Peter Holland, School of Economic Science,

This Paper follows on from Location Theory and the European Union by the same author, in an earlier post.

1. Introduction

The first attempt at the peaceful integration of European Nation states started as the European Economic Community (EEC) in 1957.The original six member states signed the Treaty of Rome, which consolidated earlier attempts at co-operation such as the European Coal and Steel Community and the European Atomic Energy Community. Whilst this was fundamentally a customs union, some of the founding fathers had an ambition for more comprehensive integration. For example Jean Monet in 1952 stated that “Europe’s nations should be led towards a super-state, without their people understanding what is happening”. This ambition has driven the steady progress of further integration, despite the severe misgivings of most European citizens.

Unfortunately the EEC’s economic arrangements ignored a fundamental principle right from the start, the principle expanded in Location Theory, the effects of which will cause severe international stress and probably the acrimonious disintegration of the EU if it continues to be ignored. This decline has been accelerated by the adoption of the Euro. The previous paper described this Location Theory, gave numerical examples for the early stages of the EC, and showed how the effect is compounded by the Euro. This paper provides further insight into the effects of the Euro and deals more fully with possible solutions to correct this error and provide an equal opportunity for all nations in Europe to prosper.

2. Location Theory

It is a general weakness of conventional economics that it pays little attention to the actual locations in which economic activity is taking place. The benefits of a particular location include factors such as inherent fertility or proximity to natural resources, but the largest factor in a trading economy is that the work of the whole community confers a great advantage on particular locations. If individuals, firms or nations are allowed to claim this the result is a large, unfair and ever increasing disparity in wealth, unemployment and civil unrest. [This was described more fully in the previous edition of the Monitor].

3. The Euro

The Euro was introduced in 1999 as an accounting currency for eleven members. Euro notes and coins became common currency amongst the then twelve member states of the Eurozone in 2002. The founders of the Euro claimed that its arrival would reduce financial risk for business, reduce the risk on government debt (due to exchange rate fluctuation) and facilitate economic convergence between the member states. A precise definition of convergence is hard to find, but the indicators appears to be productivity, international competitiveness, the cost of national government borrowing, employment and inflation. Unfortunately these founders ignored the lessons of history. Between 1947 and 1968/72 the Bretton Woods system of fixed exchange rates had been adopted by most of the free world, and between 1979 and 1992 the Exchange Rate Mechanism (ERM) of the European Monetary System attempted to stabilise exchange rates within the European Community. Neither system survived. The ERM endured eight crises in its first ten years, and over twenty years suffered a total of eighteen realignments affecting fifty-six central rates. The disconnect between the ambitions of politicians and hard economic sense is illustrated by the fact that when John Major (the UK prime Minister at the time) failed to keep the UK in the ERM in 1992 this was regarded in the City of London as economic liberation and an era of increased prosperity commenced. Over the next 10 years the unemployment rate halved, the bank rate dropped from 10% to 4%, inflation reduced and GDP went up.

In its early years the Euro seemed to be delivering on the promises of its founders. For example the cost of borrowing (by issuing bonds) by the national governments of Spain, Italy, and France compared with Germany in 1990 was + 6%, +6%, +2%, respectively and for Greece in 1998 +5%. In Q1 1999 there was no difference in the cost of borrowing for any of these governments. The assumption was that the principle risk, that of exchange rate fluctuations, had been eliminated. Ten years of apparent prosperity followed, but this was fuelled by the steady accumulation of debt in many instances and following the financial crisis at the end of 2008, a reappraisal by the markets established spreads similar to those of a decade earlier, in 2011 Spain +4.5%, Italy +5%, France +1%, and Greece +9%, due to the fear of sovereign default. These escalated to an 11% peak in Italy and 25% peak in Greece. It was President Mario Draghi’s “Whatever it Takes “ speech in July 2012 which calmed the markets, followed in September by the introduction of Outright Monetary Transactions (OMTs) which enabled the European Central Bank (ECB) to buy national government bonds. However, divergent national bond rates continue.

Another example of divergence is the productivity of the motor industry. Between 2000 and 2013 vehicle production in Western Europe overall fell by 29%, whilst in Germany it increased by 10% with profits doubling between 2007 and 2013.

Some commentators consider this divergence to be due to asymmetric national behaviour and the concept of a “North/South Divide” is gaining credence. This is described in terms of differing levels of respect for the rule of law, levels of corruption, regulatory quality and government effectiveness. Whilst all of these undoubtedly have an effect there are fundamental issues that would cause divergence even if all citizens and governments exhibited exemplary behaviour.

Before the establishment of the Euro the nation states each managed their own currency.

They could set their own interest rates, moderate their own money supply, and step in if the market-set exchange rate was deemed too disadvantageous. In this era the centrally located nations locational advantage, in particular Germany, could be corrected from time to time by a national currency devaluation or more frequently revaluation of the Deutche Mark, and the national governments local issues could be addressed with the fiscal and monetary tools available.

Once the Euro was established the international exchange rate and interest rates were set by the stronger economic regions via the European Central Bank (ECB), and the cost of borrowing was uniform across both strong and weak economies. As the competitiveness of the peripheral nations started to decline the traditional exchange rate correction was not available, nor the variation of interest rates to control borrowing, nor the ability to vary the reserve ratio and interest rates to modulate the amount of money in the national economy. Thus the locationally disadvantaged nations started to experience a reduction in creative activity, the closure of companies, increasing unemployment, and a huge increase in personal and public debt.

4. Potential remedies

The fundamental issue is that some regions enjoy an enormous advantage due to their position with respect to the surrounding regions. This is true on a national, European and global level. In the UK, London and the South East have a far greater economic potential than Northern Scotland, West Wales or Cornwall. However, extremes of poverty are avoided by a tax system that redistributes income from the wealthy centre to the regions that are less well off. Some advocate a similar system for a politically unified Europe, and perhaps that is what Draghi had in mind in the less well reported part of his ”Whatever it takes” speech, namely that full fiscal union, economic union, banking union and political union for Europe. However, a brief look at the detailed working of the system in the UK would show that the resultant dependency culture, anomalies and the immense bureaucratic overhead of such a system are highly undesirable. In addition most of these taxes fall on productive enterprise and are often the cause of failure of marginal businesses, causing further unemployment and an increased charge upon the state.

In contrast to this a system that addresses the core issue of locational advantage is one that assesses said advantage and charges a levy on that alone. This levy would enable taxes on productive effort to be reduced substantially or removed altogether, increasing employment and reducing some of the need for government funding. To work across Europe this would require a levy on locational advantage to be collected and redistributed both on a national and pan national basis to provide the necessary funds for government.

If the issue of locational advantage were addressed on a pan European basis the Euro could continue, though a means of restoring some national or regional controls would be advantageous. In the absence of this in the author’s view an orderly and well-timed dismantling of the Euro is necessary. This would be very difficult as the sovereign debt accumulated to date is crippling, so any national currency restored in the near future would suffer an immediate and considerable devaluation which could bankrupt said nation overnight. Some level of debt forgiveness, however disguised, seems to be necessary for this path to work. This may be painful in the short term, but it is in the interest of the stronger economies to get their principle customers back to reasonable economic health.   This would provide a safety valve and prolong the life of the European project, but would not provide economic justice.

If Europe is to have a prosperous, long term future the issue of locational advantage needs to be addressed. This would ensure a just economic system that would get all of Europe working for a fair reward.