March 16th 2013

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Articles from this issue:

COVER STORY: Red China's global cyber-espionage exposed

CANBERRA OBSERVED: Labor government 'drowning, not waving'

EDITORIAL: A new agenda for the next five years

NATIONAL AFFAIRS: Bill to end Medicare-funded abortions for sex selection

SCHOOLING: Progressive education's disastrous legacy

CHINA: Chinese Communist Party set to implode

EUROPEAN UNION: Can 'internal devaluation' save the European Union?

ITALY: Former comedian now Italy's kingmaker

UNITED STATES: President Obama's Captain Queeg moment

OPINION: Where is Baden-Powell's Scouting movement today?

LIFE ISSUES: China: Baby crushed to death during one-child policy enforcement


CINEMA: Life, liberty and the pursuit of vengeance

BOOK REVIEW Scholarship trumps victimhood

BOOK REVIEW Epic voyages of a national hero

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Can 'internal devaluation' save the European Union?

by Colin Teese

News Weekly, March 16, 2013

The term “internal devaluation” needs explanation. It is, in truth, a jargon-laden phrase invented by the European Central Bank (ECB), and designed, one suspects, to conceal as much as it reveals.

Internal devaluation is among the grab-bag of austerity prescriptions used by the ECB to deal with the problems of the European Union’s heavily indebted southern European member-states.

It is one component of the austerity programs whose stated intention is to restructure the southern European economies and, in the process, ensure repayment of the amounts owed to the northern European banks.

According to the London Daily Telegraph international business editor, Ambrose Evans-Pritchard, the specific intention of internal devaluation is to force wages in the indebted countries down to bedrock levels. The expectation is that, by this means, the debt-burdened economies will be able to regain international competitiveness while remaining tied to an overvalued currency — the euro.

Leaving aside the questionable morality of forcing wage-earners to bear the greater burden of adjustment — from a folly they did not create and lack the means to repair — there is little to suggest that this misguided strategy will work. At best it will provide the ECB and the Brussels bureaucrats with a further extension to their daydream that they can prolong the fiction that a failed euro experiment is succeeding.

Anecdotal evidence suggests that the wage policy is already foundering. Greek wage-earners — the target of the internal devaluation approach — are not unfamiliar with attacks on their wage packets. Apparently, they are doing what they have always done when confronted with huge wage reductions; they are deserting the paid labour market entirely, and surviving by barter and exchange among themselves.

In effect, a separate “grey” economy is being created, disconnected from the possibility of tax collections and recorded economic activity. This is hardly a basis for economic reconstruction.

Meanwhile, the EU will limp on, at least until the true impact of its accumulated policy mistakes can no longer be concealed.

Confronting the real problems would mean conceding that the ambitious 1992 Maastricht Treaty — which set the EU’s course for budgetary and monetary policy integration, along with the creation of a single currency — was the ultimate cause of the EU’s present predicament. Maastricht led to the EU pushing ahead with deeper economic and political integration of its member-states, too far and too fast.

The reason for this undue haste is not entirely clear. Was it the ideological intent of economists in the European Commission in Brussels to impose on the EU membership their model of free-market economics? Or was it the commission’s intention, in concert with the Federal Republic of Germany, to shepherd the rest of the EU membership towards Germany’s chosen monetary and budgetary orthodoxy?

Quite likely, it was a combination of both. It is also possible that Germany might have seen the Maastricht Treaty as a way out of uncomfortable developments emerging within the German economy.

The collapse of the Soviet empire and the fall of the Berlin Wall in 1989 caught Germany by surprise. Its then conservative Chancellor Helmut Kohl opted to swallow whole — in one gulp — the dysfunctional economy of the former communist East Germany.

Reunification proved more difficult and expensive than expected. As German living standards in the more prosperous West Germany declined, political hostility to the program mounted.

Even Kohl’s successor, Chancellor Gerhard Schroeder, and his Social Democratic government, lost office as a result, and there were unanticipated flow-on effects for the European Union.

Germany had been, in the period of the EU’s expansion beyond the original six member-states, the most powerful and prosperous of the member-states.

The Federal Republic of Germany — or West Germany as it then was — enthusiastically supported the original idea of an integrated Europe. This was to include the idea of income redistribution from the richer to the poorer member-states, this being seen as a necessary first step along the road to true European federation.

This policy was flourishing when countries such as Spain, Portugal and Greece joined the EU. And certainly the EU’s redistribution policies enabled those incoming member-states to enjoy meaningful economic gains.

But Germany’s costly reunification after 1989 changed the deal for the rest of the EU. German surpluses were now channelled into rehabilitating the former East Germany, so there was nothing with which to support the poorer EU member-states.

The European Commission no doubt woke up to Germany’s diminished capacity to support the redistribution ideal. Perhaps it came to believe that, in these changed circumstances, deeper economic integration of the EU was the only way forward — regardless of whether Europe was ready, economically, politically or culturally, for such a bold step.

Many commentators outside the EU — and some within — expressed misgivings at the time. Special condemnation was reserved for the idea of introducing a single currency in advance of deeper political integration.

EU policy-makers refused then, as they do now, to acknowledge that there were, and remain, significant differences in the stages of economic development, and in social and political attitudes, among the various member-states.

Effectively, these differences preclude deeper political and economic integration. They are most striking when comparing northern and southern Europe.

Southern European countries willingly accepted the deal on currency alignment, in the belief that they were being drawn into an EU still committed to income redistribution. However, they chose to ignore that committing themselves to deep political and economic integration (including, especially, accepting a common currency), meant saddling their economies with an overvalued currency.

A euro value struck at a level which allowed the north (especially Germany) to retain international competitiveness automatically condemned the more vulnerable southern economies to an overvalued euro.

Thus burdened, they found it increasingly difficult to export, either within or beyond Europe. Borrowing to stay afloat became a necessity, and the Germans were happy to oblige with both goods and money.

These transactions could not be underwritten by redistributionary transfers, as in the past, not least because Germany and the rest of the prosperous north were distancing themselves from idea of European-wide income redistribution.

A new consensus was emerging in the European bureaucracy, and among the prosperous northern member-states, that money loans to the weaker economies by German, Dutch and, to a lesser extent, French banks could better serve the same purpose.

Nobody was prepared to ask the obvious question: how could these southern countries, stripped of their competitive edge and the ability to earn export income, be expected to pay for their import bills?

By the time policy-makers realised what was happening, the accumulated debts had reached unmanageable proportions.

Policy-makers were then confronted with two possible solutions. The first — recasting the euro — was simply too awful to contemplate. It meant dismantling the ambitious scheme inaugurated by Maastricht and admitting that the EU’s “deeper integration” experiment was misguided. Worse still, it could leave the northern banks holding debt that might never be repaid.

They chose the alternative, which was no less misguided, but which they hoped would keep the Maastricht experiment alive. It prescribed a strong dose of austerity for the indebted countries. The belief was that this would compel them to practise economic rectitude and enable them finally to enjoy a measure of prosperity.

The southern member-states — believing, perhaps correctly, that under any other scenario they might be forced out of the eurozone — agreed to pursue deflationary measures, including forcing down wages. They hoped that this drastic process of cutting their internal costs would be enough to offset the overvalued euro and make their exports competitive again.

The expectation of the more prosperous northern member-states was that the southern states, by practising such austerity, could generate surpluses with which to repay the northern banks. That, of course contradicted reality. Over-borrowed countries, denied the ability to devalue, usually default.

Whatever one might say about the internal logic of the austerity package, it fails the test of realism. However, the alternative of pushing ahead with yet deeper political and economic integration won’t work either — more about that later.

The austerity option of forcing wages and public spending down was never likely to deliver stability and growth to the indebted economies. Anecdotal evidence emanating from Greece, as mentioned earlier, suggests it could be counter-productive.

And the alternative strategy of pushing for ever deeper political and economic integration cannot succeed without the EU partners underwriting the idea of transfer payments from richer to poorer member-states.

Tackling this problem may prove to be crucial to the European Union’s ultimate aim of federation. As the experience of the United States clearly demonstrates, creating a United States of Europe rests on one fundamental assumption: that is, establishing a central government able to collect tax on a uniform basis and redistribute it, as necessary, from richer to poorer areas on a permanent basis.

Federation is never easy to achieve or maintain. The US, having much more going for it than has modern Europe, including a common language and currency, nevertheless fought a ferocious civil war between 1861 and 1865 over cultural differences which, even to this day, are not yet fully resolved.

For the moment, most of the conditions necessary for the EU to proceed in the US direction are absent. Some of the present member-states — Spain and Belgium, and perhaps, Britain, for example — seem to be battling with active internal separatist movements.

Right now, a wiser course for the EU might be to step back from the Maastricht experiment and work on consolidating support for a less ambitious level of EU integration. Aiming higher might do more harm than good.

Any new strategy should feature prominently a commitment to rebuild the most fragile, indebted economies, to restart EU-wide growth and to restore confidence in the EU experiment.

Nothing resembling that appears to be happening at the moment. Indeed, if policy-makers had their eye on the real game, they would surely be concerned that Germany — the EU’s strongest economic engine — is looking away from its European neighbours and towards distant China, for its future export growth.

Colin Teese is a former deputy secretary of the Department of Trade. 

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