past—it is a driver of structurally higher levels of unemployment in Europe compared with the U.S. The alternative to this kind of wage devaluation is the solution that Greece and the other Mediterranean countries have always resorted to in the past: currency devaluation.

This is what success would look like for the eurozone and the European Union in its present form. It is a long way away, and, in many respects, failure looks a lot more likely. Tomorrow we’ll look at what failure would imply.

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