David Frum

05.31.12

Countdown to Euro Crack-Up

Why full fiscal union probably cannot happen in Europe—and thus why the Euro probably cannot be saved.

I missed yesterday this very important Austan Goolsbee piece on why it will be more difficult than is sometimes supposed to save the Euro by consolidating Europe's fiscal union. Don't repeat my mistake, read the piece: It explains forcefully why full fiscal union probably cannot happen in Europe—and thus why the Euro probably cannot be saved.

[W] thout an exchange-rate safety valve you need an alternate way to rebalance economies. Moving, inflating, struggling, or subsidizing are your only choices—and none of them is easy.

If workers move freely to high-growth areas or if the central bank is willing to loosen monetary policy to get the high-growth economies to start inflating, that can replace the exchange rate as the safety valve. Inflation in the high-growth economies will change the relative real wages between the counties the same way a devaluation can. Labor mobility helps the U.S. in that sense. In Europe, though, mobility between countries with different languages is low and German tolerance for inflation seems even lower. That leaves suffering and subsidies.

Southern Europe can struggle through the problem—grinding down wages through high unemployment and structural labor-market reforms to make a country such as Greece more competitive internationally. History suggests this will not be an easy sell. Wage cuts usually come only after tremendously extended bouts of high unemployment. Structural reforms can take years to actually raise productivity growth rates.

Or Northern Europe could decide, for the sake of a united Europe, that it is willing to permanently subsidize euro-zone countries with low productivity growth. That could be through explicit subsidies or through bailouts and broad-based guarantees. But in the North, subsidies remain anathema. The Germans are quite right that the euro zone was absolutely not created to enable permanent subsidies, and their opposition is easy to understand.

Thus, lacking the normal safety valves to keep dangerous imbalances from destroying the monetary union, the euro hardliners are left with the idea of fiscal union. These hawks, however, misunderstand a fundamental strength of the U.S. fiscal union. They seek a union to impose budgetary discipline and structural reforms on laggard countries while the U.S. fiscal union serves mainly as an engine of subsidy.

Last year, the Economist compiled census data from 1990 to 2009 for all 50 U.S. states on the amount of federal spending in each state minus the amount the state's residents pay in federal taxes. Over 20 years, states like Minnesota and Delaware annually paid in about 10% more of their state GDP than they got back. On the other side, for the last 20 years New Mexico, Mississippi and West Virginia have received annual subsidies of more than 12% of state GDP. While not a perfect measure of subsidy, it conveys the basic point well. These are big. Greece's entire 2011 deficit, for example, was 9.1% of GDP.

The U.S. fiscal union has worked, in no small part, by enabling subsidies to the Mississippis without requiring the approval of the Minnesotas.