Euro will not let us catch up with the West. Interview with Stefan Kawalec [part 1]

02.12.2018 | By Piotr Trudnowski and Stefan Kawalec

President Hollande announced several actions to improve the situation in the country, but he ended up supported only by few percents of the French. It turned out that he was helpless as the president of France. The main reason for Hollande’s failure was euro. It causes France’s problems with maintaining its competitiveness, but at the same time, the lack of own currency makes it difficult to carry out the vital reforms. If Macron doesn’t understand this, then he will likely be in the same situation as Hollande, and in a few years, his popularity will also be dramatically low. Then, the next election will probably be won by the National Front candidate. The European Central Bank is able to defend the currency against market fluctuations, but is unable to protect Europe from voters in individual countries – says Stefan Kawalec, president of Capital Strategy, former deputy finance minister, one of the creators of the so-called ‘Balcerowicz’s plan’ and co-author of the book “Euro Paradox. How to get out of the single currency trap? “

When did you speak with Donald Tusk the last time?

It was autumn 2008, at a meeting hosted by the Prime Minister with a group of economists. Over a dozen people discussed the economic crisis. Donald Tusk mainly listened.

I am asking because you, together with Jan Rokita, are the co-author of the 2005-2009 Governance Plan of the Civic Platform. This is probably the most in-depth document of this type in the history of the Third Polish Republic, whose compilation was coordinated by Tusk. Therefore, it would seem clear that when you write a book on how to save the European Union, you will try to convince your old friend, the President of the European Council. Does Donald Tusk know your theories?

Well, I actually sent the book. I received a thank you from the secretariat. Did the book get to Tusk and if he has read it – I do not know.

‘The Euro Paradox’ that you wrote with Ernest Pytlarczyk is, contrary to appearances, not so much an economical, but more a political book. Therefore, should it be directed primarily towards politicians, and only afterwards to intellectuals and economists?

The book deals with the economic consequences of the existence of the euro, but it is written so that an ordinary educated person can read and understand it. When writing about economic mechanisms, we draw attention to their political consequences, which will become stronger along with the next stages of the euro crisis. The European Central Bank is able to defend the currency against market fluctuations but is unable to protect Europe from voters in individual countries.

Before we go into the detailed steps you propose, I would like to ask about the founding error of the Eurozone. What was the fundamental disadvantage which, according to you, makes this project impossible either from the economic or political side?

Country’s own currency is an essential adjustment mechanism that protects the international competitiveness of the country and facilitates its recovery if the economy loses it for some reason. When a state is deprived of its own currency, the risk of losing competitiveness is higher, and regaining lost competitiveness is much more difficult. It may result in many years of economic stagnation and high unemployment.

The national currency, of course, does not guarantee economic prosperity. It depends on many factors, including the right economic policy. However, without one’s own currency, the risk of falling into long-term trouble in a changing environment of the global economy is much higher, even with a healthy economy. Finland, for a long time a fiscal solidarity champion and the icon of an innovative economy, can be a good example. For several years it has been struggling with the problem of structural non-competitiveness. In 2016, the real level of GDP in this country was 3% lower than in 2007, the last year before the outbreak of the global financial crisis. In Poland, GDP grew by 32% since that time.

What’s the importance of currency for the state’s competitiveness?

Speaking of international competitiveness, I mean the ability of the economy to use the national labour resources in conditions of open international trade.

International competitiveness should not be equated with or confused with, labour productivity. Those two are different concepts. Labour productivity, or the amount of GDP produced on average by one employee, is related to the level of economic development measured by GDP per capita. More developed economies and rich countries have much higher productivity than less developed countries. International competitiveness, on the other hand, does not depend on the level of the country’s economic development. It depends primarily on the relationship between labour productivity and wages in goods-producing companies that are subject to international exchange.

A country at any level of economic development may be competitive or non-competitive at different times. The countries of the South of the Eurozone such as Italy or Spain have lost competitiveness, which resulted in high unemployment. On the other hand, China and Poland have no such problems with competitiveness, even though labour productivity there is lower than in Italy and Spain. Germany, where work efficiency is higher than in all of the countries mentioned here, also has problems with competitiveness.

How did it come about that Italy and Spain have lost competitiveness?

There was a significant increase in wages significantly exceeding the rise in labour productivity. When the euro crisis broke out in 2010, it was estimated that countries in the south of Europe should reduce wages in their economies from 10% to 30%. If both countries did not belong to the Eurozone, such an improvement in competitiveness could be achieved by weakening their national currencies. This happened in Poland at the turn of 2008 and 2009. The zloty weakened by 30% at that time.

Let’s remind the readers what this involved. After all, we did not particularly feel the effects of this phenomenon in our wallets.

The nominal wages in PLN have remained unchanged, but the exchange rate to euro and other currencies of our trading partners has fallen. This was one of the main factors that contributed to the fact that in 2009 Poland was the only country in Europe to maintain economic growth.

On the other side, those countries in the Eurozone that lost their competitiveness could not count on a correction mechanism related to the change in the exchange rate. Therefore, they have been trying to implement a so-called “internal devaluation” policy.

Meaning?

It incorporates attempts to reduce domestic demand by reducing budget expenses and increasing taxes, hoping for local enterprises to cut wages.

In your book, you convince that it is a vain hope.

For several decades, the economists have been arguing that wages are “inflexible down.” What does it mean? Nominal salaries are easily growing when the economy improves. However, when demand falls, companies do not reduce wages. They lower employment and production, but not wages. The effect of the internal devaluation policy is a decline in GDP and jobs, resulting in an increase in unemployment.

In 2016, the southern countries of the euro area had GDP at a level not exceeding the level of 2007. Some even remained at a much lower level – the GDP of Greece was smaller by 25%, Italy by 7%. Poland, as I mentioned earlier on, had a GDP higher by over 30%!

So, answering the initial question about the Eurozone’s founding error: the mistake is to deprive the Member States of their own currencies. This error cannot be compensated in any way.

But why would the continued integration not solve this problem? You believe that the Eurozone will never be able to become an optimal currency area. But why would a monetary union, if decision-makers focus on stronger integration, not create a counterpart of the United States, where economically diverse states do not get too bad with one currency?

If a country that has its own currency loses competitiveness as a whole, it can regain it by adjusting the exchange rate. However, if within a large currency zone some of its regions lose competitiveness, the recovery is challenging. The American experiences are fascinating. The research we quote in our book shows that if in the US a local crisis is growing, causing an increase in unemployment, then there is no return to competitiveness through “internal devaluation” or lower wages in the region!

So what is happening?

People are moving. Such local unemployment crises are solved by migration to other regions of the country. The most spectacular example is Detroit. The former capital of the US automotive industry has lost thousands of jobs, but there is no severe unemployment problem there. Unemployment is at a slightly higher level than the American average. Almost twice lower than in the Eurozone! What happened? Well, residents simply left Detroit. From nearly two million people, there are only 700,000 remaining. The main problem of the city is that a reduced number of inhabitants is unable to maintain the infrastructure and pay off the city’s debts. The city has declared bankruptcy.

What does this tell us about the potentially “completed” Eurozone?

It tells us that even achieving such labour market flexibility in the Eurozone as in the US will not ensure the effectiveness of the “internal” devaluation process in case of a local competitiveness deterioration. In a case of the Eurozone member state that has lost or will lose competitiveness in the future, the only solution to the long-term high unemployment is and will be mass emigration and forced nation’s dissolution across Europe.

However, I believe that neither long-term stagnation nor mass emigration of the population is an acceptable solution for any nation-state in Europe. For the cohesion of the European Union and the Member States, it is vital that the citizens of Europe have the best opportunities for development and prosperity in their own country. Therefore, European countries should not give up their own currency, whose possession makes it easier during crises to improve their economic situation.

And what about non-competitive regions within the Member States?

In many countries, there are regions where young people migrate from. This is not a good situation, and there is no satisfactory solution to it. In Poland, such a case is the Warmian-Masurian Voivodeship, where the unemployment has been one of the highest in the country. People leave for work to Gdańsk or Warsaw, and in Masuria, well-to-do people from all over Poland build their holiday homes. Of course, it would be good to have mechanisms to improve the region’s competitiveness, but these migrations within one country are much more acceptable than mass forced movements between countries.

In practice, it is easier to blame a Ukrainian for own failures in Warsaw than a migrant from Olsztyn?

People who come from Olsztyn to Gdańsk or Warsaw, neither feel like in a foreign country nor are they treated as strangers.

Again, the primacy of socio-political arguments over economic ones can be seen here. When we talk about migration between countries, the tensions are caused by cultural differences.

Such migrations, when they exceed a certain critical mass, give rise to a double tension: in the country, they leave and in the state migrants come to. The situation becomes a breeding ground for the development of nationalist, populist and anti-European movements. If you talk about the optimal currency zone, you need to consider more than purely economic considerations. If only we were concentrating on them, we could, for example, come to the conclusion that Szczecin should have the same currency as Berlin, and not the same as Białystok. After all, it has more business relations with Berlin than Białystok! By analogy, London should then have the same currency as northern Germany and France, and not some remote areas in the north of Great Britain. Economic parameters alone do not determine the possibility of efficient operation of currency zones. It is essential to decide on an appropriate area of ​​the social community for the operation of one currency.

Some important adjustment mechanisms are associated with the existence of the currency, both self-acting and economic policy instruments. Therefore, this area should coincide with the territory of the community with which people realistically identify the strongest. You can identify with different communities to different degrees, but for the currency area, you should choose the one that people are most willing to entrust with responsibility for their fate. In our opinion, within Europe, such a community is a Member State that usually shares culture a language.

By putting such serious cultural and political arguments, it is difficult to conduct more pragmatic considerations at all.

I believe that pragmatism actually takes into account the existing cultural and political conditions. Europe is filled with nations using different languages and having distinct historical and cultural traditions. The Member States are the main centres of identification and identity of citizens, as well as are the source of democratic legitimacy of the authorities. If the Eurozone member is in trouble which cannot be solved without its own currency, populist and anti-European movements will grow. When they come to power, they can threaten not only the Eurozone, but also the existence of the European Union, the common market and, consequently, peace in Europe.

Can further integration, creation of a separate budget for the Eurozone to stimulate those problematic regions, be a response to these threats?

Transfers within one currency zone do not improve competitiveness. They can only finance permanent deficits, but paradoxically they contribute to the deepening of the competitiveness crisis! This is clearly demonstrated by German and Italian experiences –  for years they have been trying to improve the competitiveness of their backward regions through structural policy. For many years, fiscal transfers from western Germany constituted 25% of former East Germany’s GDP annually. In southern Italy, fiscal transfers from the north account for 16% of local GDP. In both cases the convergence process has stopped – these backward regions are not able to improve their competitiveness. Unemployment is much higher there than in other parts of these countries. In the USA, poor states and territories have been depending on transfers from the federal funds for decades, reaching 10% of local GDP, but this has not improved their competitiveness at all. Nothing is surprising in this because the attempt to bring a non-competitive region within the currency zone through fiscal transfers is a contradiction in itself. The “internal devaluation policy”, officially recommended to the crisis-struck countries of the Eurozone, consists of the limiting internal demand to enforce wage cuts. Meanwhile, fiscal transfers increase domestic demand and thus make it difficult to regain competitiveness.

If we know that transfers do not work, why are they still a proposed solution not only for the Eurozone but also for regional policy in the aforementioned countries? Is this a conscious policy of equalising the standard of life and maintaining the political cohesion of these regions?

We can refer to the experience of EU funds in our country. Nobody disputes that EU funds affect the quality of life have political significance and profoundly change the appearance of many regions. However, the research we quote in our book (of Professor Wojciech Gorzelak and the team of Jan Misiąg, Wojciech Misiąg and Marcin Tomalak) prove that these measures do not cause a permanent increase in the number of jobs. EU funds stimulate the economy at the moment when they are spent, but they do not generally form the basis for economic growth in the future. In our book, we emphasise that the critical factor that makes Poland gradually catch up with the more prosperous European countries are not EU funds, but access to the European market and trade. Revenues from exports to the EU are several times larger than net funds received from the EU budget. Thanks to the fact that Poland has guaranteed access to the EU market and is competitive in this market, companies invest in our country, which results in higher labour productivity and regularly growing GDP and wages. Poland’s entry into the Eurozone would create a risk of losing international competitiveness. Then this effective convergence process could stop, and the development gap between the affluent Western countries and Poland could be perpetuated for years.

In your book, you argue that the common currency is a harmful solution for Europe and you are calling for a controlled dissociation of the Eurozone. At the same time, you think France is the only country that can initiate such a process. Do you see such potential in Emmanuel Macron’s statements? On the one hand, he talks about the need for stronger integration within today’s monetary union, on the other, he occasionally mentions that the  Eurozone in 10 years may not exist.

For now, Macron is talking about strengthening and further integrating the Eurozone.  However, it is worth considering the cause of his predecessor’s failure. Six years ago, François Hollande won the presidential election with a leftist program, in the creation of which Macron participated. After taking office, Hollande initially tried to implement his agenda, and Macron became the deputy head of his administration at the Elysée Palace. Two years on, Hollande decided to turn towards a more liberal economic program, and Macron became an economy minister in the government of Manuel Valls. Valls’ and Macron’s attempts to reform, however, encountered strong political resistance and did not result in any change. At the end of the term, Hollande was supported only by four per cent of the French. Such a low level of acceptance for the incumbent President of France is something unimaginable. Hollande may not be an eminent politician, but he did nothing terrible that would justify such a dramatic loss of popularity. It just turned out that as the president of France he was… helpless. This was not due to any special features of his personality, but above all from the situation in which he found himself.

What happened?

Well, in my opinion, the main reason for Hollande’s failure was the euro. Until the introduction of the single currency, France was the leading political force in Europe, the initiator and leader of integration. The French, however, complained that it was Germany who ‘played the first violin’ in Europe regarding currency matters. When the German Bundesbank changed interest rates, other countries, wishing to avoid shaking the exchange rates of their currencies, had to follow its footsteps. The introduction of the euro was considered by the French elite as a huge success because thanks to this the period of the Bundesbank domination ended. It was believed that the common currency would strengthen France’s economic position relative to Germany. However, it turned out to be the opposite. Germany coped with the situation very well. France, on the other hand, has been stagnant and has had high unemployment for years. Deprived of its own currency, there suddenly was no possibility of manoeuvre, and the French found themselves in the position of an ineffective petitioner to Germany. That is to say, both the economic situation and the degradation of France’s political position contributed to the increase in support for the National Front.

Why is France not doing well without its own currency?

France has significant problems with maintaining competitiveness, and the situation will not improve itself only by adjusting the exchange rate. An attempt to address this situation were reforms that were ineffectively attempted in the second part of the Hollande’s presidency. Macron announces that he will carry out the reforms, aiming to liberalise the labour market and reduce budget expenses. Economists have been long indicating that France needs such changes. The problem is that the lack of their own currency makes it more difficult to carry them out. What is worse, within the Eurozone, such reforms are not enough to fundamentally improve the situation of a country that suffers from competitiveness problems.

Why is the lack of its own currency impeding the reforms?

The reforms we are talking about would reduce demand and slow down economic growth in the first period. If France had its own currency, this recession effect could be offset by weakening the currency that causes an increase in demand for domestic goods both on the domestic and export markets. In most cases in the world, when such adjustment programs succeeded, they were accompanied by a devaluation of the national currency, which improved the competitiveness of the economy and mitigated the economic and social costs of reforms. In the case of France deprived of its own currency, such support is impossible, and in a situation of long-term social frustration caused by high unemployment, it is difficult to take actions that will in the first-place cause further deterioration of the situation.

You said that if Macron was able to introduce the announced reforms, they would not bring about any substantial improvement?

To improve its international competitiveness, France should reduce labour costs compared to the costs of trading partners. Labour market reforms will not make it happen. As I said, even in the US, where the flexibility of the labour market is considered to be at an unattainable level for Europe, the situation of locally higher unemployment does not decrease wages.

The second idea of Macron is the common budget of the Eurozone and the allocation of funds for investment to revive the economies of countries experiencing problems. However, as I explained, transfers from the common budget are unable to solve the problem of the country’s non-competitiveness, and actually, they will hinder the recovery of competitiveness.

So what do you think Macron should do?

He should offer Germany to initiate a controlled dissociation of the Eurozone to save the European Union and the common market.

If Macron does not understand this, then it is likely to be in the same situation as Hollande. In a few years, his support will be dramatically low. The next election will probably be won by a National Front candidate.

You write that the impulse to dissociate the Eurozone must come from a pro-European democrat, not a populist. But if Le Pen wins and she proposes to leave the Eurozone, would you see the hope or threat to your controlled dissociation project?

Definitely a threat. The European Union and the common market are significant achievements that have been generating economic growth and peace for decades. We propose the dissociation of the Eurozone as a way to minimise the disturbance that will result from it. We want to do this to preserve the European Union and the common market – and Le Pen’s views are entirely different in this respect.

To limit potential conflicts, we suggest dissociating the Eurozone in reverse order than it would seem obvious to many people. The strongest should be the first to leave it, and we should not start with throwing away the weakest.

Translation from Polish: Kosma Nykiel

 

This publication has been cofinanced by the Ministry of Foreign Affairs of the Republic of Poland within “Cooperation in Public Diplomacy 2018” programme.
This publication reflects the views of the author and not the official stance of the Ministry of Foreign Affairs of the Republic of Poland.

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