Eurozone is a negative-sum game. Let’s disunite it to save the EU. Interview with Stefan Kawalec [part 2]

10.11.2018 | By Piotr Trudnowski and Stefan Kawalec

Until the introduction of the single currency, the European Union was a positive-sum game. After the introduction of Euro, the EU became a negative-sum game, in which everyone loses in the long run. Germany also has issues with the currency: a dangerous trade surplus. Any crisis in Germany is a direct threat to peace in Europe. Everyone is afraid of Wilders in the Netherlands or Le Pen in France, but their counterpart in Germany, if he had a chance to come to power, should raise real concerns. Finding the solution to the German surplus problem is, therefore, a common interest of the Union – says Stefan Kawalec, president of Capital Strategy, the former deputy finance minister, one of the creators of the so-called Balcerowicz’s plan and co-author of the book ‘The Euro Paradox. How to get out of the single currency trap?

In the first part of the interview, you persuaded that the greatest blessing of having your own currency is the possibility of devaluation. How does it work in practice? Let’s analyse the case of the famous “Polish green island” of prosperity during the 2008 crisis.

The point is not about letting the currency devalue continually, or to stay weak, but it is about allowing its strength to adjust to the situation of the economy and its international environment. For over a dozen years, Poland had a flexible exchange rate system. Sometimes, some National Bank of Poland or the Ministry of Finance interventions affecting the course may have appeared, but in general, the course is shaped by the market. The flexible exchange rate of zloty acts as a much-needed countercyclical mechanism.

Which means?

If the economy is doing well, the exchange rate strengthens. As the zloty strengthens, Polish exports become less profitable, and this halts Polish economy. If, on the other hand, the situation on the Polish market or the European or world economy deteriorates, severe disturbances occur, then investors start to flee Poland. As a result, zloty weakens. What happens next? The goods produced in Poland become cheaper and more competitive in relation to foreign goods, both on the Polish and international market. Then, in Poland, we buy more products manufactured in Poland than goods produced abroad, but also Polish companies sell more goods overseas. As a result, production in factories in Poland is not falling, and people are employed.

In this case, why has Poland’s smooth transition through the crisis has not undermined European elites’ trust in the whole idea of the Eurozone?

The existence of a single European currency is something obvious, as is the existence of a common system of measures and weights. Everyone understands that it helps the day-to-day life of companies and people travelling around Europe. Europeans do not have to bear the costs of currency exchange and the risk associated with exchange rate fluctuations.


Everyone understands these benefits. However, the reason why separate national currencies are vital is not so intuitive and is not always understood. It’s just like expansion joints in a bridge. You do not need to explain to anyone that a bridge built as a unified structure that you can pass without jumping would be a good solution. What needs to be explained is why, from time to time, there are the gaps where the cars bounce.  Although a bridge without expansion joints would be more comfortable, it could lead to excessive stresses, bulges, cracks and even collapse. The same applies to the issue of different currencies in Europe. One currency is more convenient in many respects, but it creates enormous tensions, which in consequence may lead to the collapse not only of the Eurozone but of the entire EU.

There are still various opinions being repeated about the benefits the euro brings to the stability and pace of economic growth, which seem intuitively justified, but is based on flawed economic analysis and the empirical experience contradicts them. For example, there is a widespread belief that a medium-sized country having own currency creates the risk of destabilisation, especially in a case of severe disturbances on the international markets. It appeals to the imagination that in the conditions of a global storm, it is better to be on the big transatlantic ship, which is a dozen per cent of the global economy than on a small boat like Poland, where market disturbances can throw it on various sides like a boat.

This seems to make sense.

Intuitively, it seems obvious. Hence many economists and politicians are unknowingly repeating it. Meanwhile, the paradox is that it is that the truth is the exact opposite. In the conditions of disturbances on the global markets, the economy of a country that has its own currency turns out to be more stable than an own-currency-less country in the Eurozone. The exchange rate acts as a shock absorber, and its fluctuations stabilise the economy.

And when there is no national currency?

Then, in the conditions of the disturbances, the currency is stable. On the other hand, the real size in the economy changes significantly: employment, production, prices and GDP. An extreme form of this process can be observed in the example of the differences between Poland and the southern European countries. These countries have been enjoying a stable currency all the time, but they were experiencing fluctuations and severe declines in production, employment and GDP.

Many people answer that relying on the recovery from the crises using devaluation is a shortcut, swapping the problem under the carpet. Maybe it allows a country to pass in a politically stable way through a period of economic unrest, but it does not give impetus to conduct ambitious economic reforms. And the point is to deal with these problems, which are not a symptom, but the cause of the financial crisis.

The wealth of a country is not determined by the level of an exchange rate, but the productivity of work. The fluctuation in the exchange rate does not directly improve work efficiency. However, it can restore competitiveness. If wages are too high in relation to productivity, then the competitiveness of the economy can be theoretically improved either by increasing labour productivity or by lowering wages. Of course, an increase in labour productivity would be the most desirable, but in a non-competitive economy, it is challenging. The primary source of productivity growth is the investments of companies that create new jobs or modernise existing positions, and in the absence of competitiveness of the economy, it is difficult to expect such investments. First, you must regain your competitiveness by reducing wages in comparison with your business partners. Only then you can you can expect the investment that increases productivity, GDP and wages.

Exchange rate adjustment is an effective method of improving the distorted relation between wages and labour productivity. The improvement in competitiveness achieved will not last if the country has excessively expansionary monetary and fiscal policies. Then, the competitiveness will be quickly ‘eaten’ by inflation and further weakening of the currency will be necessary. However, with healthy macroeconomic policy, the improvement in competitiveness achieved due to currency devaluation may be permanent. In the book, we give examples of, among others, South Korea after the Asian crisis of 1997, Iceland and Poland after the 2008 crisis. In these and many other cases, adjusting the exchange rate permanently restored competitiveness and enabled economic growth for many years to come. On the other hand, countries that attempted to repair a significant gap in competitiveness without adjusting the exchange rate paid for vast losses of GDP or a long-term stagnation of the economy.

But let’s look at the south of Europe. Today it is probably a less popular statement, but a few years ago, most commentators would say with deep conviction: do you want to increase the foreign investment? Devaluation will not help, labour market liberalisation, cutting budget expenditure and deregulation of the economy will! After all, these problems are indicated as the foundations of economic issues.

Countering the exchange rate adjustment to economic reforms is a misunderstanding, as these are not mutually exclusive. For the economy to grow well, one needs a proper level of the exchange rate and favourable conditions for running a business, an efficient labour market and sound public finances. One cannot replace the other. Of course, having your own currency does not guarantee that the country will conduct sound economic policy and maintain healthy regulations.

The frequently expressed view that a country should not be allowed to adjust currency to force the economy to reform, I think, to put it mildly, is not very sensible. Firstly, in a situation of a significant gap in international competitiveness, structural reforms are insufficient to restore competitiveness. Secondly, it is often impossible to carry out painful economic reforms without own currency, what I have explained in the first part of the interview, speaking about the case of France.

However, Germany has managed to improve its competitiveness within the Eurozone thanks to the reforms of the Schroeder government that you write about in ‘Euro Paradox’. Why others can’t follow that path? Do they lack courage and determination?

Indeed, hardly anyone remembers that during the euro introduction period, Germany was struggling with the lack of competitiveness problem. They had slow economic growth and high unemployment, compared to other Eurozone countries. In 1999, The Economist weekly described Germany as a “sick man of the Eurozone”. The answer to these problems were so-called Hartz reforms introduced in Germany by the Gerhard Schroeder’s government between 2003 and 2005.  The amount of benefits for the long-term unemployed was radically reduced. Changes were painful and resulted in a loss of power for the Social Democratic Party. However, they brought results. The unemployed began to return to the labour market and were willing to work for lower wages. The unemployment started to decline, and the German economy regained its competitiveness. In our book, we analyse this case and show that Hartz’s reforms did not lead to wage cuts in Germany, but they weakened the rate of growth. The Germans managed to improve their competitiveness within the Eurozone without a nominal wage decline because in that period the wages in other Eurozone countries snowballed. However, it is not always possible to count on such favourable internal circumstances.

So, the Germans have succeeded, but the Greeks won’t repeat the success?

In a situation when the trade partners have low inflation and wages are growing slowly, as it currently is the case in the Eurozone, improving the international competitiveness of a country deprived of its own currency requires a decline in nominal wages, which is a daunting task.

It did not succeed in Germany or the United States. Realistically, no potential labour market reform will cause this.

Let’s assume that you have convinced me that the best thing we can do with the Eurozone is to unbind it. Let’s go back to the plans outlined in the book. Imagine that one of the advisers suggested the European Solidarity Manifesto to Emmanuel Macron, signed by economists from different countries. He takes your voice into account. He goes in his office, calls Angela Merkel – and what does he say?

Macron should tell Angela Merkel that to save the European Union and the common market, a controlled dissociation of the Eurozone and a return to national currencies is necessary. The first step of this process should be Germany exiting the Eurozone and an agreement on a mechanism for monetary coordination in Europe.

Why would Germany benefit from it? 

There is a fairly common belief that Germany is gaining on the euro and countries in the south of Europe are losing. That Germany is the beneficiary of the euro…

… and Germany officially claims otherwise.

Just as the European Union was a positive-sum game until the introduction of the single currency, the euro has become a negative-sum game in which everyone loses in the long run.

Germans lose too?

The German economy has been developing in recent years, but due to the enormous trade surplus, which is unsustainable in the long run. It results from the fact that the European currency is too strong for the countries of the south of Europe and France, and too weak for Germany.

When the euro crisis broke out in 2010, the southern countries of the euro area had a huge current account deficit, while Germany and some smaller countries had a huge surplus. As a result, the euro area as a whole had more or less sustainable external turnover. In the subsequent years, deficits in the southern countries disappeared or were substantially reduced. First of all, the recession contributed to that – if the economy is shrinking, internal demand decreases, imports decrease, and the balance of trade and the current account balance improve. The second factor was the weakening of the Euro. Since the beginning of the crisis, many economists and politicians have argued that to help the countries of southern Europe to recover from crisis, the ECB should seek to weaken euro, which has indeed happened. The effect of the weakening of euro was a further increase of the German trade surplus and surplus of current turnover. Due to the reduction of deficits in the south and the surge in Germany’s surplus, the euro area as a whole has gained a considerable surplus in external trade. 2016 was the fourth consecutive year in which the Eurozone had the highest current account surplus of all economies in the world – higher than China. I wrote two years ago that this situation is unsustainable and will sooner or later lead to a conflict between Europe and its trading partners.

Sooner or later?

For years, economists have been showing that global trade, with sustainable sales, can benefit all participants. On a global scale, by definition, trade is always balanced – so if an economy has a large surplus, then someone else must have a large deficit. A large trade deficit means a reduced demand for goods produced domestically, which translates into a loss of jobs. That is why I wrote that it would jeopardise the implementation of the free trade agreement between Europe and the United States and could expose the European Union to a trade conflict with the US. When Donald Trump comes to power, this perspective becomes more and more real. Today, it is not China, and the Euro area is a partner who conducts a huge commercial surplus on a large scale. Two-thirds of this trade surplus is Germany, and in the German economy, it accounts for almost 8% of GDP. This is unsustainable in the long run.

How can it end up?

As we drive on a bumpy road too fast and we are not able to slow down, it may end up badly. For example, in conditions of a global crisis, the surplus will suddenly fall, and a dramatic recession will begin in Germany, much more profound than in other countries.


Because, paradoxically, the high trade surplus is not proof of a healthy and robust economy. It is a testimony to its inflexibility and inability to use the labour force in the country with a balanced turnover. France’s experience from the interwar period can be cited here. Before the Great Depression of the 1930s, France had a large trade surplus and substantial gold resources. When the great crisis began, it was thought that thanks to this surplus France is safer and can do better than other countries. It turned out the opposite. It managed worse than many other countries. If there is a breakdown in the world economy or German partners introduce trade restrictions, then their surplus will be reduced in the conditions of falling trade turnover.

What options does Germany have? 

They can pretend that they can go on forever, but this may end tragically. They can try to limit the surplus. A significant proportion of economists and European politicians believe that Germany should increase its internal demand by more spending on infrastructure, raising wages and so on. Theoretically, it will have the same benefits: Germany will spend more, earn more, increase German imports, which will benefit the experiencing problems of the Eurozone economy, while the German surplus will be reduced or disappear altogether.

You disagree with this.

In the book, we compare two variants of the German trade surplus reduction. The first variant is the one just described. The second option is a return to its own currency, which will strengthen itself and Germany’s trade turnover will be balanced. What’s the difference between those two? In both options, wages in Germany, as converted into partner currencies, will increase, the balance of trade will gradually level out. The main difference will be revealed when, at some point, the German economy starts to have serious competitiveness problems. Competitiveness of the economy is not given once and for all. Even the wealthiest and most efficient economy can lose competitiveness. The current example is Finland, which I have already discussed in the previous part of the interview. Germany also had serious competitiveness problems in the first years of euro. At that time, Hartz’s reforms helped the country. It will not be easy to repeat such changes.  There are no more reserves in the public benefits system. The political costs of further reforms liberalising the labour market or decreasing the social support are enormous. Moreover, as I said, labour market reforms are not enough to restore competitiveness if there is no significant increase in wages among the trade partners.

In a variant in which Germany’s surplus will be reduced, thanks to the restoration of its own currency, it will help Germany to remain competitive or to restore it in the event of a future crisis. Following the second option, Germany will reduce its surplus by increasing wages within the Eurozone, if at some point the German economy becomes uncompetitive, then the country may be doomed by a long-lasting recession.

Germany being in a crisis? Many would be pleased!

This is a dangerous scenario not only for Germany but for the whole of Europe. Today it is said that populism is growing everywhere, but the Germans are still doing well. Why? Because their economic situation is good. Meanwhile, the crisis in Germany is a direct threat to peace in Europe and an analogy with what has happened in the 1930s. Then the consistent policy of internal devaluation led Hitler to power. Everyone is afraid of Wilders in the Netherlands or Le Pen in France, but their counterpart in Germany, if he has a chance to come to power, should raise real concerns. To solve Germany’s problem with a surplus is, therefore, a joint interest of the whole Union.

This story sounds logical, but the views of supporters of the controlled demolition of the Eurozone remain on the margins. It may be a wider margin than before, but still a margin.

Germany is a country where there is far-reaching political correctness in public discourse, and at the same time, the government and political leaders have great authority. Chancellor Kohl agreed for Germany to join the Eurozone, although most Germans wanted to preserve the mark. Citizens acknowledged and accepted this decision. There is no discussion on of dissociation of the Eurozone in the German mainstream today. If, however, after this hypothetical conversation with the French president, Chancellor Merkel said that to save Europe, Germany must return to its own currency, I think Germans would accept it, and many of them would be very happy.

Recently, President Trump attacked Germany for a trade surplus and currency manipulation, threatening to impose trade restrictions. The German leaders answered that they were not guilty of anything because they did not affect the euro value. They said that the euro is too weak for them and they would like it to be stronger. Low-interest rates cause considerable concern in German economic circles. They cause problems for insurance companies, and their ability to pay long-term benefits is at stake.

Let’s say that the Germans got along with the French. How does it appear in the steps described in the “Paradox Euro”? In the beginning, Germany, probably alongside some of the larger European economies, is excited. What’s next?

We propose that the European Central Bank should be left as a temporary central bank for countries that leave the Eurozone to ensure stability in the transition period. This will ensure that the arrangements for admissible currency bands will not be contested by the market.


The new German currency will strengthen against the euro, and this is one of the goals of this operation. However, this should be done within reasonable limits, as excessive changes could lead to the collapse of exports and recession in Germany and high inflation in the countries still remaining within the Eurozone. Therefore, we anticipate that bandwidth allowable exchange rate changes will be established. The new role of ECB proposed by us will cause such established bands to have high credibility, and it will be challenging to distort them with any speculative attack.

Is it that important?

The credibility of currency bands can usually raise doubts because the central bank issuing the domestic currency may not be able to prevent it from falling below the minimum threshold. In the short and medium term, the country can defend itself against the appreciation of its own currency, but cannot protect itself against its depreciation. If the state wants to prevent its currency from falling, it uses its foreign currency reserves to buy its own from the market. When they are finished – there is no possibility of such an intervention. On the other hand, the options of preventing the increase in the exchange rate of own currency are technically unlimited, they consist in issuing this currency and buying foreign currencies, which results in an increase in foreign exchange reserves. This creates a variety of tensions when you do it for a long time, but in a few months, a year or even longer – you can do it safely. If we are dealing with the currency band and the issuer of the currencies of the countries of the former members of the euro area will for some time still be the European Central Bank, it will be difficult to speculate against it. He will always be able to intervene by issuing a currency whose exchange rate is growing too much and using it to buy weaker currencies from the market, raising their exchange rate.

Why would states, leaving the Eurozone, agree to such a lack of control over their own currency and wait years for their own competence in this area?

Because this is a solution that protects us from getting out of control of the whole process. The European Central Bank enjoys strong credibility in the markets, as evidenced in 2012, when Southern Europe countries’ bond interest rates grew, and the situation was dramatic, the ECB’s declaration itself is ready to buy these bonds on the secondary market without any restrictions, what caused the interest on the bonds to fall.

However, in the scenario we are talking about the tensions will grow. European Demos will have the prospect of a significant challenge to be solved by the monetary union. Yet, nowadays within the debate in many countries – sometimes more in its centre, sometimes on the outskirts – we have a conviction that the European Central Bank is dominated by Germany. The sentence that “Germans leave, while it is safe, and at the same time keep control over our currencies” is, after all, a political bomb that populists will speak very efficiently.

Theoretically, one could try to guarantee relations between the currencies of central bank contracts, but this requires coordinated actions of all banks. In practice, not all of them can take these actions and the whole system can fall apart. If Germany leaves the Eurozone, then in other countries there may be fear of euro becoming the currency of the crisis countries and that Germany will not collapse. There will be a fear of currency collapse and fear of inflation. The proposed role of the ECB will be a stabilising factor for all.

We must remember that today, no one, including the ECB, has a monetary policy instrument that only affects the economy, for instance in Italy. Tools in the hands of the ECB change the entire euro area. At the moment when the national currencies are restored, and the role of the ECB is maintained, instruments that do not exist today are created: in the form of a separate exchange rate policy concerning the individual countries. What we propose is that the countries regain these instruments, while the management of these instruments will remain in the hands of the ECB during the transition period, which will be conducive to stabilisation.

How long would this transitional period of the existence of the Eurozone, from the exit of Germany to the departure of Greece, would it last? How much longer would the ECB last exist after a “shut down” of the currency?

This could take around three years from Germany’s departure to the final dissociation of the Eurozone. This could take place in three stages: first, Germany goes out along with, for example, the Netherlands, then countries with medium levels of competitiveness, and finally other countries return to their national currencies. However, the issue of the further role of ECB is already a political decision depending on the dynamics of this process. If it runs smoothly, there may be interest in maintaining the ECB and leaving it to its role for a long time. I think that this process of competence recapture by central banks may also be staged, and even when they entirely become issuers of their own currencies, the ECB’s structures may remain to manage the system of monetary coordination in Europe.

Let us look at the entire process from the Polish perspective and in the context of today’s mainstream discussion about possible development scenarios of the Union. The louder the postulates regarding financial transfers within the Eurozone are, the more obvious it is they will be at the expense of structural funds for Central and Eastern Europe. Can you imagine that Poland, as the largest EU member outside the zone and in some sense neutral about the details, comes up with the initiative of convincing the Union to the scenario you draw in ‘Euro Paradox’?

I believe that from Poland’s point of view, the EU’s behaviour in its political dimension and a common market in the economic aspect is nowadays almost like “to be or not to be”. Poland, of course, is also interested in a healthy condition and development of the European economy, while today euro is holding back this development. However, I do not believe in the possibility of Poland’s driving force as a political initiator of such a process. As I said, it seems to me that for historical reasons only France can initiate this process. In a situation where Macron draws Poland as a country that is an obstacle in the European Union, I am afraid that the political movement from Poland in this direction would not be well received.

Perhaps, it will always be a problem for the political dimension of this decision, when one country asks another with an initiative in this subject? It seems logical that such a stimulus would have to appear on the part of one of the EU institutions leaders. Perhaps, they can try to tell this story today by the language of concern for European solidarity and community. After all, when the French turn to the Germans, regardless of their intentions, all other nations will grab their wallets for fear that the big ones want to hurt them.

Indeed. European institutions are a place where such a proposal should come from. It would be natural and proper. However, it is implausible. These institutions, on the one hand, are hardly self-sufficient, and on the other hand are firmly attached to the ideology of ‘ever closer union’, a vision of even closer integration. We believe that our proposal is a pro-EU and pro-European proposal, which is why we have created the European Solidarity Manifesto, under which economists from several EU countries have signed up, both from the Eurozone and from the outside. That is why we presented the outline of our concept under the slogan of European solidarity, to emphasise that Germany’s departure should not be a manifestation of the lack of solidarity, but quite the opposite. It would be a real help for countries in a crisis. In contrast to aid solutions, which are mainly used to collect money for the repayment of loan instalments for creditors.

Have you encountered any real political interest in reaction to the book and the manifesto? Has anyone, no matter who and no matter in which country, asked you for an executive document?

Not yet.

Do you believe that this process of deliberate and, unprovoked by the populists, demolition of the Eurozone can come true with the state of mind of today’s European elites? Wouldn’t you be shocked?

It will only depend on political decisions. These are difficult to predict because they are non-linear. You can say that something will probably happen sometime, but it is tough to predict when. It’s much easier to explain political phenomena after the fact. Nevertheless, the risk that we will survive the shock accompanying the uncontrolled break-up of the euro area is high, and it is getting more significant over time. Possibly, European elites will remain deaf to these proposals and end up in a severe destabilisation of the European Union. But I can also imagine a scenario in which our arguments will be , and the whole process carried out. Then, the majority of those who cannot imagine withdrawal from the euro today will think that they have always believed that the common currency was a misunderstanding.

Thank you very much for the conversation.

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.