Economic Depression
In Spain, the unemployment rate has reached 27.2 %. Just think of that--that is more that 1 out of every 4 people in the workforce without a job. The youth unemployment rate is approaching 60 %. The country's economy is expected to contract by about 1.5 % this year, and unemployment may well continue to worsen. There is tremendous debate in Europe over why this is occurring. One school of thought blames the Euro itself (and I would include myself in that school of thought). "How could this be due to a currency?", you may well ask? Imagine there are two small islands next to one another--Island 1 and Island 2. Island 1 sells fine machinery of which there is acute demand all over the world. The other sells, say, very lovely Olive Oil. Now imagine that these two island countries decide to share one currency--let's call the currency the "Island Shell". Why would anyone want Island Shells? They would want them so that they can purchase either the machines from Island 1 or the Olive Oil from Island 2. Now imagine that the world wide demand for the machines from Island 1 continues to grow. This will push up the price of Island Shells in terms of other currencies. That is, say, if you are American, and you want one of those fine machines from Island 1, you first need to buy Island Shells so that you can pay in the proper currency. You buy them with your American dollars, of course. This activity pushes up the price of Island Shells in terms of American dollars. But now imagine that there were other Americans who might like to have purchased some of that Olive Oil from Island 2. Because the price of the Island Shell currency has increased (due to the demand for the machines from Island 1), the price to any foreigner--such as an American--of the Olive Oil has increased as well. If Olive Oil can be purchased from other markets, folks may cease to buy any Olive Oil from Island 2, or certainly buy less than they would have, precisely because it uses the same currency as Island 1, and that currency has now become expensive. This is the kind of situation that Spain confronts, although, of course, they have a lot more to sell than Olive Oil. The problem, however, is that they share a currency--the Euro--with countries that sell products that are substantially more competitive than their products, given current prices and wage structures. If Spain had its own currency, instead of sharing a currency with these other more competitive countries, then the value of that Spanish currency would decrease right to the point where it made Spanish industries competitive with these other countries. But since that can't happen, there is a reduced demand for what those Spanish industries produce, and therefore massive unemployment. It is really that simple. There is an alternative way that Spain could become more competitive, and that is if their internal prices and wages fell enough to offset the competitive disadvantages created by a currency that is too expensive for what they have to offer. But that drop--in wages and prices--might have to be as much as 20 to 30 %. The problem with that is that folks who are suddenly earning 20 to 30 % less than they were before, they may not be able to pay whatever debts they have. Thus, in such a deflation--with prices and wages falling substantially--one would expect many bankruptcies, and perhaps even financial contagion. So, you may ask, why do they not simply leave the Euro and return to their own currency? The problem is that if people generally thought a given country was going to abandon a shared currency, such as the Euro, those folks might try to take all of their Euros out of the country, so that they wouldn't be forced by the country to trade in those Euros for a currency that was apt to depreciate (that is, go down in value) which any new currency would likely do (since that is the very point of abandoning the initial currency.) This massive flight of money out of the country could be very disruptive. As a consequence, the Europeans remain committed to the Euro, because they don't want to face such a potentially massive disruption. In the meantime, however, a generation is being lost and the social fabric is apt to be weakened severely. How it will all play out is anyone's guess.
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There is a concept in economics known as an "Optimal Currency Area". There are a number of characteristics of an optimal currency area that can best be understood by examining when one might want to have a different currencies across particular jurisdictions. Basically, if different countries share a currency, it means that they cannot independently set their own monetary policy, fiscal policy and exchange rate to just match what is needed in terms of their economic conditions. Clearly, the economies of the "periphery" countries in Europe--say Italy, Greece, Spain and Portugal--would benefit from a somewhat different monetary and fiscal policies than say the "core" countries, such as Germany. But because they are in the Eurozone, they cannot set those policies independently. The other great advantage of having your own currency is that you know that the government can always somehow pay off its sovereign debts, simply because it could always print some more money. But if you don't have an independent currency, you can't do that. Thus, one finds that the interest payments that the government has to make on the debt it issues tends to be higher for countries that share their currency with other countries, because of the higher likelihood that they could fail to meet those payments. Of course, if a country simply starts to print money, it is likely over time to debase its currency, and lead to high inflation. Nonetheless, it can always avoid out-and-out default in this manner, and that is a huge advantage. In sum, if a country's economy is in sync with another country's economy, they may do well to share a currency; but if their economies are out of sync, then it can be a big problem to share a currency. As to Germany, by being linked under one currency with countries that are less globally competitive, it does end up with the Euro being of lesser value than if Germany had stuck with the Deutschmark. Thus, by being in the Euro, Germany's exports are made cheaper, and thus more attractive globally, than they otherwise would have been. In that sense, the Euro has served Germany well. But the macroeconomic problems of the periphery countries are now starting to feed back into Germany, resulting in some decreased demand and a recession in Germany itself. Given all this analysis, one may wonder how an area as economically diverse as the United States holds together under one currency. The answer to that involves the automatic subsidization of the areas that are not doing so well at any point by the areas that are prospering. That is, when an area is economically distressed, the people in that area automatically begin paying less to the federal government in terms of income taxes. At the same time, there are more payouts to that depressed area in terms of unemployment benefits and so forth. This amounts to a huge redistribution of income from prospering states to poor states. It is the fiscal integration of the country that helps ensure that the shared currency works well for the whole. This is not the case in Eurozone, of course.
Karen