European Social Democracy and the Roots of the Eurozone Crisis

Part 1: Monetary Union and Fiscal Disunion

By Alejandro Reuss | July/August 2016

This article is from Dollars & Sense: Real World Economics, available at

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In 2007–8, after the real estate bubble burst, the entire U.S. economy plunged into a deep recession, the worst since the 1930s. But the downturn hit some parts of the country harder than others. Overall, real gross domestic product shrank by just over 4% between the pre-recession peak and the trough. Meanwhile, Florida, for example, saw its state GDP decline by over 11%—so, more than 2½ times as much. The official unemployment rate for the United States as a whole more than doubled from a pre-recession low of 4.4% (May 2007) to a peak of 10.0% (October 2009). In Florida, it more than tripled, from 3.1% (March–April 2006) to 11.2% (November 2009–January 2010). Florida’s state and local tax revenues declined from nearly $37.5 billion in fiscal year 2006 to about $28.8 billion in fiscal year 2010.

Do you remember, then, how officials from Florida had to engage in protracted negotiations with the federal government—the Department of the Treasury, the Federal Reserve, etc.—to get federal assistance in dealing with the crisis? Do you remember the recriminations from the governors and legislators of other, less severely affected states, decrying Floridians for their profligate spending and lazy work habits? Federal authorities’ insistence on state tax hikes and deep spending cuts, as Florida’s just penance for a crisis of its own making? The mass marches in the streets of Miami, Tampa, and Tallahassee as Floridians resisted this painful austerity?

Me neither.

The United States, like Europe, experienced what economists call an “asymmetric crisis”—affecting some regions more severely than others. We may only now be seeing some of the political repercussions of economic problems—both acute and chronic—in the United States. Yet the kind of turmoil that happened in Greece and other countries of the European “periphery”—the negotiations, recriminations, austerity measures, and massive street protests—did not happen in the especially hard-hit parts of the United States. One reason was that large-scale fiscal transfers between one part of the union and another happen quite automatically, and with relatively little contention, in the United States. Economist Paul Krugman, who has used Florida as an example of what was missing in Europe in response to the Great Recession, put it this way in a 2012 blog post: “Florida received what amounted to an annual transfer from Washington of $31 billion plus, or more than 4% of state GDP. That’s a transfer, not a loan. ... Aid on this scale is inconceivable in Europe as currently constituted.”

Krugman’s analysis points to one of the structural problems with the eurozone—monetary union without fiscal union. Monetary union, the adoption of a single currency throughout the eurozone, deprived member countries of policy tools which they otherwise might have used in response to the sharp downturn. (Not all of those, mind you, would have been painless or desirable.) Meanwhile, the absence of fiscal union, that is, the lack of unification of taxation and spending at the federal level, ruled out large “automatic” transfers from less-affected to harder-hit countries.

Too United?

In one diagnosis, the severity of the European crisis—especially for the “peripheral” countries of Ireland, Italy, Portugal, Spain, and (most of all) Greece—can be thought of as a result of Europe taking economic unification too far. Key elements of Europe’s economic unification—in terms of finance, trade, and monetary union—played some role in setting off the crisis. Financial liberalization helped enormous financial flows pour from Europe’s higher-income “core” countries to its lower-income “periphery,” helping to fuel large housing bubbles in countries like Ireland, Italy, and Spain. Trade liberalization exposed domestic industry in Europe’s periphery to withering import competition from Europe’s core. The bubble-fueled boom, in addition, drove up domestic prices relative to import prices, helping push up trade deficits in the peripheral countries. The adoption of a single currency, the euro, by 19 of the 28 EU member states, however, merits special attention. Monetary union deprived member countries of two important policy instruments that they might have deployed as the crisis developed.

First, a eurozone member could not devalue its currency against those of other members. Greece’s current account deficit soared from the mid-1990s on, peaking at nearly 15% of GDP in 2008. (The current account balance is a standard international-accounts concept that includes the trade balance.) A country with its own currency might have “devalued” its currency; that is, Greece might have allowed the drachma (if there were still a drachma) to decline in value relative to, say, the deutschmark (if there were still a deutschmark). Here’s the standard argument: Devaluation would have made imports of goods from Germany more expensive to Greeks, and so tended to reduce imports. Meanwhile, it would have made Greek exports less expensive to Germans, and so tended to increase exports. Together, these effects would have tended to reduce Greece’s trade deficit. How fast or strong the effects would have been is debatable, considering how much Greek industries had been weakened over the years by punishing international competition. (To be clear, currency devaluation is not a rosy or painless option. Devaluations drive up the prices of imports and, by reducing import competition, the prices of domestically produced goods as well. The result is an erosion of real incomes, often hitting lower-income people especially hard. The country may be producing more goods and services, but because it is exporting more, its people—especially ordinary people—may be consuming less.)

In the absence of the policy option of a currency devaluation, Greek policymakers engaged in what economists call an “internal devaluation”—pushing down domestic wages in order to make Greek goods cheaper and more internationally competitive. One might say that, rather than devaluing its currency relative to other currencies, it devalued Greek workers relative to the workers of other eurozone countries. How can government economic policy bring about a reduction in wages across an entire national economy? Massive unemployment can do the trick—and it did so in Greece, to the tune of a 20% total decline in real wages between 2009 and 2013. Unemployment, of course, exacts an enormous cost in lost production and human suffering (see Evita Nolka, “The Human Toll of Greek Austerity,” Dollars & Sense, March/April 2016).

Second, no eurozone country could unilaterally increase the money supply to pull down interest rates or increase the inflation rate. Both lower interest rates and higher inflation, arguably, could have been good for Greece. Lower interest rates would have made it cheaper for Greek households and businesses to borrow, stimulating spending and boosting output. This is why “expansionary” monetary policy—increasing the money supply and lowering interest rates—is a common central-bank response to an economic downturn. Higher inflation, meanwhile, would have reduced real debt burdens. Debts are usually specified, at some point in the past, as a specific quantity of money. Inflation means that a certain number of dollars or euros (or whatever monetary unit) becomes easier to come by for anyone getting paid in the new, higher prices. This makes debts easier to pay off. A hard-hit country, then, might have quite sensibly adopted a highly expansionary monetary policy.

Monetary policy in the eurozone, however, is made not by individual countries but by the European Central Bank (ECB). The ECB’s mandate, as economist Gerald Epstein points out, is strictly about maintaining price stability (that is, low inflation). Contrast this to the U.S. Federal Reserve’s so-called “dual mandate” to maintain both low inflation and low unemployment. One might think that, in the midst of depression conditions and massive unemployment, the singular focus on low inflation would go out the window. Under a different balance of political power, it might have. But for much of the crisis, the most powerful country in Europe, Germany, successfully opposed a more aggressively expansionary monetary policy.

Germany was not hit very hard by the crisis, thanks in no small measure to its large trade surpluses with the rest of the eurozone and the world. (These large surpluses have developed since the creation of the eurozone, which D&S columnist JohnMiller argues “has functioned for Germany as a built-in currency manipulation system” (see Miller, “German Wage Repression: Getting to the Roots of the Eurozone Crisis,” September/October 2015).) Germany’s unemployment rate, declining dramatically before the crisis, turned upward briefly (to about 8% in 2009) before continuing its decline. So the urgency of stimulating spending, for German policymakers, was relatively low. In addition, German policymakers are notoriously inflation-averse. Some point to the scarring historical experience of hyperinflation in the 1920s, but the main reasons are probably more prosaic. As Frankfurter Allgemeine Zeitung economic correspondent Winand von Petersdoff remarked in a 2011 article, the real issue is not a historical “trauma” but the simple fact that “inflation is a major redistribution,” with debtors among the winners and creditors among the losers.

The structure of the European Union, it should be pointed out, also limited member countries’ fiscal policy space in two major ways (both constraints, though, were closely related to the logic of monetary union).

Federal Unemployment Insurance for Europe

Some economists have proposed reforms that would move the EU’s fiscal system in the direction of fiscal union, especially in regard to “automatic stabilizers.” For example, Leila Davis, Charalampos Konstantinidis, and Yorghos Tripodis, in a Political Economy Research Institute (PERI) working paper, have proposed a federalized system of unemployment insurance for the EU. “The logic for fiscal transfers is well known,” they write, citing a considerable body of literature on the perils of monetary union in the absence of such transfers. “[C]ountries in monetary unions neither have independent monetary authority nor exchange rate control and, therefore, have limited policy options with which to respond to adverse shocks. Fiscal transfers across member countries can, however, mitigate the impact of asymmetric shocks, particularly in the context of restrictions on domestic fiscal spending.”

First, the 1997 Treaty on European Union, better known as the Maastricht Treaty, placed limits on government deficits and debt. (The 1998 Stability and Growth Pact (SGP) added mechanisms for monitoring and enforcing these limits.) As the website of the European Commission puts it, “The [Maastricht] treaty limits government deficits to 3% of GDP and public debt levels to 60%, so as to enable countries to share a single currency.” The logic of monetary union—and the fear, especially on the part of German policymakers, that deficit spending could fuel inflation—explicitly drove the imposition of “fiscal discipline” on the member states. (As it turned out, Germany and France, mired in recession in the early 2000s, both repeatedly breached the deficit limits without punishment.) The European Commission states that, since the limits imposed by the Maastricht Treaty and SGP are based on the structural deficit (the portion of the overall deficit that is not driven by the business cycle), they “take into consideration business cycle swings.” However, critics argue that the Maastricht/SGP limits have nonetheless been a major driver of austerity policies. As Sebastian Dulien, a researcher at the European Council on Foreign Relations, put it in 2012, “The severe [fiscal] adjustment programmes in Spain and Italy are all part of the normal working of these legislative acts.”

Second, when a government borrows by selling bonds in a currency it controls, it has the option of paying back the creditors by creating more money (known as “monetizing the debt”). This means that such a country really never has to default on its debts, and the creditors who have loaned it money need not fear that they will not get paid back. (As former Federal Reserve chair Alan Greenspan put it in 2011, “The United States can pay any debt it has because we can always print money to do that. So there is zero probability of default.”) Lenders charge higher interest to compensate for higher risk of not getting repaid. So if creditors do not fear default, they will lend at lower interest rates than they would otherwise. Even if a country’s public debt becomes large, so long as it controls the currency in which it has borrowed, its creditors will have little reason to panic, cut off further credit, demand immediate repayment, and thereby trigger a crisis (the equivalent, at the national level, of a “run on the bank”).

The European countries that got deep into debt, in contrast to the United States or the U.K. (which, for now at least, is a member of the EU, but has never been a member of the eurozone), owed their debts in a currency they did not control (the euro), and did not have the option of creating more money to pay it back. “When investors lost confidence in these countries, they ... [pushed] interest rates to unsustainably high levels,” explains economist Paul De Grauwe of the London School of Economics, “making it impossible for the governments of these countries to fund the rollover of their debt at reasonable interest rate.” What does this have to do with fiscal policy? Unable to borrow further, these countries “had to scramble for cash and were forced into instantaneous austerity programs.”

Or Not United Enough?

If one could argue that the eurozone was “too united,” in regard to monetary union, however, one could equally argue that it was not united enough, in terms of the lack of fiscal union. In a federal political structure, fiscal union means that households and firms in the member states pay their taxes (at least in part) into a common federal treasury, and expenditures are paid out from this treasury back to people across the member states. This is not an exotic idea: The United States is a fiscal union in precisely this sense.

During a business-cycle downturn, a standard “Keynesian” policy response is to increase government spending or reduce taxes (or both)—to boost demand, output, and employment. Governments may push through new spending and tax legislation (fiscal “stimulus” programs) for this purpose—as, indeed, the U.S. government did during the Great Recession. However, some existing government programs result in increased government spending and reduced tax collection during downturns without any need for deliberate policy changes. These are known as “automatic stabilizers.” As an economy goes into a downturn, some people lose their jobs. Some see their hours cut. This reduces their incomes—but since many taxes are dependent on incomes, tax collections are reduced automatically. This helps to blunt the impact of the downturn. (As a thought experiment, to see how things would be if this were not the case, imagine that incomes were falling but each person or household still had to pay a fixed monthly tax bill.) There are automatic stabilizers on the revenue side as well. Government expenditures on unemployment insurance, for example, rise as people start losing their jobs. So, too, do public expenditures on pensions (like Social Security in the United States), as some employers downsize by enticing older workers to take “early retirement.” These expenditures, too, slow the fall in demand, compared to what it would be otherwise.

In the case of a crisis that affects different states differently, automatic stabilizers have the biggest impact in the states that are hit hardest. Their tax payments to the federal government decline more dramatically than those of other states, while expenditures from the federal government increase more dramatically. Florida and other U.S. states that were especially hard hit by the crisis were—like Greece, Ireland, Italy, Portugal, and Spain—part of a large monetary union. The states do not have their own currencies or conduct their own monetary policy. U.S. states are also greatly constrained in their fiscal policy. For example, most states have balanced budget requirements, which tend to result in dramatic spending cuts during economic downturns. (As incomes fall, tax revenues drop and spending must be cut to maintain balanced budgets.) That is, U.S. states shared many of the policy constraints that hamstrung individual eurozone countries in responding to the crisis. One ingredient that could have reduced the magnitude of the eurozone crisis, present in the United States but missing in Europe, was a mechanism for large and automatic fiscal transfers between member states.

Bad Design or Bad Politics?

“The Eurozone looked like a wonderful construction at the time it was built,” writes Paul De Grauwe. “Yet it appeared to be loaded with design failures. In 1999 I compared the Eurozone to a beautiful villa in which Europeans were ready to enter. Yet it was a villa that did not have a roof. As long as the weather was fine, we would like to have settled in the villa. We would regret it when the weather turned ugly.”

In the wake of the crisis, criticism of the “design” flaws in the foundations of the eurozone has become widespread. If we take this to mean that the structure of the eurozone left the region vulnerable to a crisis, this is surely correct. The language of “design” flaws, however, is off in an important way. The problems of the eurozone were not merely the result of a technocratic design failure, but rather a political failure. There is plenty of blame to go around, and plenty of culpable parties should share in it—including industrial and financial capitalists, economists who spun appealing fairy tales about the benefits of “free markets,” and mainstream politicians who bought into an agenda of economic “liberalization.” Part of the blame, however, belongs at the feet of Europe’s mainstream social democratic parties.

The political failings of these parties—whether they go by the name Social Democratic, Labour, Socialist, or whatever—should by now be plain to see. In hard-hit “peripheral” countries, like Spain and Greece, the mainstream socialist parties not only failed to lead a resistance against austerity policies, but actually administered these policies. Meanwhile, the German government—one of the main villains in pressing austerity policies—includes the Social Democrats (SPD) in a “grand coalition” with the parties of the Christian Democratic right.

The abdication of European social democracy, however, dates from much earlier than the current crisis or the imposition of painful austerity policies. Greece’s former finance minister in the Syriza government, Yanis Varoufakis, traces it to social democrats’ embrace of neoliberal and financialized capitalism in the 1990s. “Europe’s ‘official,’ social democratic Left fell into the trap of believing that the welfare state need no longer be financed from a portion of profits exacted by political means from industry and commerce,” Varoufakis argued in a June 2014 post on his blog. “Instead, they could finance the welfare state by tapping into the rivers of privately minted money that the financial sector was printing (while waged labour was being squeezed and real estate prices soared).” These parties, in other words, dreamed of a technocratic administration of the social welfare state, utterly divorced from class struggle. Even as political and economic institutions—a European parliament, a European central bank, the euro, etc.—were being constructed for the EU as a whole, the social democratic welfare state remained confined to the level of the individual country. At the national level, individuals make payments into a common pool according to the tax code (some pay more, others less), and receive payments from that common pool—or services funded from that pool—according to various program criteria (some receive more, others less). The welfare state, largely a product of the workers’ movement and its political parties, is one institutional expression of the politics of social solidarity within those countries. The absence of fiscal union, at least in regard to social welfare, then, can be traced in part to the absence of a comparable politics of solidarity at the level of the EU as a whole.

What was constructed in Europe was, in short, not a social democracy writ large. Rather, as Financial Times columnist Wolfgang Münchau puts it, “when the eurozone was constructed, it was given neoliberal foundations.”

Part 2 of this article will examine the the historical evolution of European social democracy, the tension between revolutionary and reformist agendas, the rise of pro-neoliberal tendencies, and possibilities for the revival of revolutionary socialism.

is an economist and historian and co-editor of Dollars & Sense.

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