The Euro: Chronicle Of The Currency Crisis Milton Friedman Foretold


Interest differentials between European government bonds and credit default swaps score new records almost every day. Greece, Ireland, Portugal and Spain face increasing difficulties in financing their public debt. Financial markets fear the situation is untenable and are becoming nervous. Politicians and the ECB all with their own preferences and interests feverishly search for a solution. The dispute between Sarkozy and Trichet is not likely be resolved soon
Who pays the piper?
Political leaders favor a scenario of debt restructuring with a rigorous "haircut" for the bondholders, including the already shaky bank sector. Banking circles and the ECB obviously shun such a scenario. For Trichet the idea that an EMU member state would fail to fulfill its obligations is unthinkable. It would undermine the credibility of the euro project even further. An earlier proposal to create European bonds as a funding vehicle for individual member states has already been dismissed. For obvious reasons, banking circles favor a solution in which the European taxpayer would come to the rescue and would guarantee faltering government bonds.
Both solutions have serious drawbacks. A debt restructuring would definitely compromise the financing capacities of defaulting nations for decades to come. Likely after such a debt restructuring the next in line after the PIGS (Belgium, Italy, France...) may soon become the next suspect. A haircut would rise the risk premium and bond yields, increasing the risk of the euro crisis spreading all over Euroland.

On the other hand, The ECB option of an unlimited guarantee is contrary to the European treaties and brings unlimited exposure to unknown risks. The ECB's proposal also meets opposition from the German public opinion. Many fear that more surprises could be hidden behind the empty state coffers. Banks could need additional state support and unfunded pension debt is becoming an unbearable burden in several countries. Moreover the European safety net may cause the moral hazard of proliferation of lax fiscal policy elsewhere. 

Euroland’s choice is indeed one between cholera and the plague. But that's only the most acute problem. In the longer term, the question arises how to avoid a repetition of future euro crises and how we can prevent Milton Friedman's prediction that the euro would fall apart at the first external shock from becoming true.

De Grauwe’s misdiagnosis
In a CEPS publication “What kind of Governance for the Eurozone”, Paul De Grauwe analyzes possible scenarios. As appropriate for a scientist, he starts by analyzing the causes of the euro crisis. On the basis of obvious data he demonstrates that excessive debt accumulation - particularly in the private sector - is the key factor leading to the euro crisis and that the bursting of housing bubbles in Ireland and Spain was the impetus. De Grauwe concedes partial responsibility of the monetary policy, but categorically rejects the inflationary low interest rates as the fundamental cause of the overall credit euphoria. Italy also enjoyed a sharp fall in interest rates since the euro was introduced and their credit euphoria was hardly noticeable, the argument goes. So the low interest cannot be the essential cause, De Grauwe concludes, without any further investigation into the cause of the divergent developments in these countries.

The essential difference between Ireland and Spain on the one hand and Italy on the other was that at the time of the introduction of the euro, Italy was stagnating at a growth rate of 1.7% at most. Spain and Ireland on the contrary were booming since years with GDP growth rates of 4.7 and 11% respectively. For slow-growing nations such as Italy, the incentive of a low interest rate came as a welcome stimulus. For the Irish economy growing at an 11% rate, the rate cuts had the same effect as a stimulant drug on a child with an ADHD condition. Such medicine  had to lead to disaster. Every right-minded housewife knows it, but apparently not so our political an monetary authorities. They simply disregarded the contra-indicative growth differentials and proceeded with their political euro project to dethrone the dollar as a reserve currency.
Animal Spirits
Forgetting about the growth differentials at the start of the euro is a deliberate attempt to  minimize the role of monetary policy as the fundamental cause of the Irish and Spanish real estate bubbles. Through exclusion, De Grauwe then comes to the traditional Keynesian explanation for the credit euphoria:  “Animal Spirits”; the “silly citizens’” irrational spending behavior funneled by successive waves of irrational optimism and pessimism. According to the Keynesian-interventionist doctrine, these animal spirits are the explanation for the boom-bust cycles, and consequently require tempering by "rational" governments.  It is the fundamental Keynesian justification for massive government intervention in the economy through monetary and fiscal policy.
Forgetting about the growth differentials at the start of the euro project has the crucial outcome of condoning the monetary blunder of the single currency and of justifying even more state intervention on the same wrong track.
The reality is that not animal instincts, but the inflationary interest policy caused the Irish and Spanish spending spree. The introduction of the common currency provided Spanish and Irish consumers and businesses with unlimited access to cheap credit on top of their excellent economic environment and outlook. Their response was as rational as it was predictable. The Irish and the Spanish factored the artificially low interest rates into their investment calculations. The opportunity of unlimited cheap credit lead them into excessive investment in real estate. Not animal instinct, but inappropriate monetary policy lies at the basis of their calculations and buying  decisions.
Differential growth rates
In substance, the current eurocrisis can be summarized to the systemic flaw that a single monetary policy for economies with highly different growth rates is not sustainable and leads to the leveling down of growth prospects. On average, the growth deficit due to the single currency can be estimated at a yearly 2 to 3%. For Spain and for Ireland particularly, the introduction of the euro caused an abrupt end to a most prosperous period of 20 years of unprecedented growth.

As both a differential interest rate policy and a change of exchange rates are unfeasible in a monetary union, De Grauwe now recurs to the third instrument of monetary policy in order to contain future growth differentials.  In order to control excessive credit expansion and the emergence of new bubbles, De Grauwe  advocates differential reserve requirements. He proposes to impose higher reserve requirements to banks of fast-growing economies. This idea would indeed be most appropriate if only the practical realization would not presuppose restrictions on the free movement of capital. The promotion of the free movement of capital was the prime objective and justification politicians used to justify the euro project. Or how the single currency increasingly gets entangled in its own contradictions.
Real solutions
The very fact that renowned financial experts now take differential monetary policies into consideration indicates that even the euro-believers start to assume the harmful effects of a unitary monetary policy and that they no longer exclude differentiation. However, solutions which cause new harmful effects for the prime objective are counterproductive. Today millions of euro-citizens suffer heavily for the monetary madness of the single currency. Most deplorably, the architects of the euro project failed to provide an exit scenario as well as emergency exits for lagging or leading countries that want to leave. It is high time the responsible authorities seriously start conceiving the practical modalities of such an exit.

Sooner or later our monetary authorities will have to recognize that money creation out of thin air cannot promote sustainable growth. Their manipulation of interest rates far below the natural equilibrium level only leads to excessive debt accumulation. Interest rates are the starting point of all economic calculations. The interest level is not only conclusive in the choice between saving and consumption, but also in the choice between labor-intensive and capital intensive investments. Forging this basic measure only leads to wealth destructing distortions.  Interest rates that are too low lead to savings deficits, excessive debt accumulation, excessive expulsion of labor from manufacturing processes, and to inequitable and counterproductive redistribution from savers to big spenders. The eternal dream of (nearly) free money is an illusion. The interest rate level is sustainable only if it leads to the equilibrium   between saving and consumption at which every generation pays for its own consumption without coercing their heirs or other nations to pay the piper.

More articles by Paul Vreymans can be found at

Lobby victory

'Beggar-my-neighbour' continues to be the official policy of Ireland even after receiving the multi-billion rescue money from Brussels. It is shameful that Microsoft, Apple, Google and some French and German banks continue their businesses in the Irish tax paradise, which once turned the country into the Celtic Tiger, an icon of neoliberalism. What was proclaimed as 'free market' and 'sane location competition' is nothing more than egoism on the shoulders of the community. When crook-banks like DEPFA rise their volume from 1 to 73 billions Euro, even the capitalist hard-liners should recognize that this is nothing but a fraud. But thanks to the Heritage Foundation, Ireland was proclaimed the economically most liberal country in the world. Well, thank you, liberals. The Irish casino collapsed and the winner are, as always in gambling, the banks.
Some in Brussels understood what had happened – Olli Rehn and Christine Lagarde asked for the end of tax dumping, but Merkel, Sarkozy and the still-in-office Irish government (Brian Cowen) denied any pressure on corporate taxes. The public (tax payers) may wonder now, why the elementary failure in Irish policies was not addressed, should it be that big IT businesses forespoke in order to maintain Ireland as celestial tax haven? The case lances a cloud on Brussels. While EU-commissioners discussed the Irish problem, Merkel & Sarkozy already decided. 'Policy made in Brussels' is nothing but a cliché! By the way, a rise of 1,5% of corporate tax would bring Ireland 1,5 billion Euro, an adjustment to the European level of 25% would bring them 12,5 billion Euro. That's nearly as much as Ireland wants to save in a quarter of a year. But instead of doing so and ask international multis for contribution, Ireland continues blindfolded the neoliberal way – drop wages, fire personnel, lower social and cultural costs. The crisis continues for sure!

As predicted

Is it my imagination, or are the Europeans treating Americans with less condescension these days?  I guess if your monetary system is about to collapse, it takes more arrogance than even the Europeans have to continue looking down your nose at your intellectual and moral inferiors.

marcfrans is right to draw parallels to the lefty U.S. states with their unsustainable budgets (he neglected to mention Obama's home state of Illinois, which is probably in even worse shape than California).  But the arrogance of the American left seems to exceed that of the Europeans:  the bankrupt blue staters continue to condescend to their inferiors as never before.

current crisis

"Sooner or later our monetary authorities will have to recognize that money creation out of thin air cannot promote sustainable growth."
What we currently watch within the global economic system is not a singular, surprising catastrophe, which can be overcome with traditional free market rules. It is a final system crisis and we need other assets for a global, sustainable social system. The so-called economic sciences are mathematically flawed and merely serve as propaganda instrument of financial elites (see George Stigler). All these evidences were silenced, no consequences drawn, as this would have meant the end of an influential elite. The current monetary system bases on mathematical methods to 'foresee' trends for the next two or three years. The impossibility of this form of prognostics already crashed enterprises (dot-com-crisis), whole branches (investment banks) and finally the whole economic system. There are created more logical deficits, as for new money must be fought on the market with increasing interest rates (fiat-money), turning ad absurdum the premise of zero-sum game for the current economic system (see Greece, Ireland, etc). Theoretically, the 'perfect capital market' gives equal information to all protagonists - would that be true the goods on the market would have the same price or value, which means that no profit is possible, therefore no transactions take place. A simple system of fraud!
The reason for the current lasting crisis, of course, lies in the technical construction of the traditional monetary system which does not acknowledge the internet era. In our society, money quickly gets obsolete – goods and service can be distributed with new innovative rules, in which the possession of standardized money is not relevant any more. The possibility of simultaneous contacts to any person basing on cooperation instead of concurrence could elevate human society to their next level of evolution: peaceful coexistence on the basis of mental assets in the place of material evolution models. Of course, money-holders would go rampant, and they would desperately evoke the necessity of money (see De Grauwe's higher reserve requirements). Yet, money only serves as distribution mean and exactly this is much easier through internet data banks as with the illusion of metal coins. The transition process should nevertheless diminish the anxiety of loss at the top of the social pyramid and the rage of simple persons to see the elites as crooks and engage in violence. It is true, though, that many experts did not foresee the current crisis, it was taught to them as a 'blind spot' to maintain the illusion of our monetary system (money is created without counter-value which raises interest rates, see Obama). Critique is unwelcome due the effect of cognitive dissonance, one main asset to maintain the absurd system of 'free market economy'.
Therefore, the success of transition depends on how the people will experience the 'crash', as something disastrous threatening their very existence, or as something positive in the sense of liberation of individuality, creativity and spirituality. If it is shown that cooperation delivers better results than concurrence, we may see a chance in the crisis.

@ kappert

Your new value system doesn't take humans in the equation, only angels and gods with unlimited goodness.
It's time for you to study your fellow human being a bit.


It seems you do not believe in mental evolution. Looking around - you may be right. Yet, keep on doing what we do for the last 5000 years might come to a surprising end.

@ kappert

I do not believe in evolution, full stop.
I believe in education and human genius, coupled to human weaknesses and human programming, genetic and unknown, some call it the soul.
Education can advance us, human faults and weaknesses delay the human education process.
Look seriously at the Greek philosophers and tell me where evolution learned us one iota more.
Study and education learned us to think in certain patterns, totally and continuously changed all the time without advancing one inch in (in)-human behavior. We are still nowhere morally speaking and we still don't know how to live together peacefully, on the contrary, we kill and murder on an ever increasing scale while half of humanity still lives in medieval thought patterns.
So much for "evolution"

Real solution

I would argue that the existence of the Euro (1) presents significant efficiency gains for the whole of Euroland, and (2) that monetary union is not much different from maintaining a fixed exchange rate regime.  The latter could be either under a 'gold standard', or some modified version of a gold standard like the 'gold-exchange standard' of Bretton Woods between the end of WW2 and the early 1970's. 

I agree with the author that it is not "animal spirits" that were behind the speculative bubbles in parts of Euroland but, rather, excessive borrowing and spending. But, I also think that the rapid growth rates in places like Spain and Ireland, prior to monetary union, were partly obtained (through the exchange rate instrument or flexibility) at the expense of slower growth rates elsewhere in Europe.

If, today, there are significant interest rate differentials between various European government bonds, it is because market participants correctly recognize that not all these governments are equally trustworthy. The 'solution' is to prove the markets right by letting the untrustworthy default. How else is one going to 'restrain' bad governments (under the control of public sector unions) and force them to mend their ways? A return to competitive currency depreciations (and that is what leaving the Euro would mean) is not likely going to do it.

This problem is not much different from what is happening in various US states. Poor fiscal management in various 'leftist' states, like New York and California, is leading to interest rate differentials on debt paper of different local authorities and states. The last thing the Europeans should do is copy the Obama Administration and start subsidising the 'bad' (local) government actors. The "real solution" can be summarized as follows: let the bad guys stew in their own mess and thereby force their (local) voters to bring real "change", i.e. NO BAILOUTS nor subsidies.

The disadvantages of the Euro outweigh the fringe benefits


The convenience of a common currency is only a limited aspect of a monetary union. A monetary union does indeed imply more profound consequences than only the convenience of using the same pay bills on our European trips an no longer needing a calculator when we do international business. Above all a monetary union implies a common central bank and a common monetary policy. The disadvantages thereof far outweigh the fringe benefits.

It means disabling monetary policy: disabling differential interest rate policies, disabling exchange rate adjustments and differential reserve requirements. In our monetary union the bureaucrats of the ECB set all those key instruments at some average level judge appropriate for the EMU as a whole, without any consideration for the diverging developments in individual countries. Friedman predicted that it would lead to disaster and the system ultimately would collapse.

Inappropriate monetary policy leads to slow growth all over the EMU. In a broader research into the causes of growth differentials in the EU we found that all other things equal, countries having stayed outside the EMU, had significantly higher growth estimated in a multiple regression analysis at 2.57%. ( page 35-36 )

Very fast growing and very slow growing economies obviously suffer most from the common monetary policy. In the fastest growing country Ireland the much too low interest rates lead to the housing bubble. The bursting thereof caused the abrupt end to their most prosperous period of 20 years of unprecedented growth. Already in 2006 we predicted that the inappropriate monetary policy would lead to an inflationary bust in Ireland. (see the a.m. study page 35-36). Moreover inflationary low interest rates lead to excessive debt accumulation all over the EMU.

Of Course the political-financial establishment will never recognize their blunder. On the contrary they prologue the agony and will force Ireland to give up their independence and excellent business model of small government and force them to join the EU high tax cartel.