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Eurozone crisis: lessons for a sovereign Québec
Many ills affect Southern Eurozone countries and Spain is the best example to illustrate the fundamental problems of the Eurozone. Spain, who, until the beginning of the financial crisis, was a role model, still hasn’t taken back control of its economy following the shocks it suffered. The helpless state in which Spain is could be the fate that awaits a sovereign Québec whose currency would be the Canadian dollar.
The Spanish crisis
Spanish real GDP is, since 2008, declining (the 2013 real GDP was 5,9% inferior to the 2007 one) and its 26% unemployment rate has surpassed the 23% American peak reached during the Great Depression. The Spanish unemployment rate is 56% for the working population aged less than 25.
The dominant narrative that tries to explain the Eurozone crisis can be summarized this way: the Southern countries, living above their means, witnessed their public finances deteriorate rapidly once the financial crisis revealed the generously abusive spending of their governments.
The problem with this narrative is that it presents a consequence of the crisis (deterioration of public finances) as a cause of it. In fact, Spanish public finances were an example to be followed until the beginning of the crisis. Between 1996 and 2007, Spanish public debt was reduced by 31 percentage points while it raised by 9 percentage points in Germany.
When the euro was adopted by 12 countries in the EU, the interest rate spread between them slimmed but rates were still higher in the Northern countries compared to the Southern ones. Banks, mostly German, massively lent to businesses and households in the south of the Eurozone where real estate prices raised remarkably. When the real estate bubble busted in Spain, real estate prices dropped in a spectacular fashion: 43% in 6 years! Spanish households, overburdened by debt, reduced their consumption while the Eurozone was also cutting back its consumption as a consequence of austerity measures, deepening European economic woes. Spanish businesses were even more debt-ridden than households: at the beginning of 2009, their debt level was 264% of the national GDP.
A currency area without a fiscal union
If Spain had been a monetary sovereign state, she could have faced these macroeconomic challenges. However, being a member of the Eurozone, she wasn’t able to. A higher inflation level in Spain would have helped to lower the value of the public debt and lowered the exchange rate of the Spanish currency, allowing the relative cost of the workforce to be more competitive at the international level. The inflation target of the European Central Bank that is below 2% but very close to 2% didn’t allow Spain to activate either of the stabilization mechanisms she needed.
Since the creation of the Eurozone, the capital inflow from Northern countries stimulated a faster increase of salaries in Southern countries than in Northern countries. This created a bubble of relative prices that became extremely hard to disarm. If the Southern countries had their own money, they could have purposely reduced their exchange rate in order to reduce the salaries of all their workers in comparison to those of Northern countries: however, since the stabilization mechanism of international exchange rates isn’t available within a currency area, an extremely slow and painful process of “internal devaluation” took place.
If Spain had been a member of a federation with a fiscal union, it could’ve counted on the support of other Member States and additional stabilization mechanisms. Sala-i-Martin et Sachs (1991) estimated that in the United States, a shock that reduces the disposable income in a given region will automatically be compensated by a federal taxation reduction of 34% and federal transfers equal to 6% of that shock, mitigating a total of 40% of that shock. In Canada, examples of federal transfers are unemployment insurance, Canada Health Transfers, Canadian Social Transfers and Equalization and Territorial Formula Financing.
In Europe, wishful thinking prevailed. Europeans believed that the economy would sail smoothly if the Stability and Growth Pact of the European Union were followed (this pact dictates rules to follow for fiscal deficits and public debt). However, most Member States didn’t respect the Pact, including Germany who broke this pact over 3 periods: 1998-1999, 2002-2005, and 2008-2010. The blocking of sanctions directed against her in 2003 even caused profound questioning of the Pact. Unlike Germany, Spain was a role model by respecting the Stability and Growth Pact from its creation until 2008, when the Eurozone crisis struck Europe.
Commenting the fragility of the Eurozone, the presidents of the European Council, the European Commission, the Eurogroup and the European Central Bank concluded that Eurozone Member States should have access to more adjustment mechanisms that share macroeconomic risks between Member States of the EU (Rompuy et al. (2012)). Thus, they implicitly judge that the (federal) budget of the European Union, which amounts to 1% of the European GDP, does not allow to fulfil properly the function of stabilization mechanism.
The thought that Québec would be above these problems and would not repeat mistakes committed in Europe is an attractive thought, yet it is mere wishful thinking. It is worth remembering that the IMF admitted its incapacity to have detected fundamental problems of the Eurozone:
“Partly owing to the difficultly of diagnosing asset bubbles until they have burst, such bubbles emerged undetected. In some countries, such as Ireland and Spain, headline fiscal surpluses generated by housing and credit booms masked unsustainable structural fiscal positions that were revealed when the crisis struck”
IMF (2013)
Lessons for a sovereign Québec
Obviously, a sovereign Québec would not pay taxes to the federal government. However, it is worth noting that Québec has always received transfers from the equalization program since its creation in 1957. The central point of this article is not to do the accounting of a cost-benefit analysis of taxes in a sovereign Québec or sovereignty itself, but rather to discuss an aspect that is not given enough attention: the impact of currency on a sovereign Québec’s economy. A Sovereign Québec using Canadian dollars would be in a macroeconomic risk situation similar to Spain’s: its macroeconomic stabilisation mechanisms would be in the hands of a then-foreign entity, the Canadian federation. Whereas the European Central Bank tries its best to help ailing Eurozone countries despite the hostility displayed by European politicians and the limits of its mandate, the Bank of Canada certainly would not have the mandate to support economic policies of an ex-province that seceded.
Some would be quick to say that Spain is very different from Québec and that a sovereign Québec would never be in a position of vulnerability as the one Spain got itself into: to that effect, let it be reminded that Alberta, whose economy relies on the exploitation and exportation of fossil fuels, can create an important upwards pressure on the value of the Canadian dollar that’d be harmful for Québécois exports without federal transfers to mitigate that shock. To illustrate this, holding other things constant (ceteris paribus in economic talk), when the Canadian dollar’s exchange rate with the U.S. dollar grows by 10%, Québécois exports fall by approximately 1%, which is an important shock that is out of control of a sovereign Québec.
If facing a debt overleverage of households, firms or government, a financial crisis, a credit squeeze or a drop in private demand, a sovereign Québec would not have access to monetary policy to fend a macroeconomic shock nor to stabilization mechanisms or interprovincial solidarity inherent to the Canadian federation. Furthermore, a sovereign Québec would have little control over its public debt as it’d be issued in a foreign currency. A sovereign Québec would thus be part of a club of countries that do not have their own currency such as Equator, Panama and Salvador.
Québec sovereignty is a legitimate choice that can be defended. Adopting the Canadian dollar for a sovereign Québec is another legitimate choice that can be defended. However, lest the movement for sovereignty shall provide serious explanations regarding the macroeconomic stabilization mechanisms that a sovereign Québec would command, wishful thinking shall be considered the centerpiece economic policy of a sovereign Québec.
References
International Montary Fund. Reassessing the role and modalities of fiscal policy in advanced economies. Policy Paper, September 17 2013. http://www.imf.org/external/np/pp/eng/2013/072113.pdf
Robert A. Margo. Employment and Unemployment in the 1930s. Journal of Economic Perspectives, Volume 7, numéro 2, printemps 1993, 41 pages. https://fraser.stlouisfed.org/docs/meltzer/maremp93.pdf
X. Sala-i-Martin et J. Sachs. Fiscal Federalism and Optimum Currency Areas: Evidence for Europe from the United States. NBER, Working Paper 3855, October 1991. http://www.nber.org/papers/w3855
H. Van Rompuy, J. M. Barroso, J.-C. Juncker et M. Draghi. Towards a Genuine Economic and Monetary Union. December 5 2012. http://www.consilium.europa.eu/uedocs/cms_Data/docs/pressdata/en/ec/134069.pdf
Data sources are cited indicated below graphs
Eurozone crisis: lessons for a sovereign Québec
Many ills affect Southern Eurozone countries and Spain is the best example to illustrate the fundamental problems of the Eurozone. Spain, who, until the beginning of the financial crisis, was a role model, still hasn’t taken back control of its economy following the shocks it suffered. The helpless state in which Spain is could be the fate that awaits a sovereign Québec whose currency would be the Canadian dollar.
The Spanish crisis
Spanish real GDP is, since 2008, declining (the 2013 real GDP was 5,9% inferior to the 2007 one) and its 26% unemployment rate has surpassed the 23% American peak reached during the Great Depression. The Spanish unemployment rate is 56% for the working population aged less than 25.
The dominant narrative that tries to explain the Eurozone crisis can be summarized this way: the Southern countries, living above their means, witnessed their public finances deteriorate rapidly once the financial crisis revealed the generously abusive spending of their governments.
The problem with this narrative is that it presents a consequence of the crisis (deterioration of public finances) as a cause of it. In fact, Spanish public finances were an example to be followed until the beginning of the crisis. Between 1996 and 2007, Spanish public debt was reduced by 31 percentage points while it raised by 9 percentage points in Germany.
When the euro was adopted by 12 countries in the EU, the interest rate spread between them slimmed but rates were still higher in the Northern countries compared to the Southern ones. Banks, mostly German, massively lent to businesses and households in the south of the Eurozone where real estate prices raised remarkably. When the real estate bubble busted in Spain, real estate prices dropped in a spectacular fashion: 43% in 6 years! Spanish households, overburdened by debt, reduced their consumption while the Eurozone was also cutting back its consumption as a consequence of austerity measures, deepening European economic woes. Spanish businesses were even more debt-ridden than households: at the beginning of 2009, their debt level was 264% of the national GDP.
A currency area without a fiscal union
If Spain had been a monetary sovereign state, she could have faced these macroeconomic challenges. However, being a member of the Eurozone, she wasn’t able to. A higher inflation level in Spain would have helped to lower the value of the public debt and lowered the exchange rate of the Spanish currency, allowing the relative cost of the workforce to be more competitive at the international level. The inflation target of the European Central Bank that is below 2% but very close to 2% didn’t allow Spain to activate either of the stabilization mechanisms she needed.
Since the creation of the Eurozone, the capital inflow from Northern countries stimulated a faster increase of salaries in Southern countries than in Northern countries. This created a bubble of relative prices that became extremely hard to disarm. If the Southern countries had their own money, they could have purposely reduced their exchange rate in order to reduce the salaries of all their workers in comparison to those of Northern countries: however, since the stabilization mechanism of international exchange rates isn’t available within a currency area, an extremely slow and painful process of “internal devaluation” took place.
If Spain had been a member of a federation with a fiscal union, it could’ve counted on the support of other Member States and additional stabilization mechanisms. Sala-i-Martin et Sachs (1991) estimated that in the United States, a shock that reduces the disposable income in a given region will automatically be compensated by a federal taxation reduction of 34% and federal transfers equal to 6% of that shock, mitigating a total of 40% of that shock. In Canada, examples of federal transfers are unemployment insurance, Canada Health Transfers, Canadian Social Transfers and Equalization and Territorial Formula Financing.
In Europe, wishful thinking prevailed. Europeans believed that the economy would sail smoothly if the Stability and Growth Pact of the European Union were followed (this pact dictates rules to follow for fiscal deficits and public debt). However, most Member States didn’t respect the Pact, including Germany who broke this pact over 3 periods: 1998-1999, 2002-2005, and 2008-2010. The blocking of sanctions directed against her in 2003 even caused profound questioning of the Pact. Unlike Germany, Spain was a role model by respecting the Stability and Growth Pact from its creation until 2008, when the Eurozone crisis struck Europe.
Commenting the fragility of the Eurozone, the presidents of the European Council, the European Commission, the Eurogroup and the European Central Bank concluded that Eurozone Member States should have access to more adjustment mechanisms that share macroeconomic risks between Member States of the EU (Rompuy et al. (2012)). Thus, they implicitly judge that the (federal) budget of the European Union, which amounts to 1% of the European GDP, does not allow to fulfil properly the function of stabilization mechanism.
The thought that Québec would be above these problems and would not repeat mistakes committed in Europe is an attractive thought, yet it is mere wishful thinking. It is worth remembering that the IMF admitted its incapacity to have detected fundamental problems of the Eurozone:
“Partly owing to the difficultly of diagnosing asset bubbles until they have burst, such bubbles emerged undetected. In some countries, such as Ireland and Spain, headline fiscal surpluses generated by housing and credit booms masked unsustainable structural fiscal positions that were revealed when the crisis struck”
IMF (2013)
Lessons for a sovereign Québec
Obviously, a sovereign Québec would not pay taxes to the federal government. However, it is worth noting that Québec has always received transfers from the equalization program since its creation in 1957. The central point of this article is not to do the accounting of a cost-benefit analysis of taxes in a sovereign Québec or sovereignty itself, but rather to discuss an aspect that is not given enough attention: the impact of currency on a sovereign Québec’s economy. A Sovereign Québec using Canadian dollars would be in a macroeconomic risk situation similar to Spain’s: its macroeconomic stabilisation mechanisms would be in the hands of a then-foreign entity, the Canadian federation. Whereas the European Central Bank tries its best to help ailing Eurozone countries despite the hostility displayed by European politicians and the limits of its mandate, the Bank of Canada certainly would not have the mandate to support economic policies of an ex-province that seceded.
Some would be quick to say that Spain is very different from Québec and that a sovereign Québec would never be in a position of vulnerability as the one Spain got itself into: to that effect, let it be reminded that Alberta, whose economy relies on the exploitation and exportation of fossil fuels, can create an important upwards pressure on the value of the Canadian dollar that’d be harmful for Québécois exports without federal transfers to mitigate that shock. To illustrate this, holding other things constant (ceteris paribus in economic talk), when the Canadian dollar’s exchange rate with the U.S. dollar grows by 10%, Québécois exports fall by approximately 1%, which is an important shock that is out of control of a sovereign Québec.
If facing a debt overleverage of households, firms or government, a financial crisis, a credit squeeze or a drop in private demand, a sovereign Québec would not have access to monetary policy to fend a macroeconomic shock nor to stabilization mechanisms or interprovincial solidarity inherent to the Canadian federation. Furthermore, a sovereign Québec would have little control over its public debt as it’d be issued in a foreign currency. A sovereign Québec would thus be part of a club of countries that do not have their own currency such as Equator, Panama and Salvador.
Québec sovereignty is a legitimate choice that can be defended. Adopting the Canadian dollar for a sovereign Québec is another legitimate choice that can be defended. However, lest the movement for sovereignty shall provide serious explanations regarding the macroeconomic stabilization mechanisms that a sovereign Québec would command, wishful thinking shall be considered the centerpiece economic policy of a sovereign Québec.
References
International Montary Fund. Reassessing the role and modalities of fiscal policy in advanced economies. Policy Paper, September 17 2013. http://www.imf.org/external/np/pp/eng/2013/072113.pdf
Robert A. Margo. Employment and Unemployment in the 1930s. Journal of Economic Perspectives, Volume 7, numéro 2, printemps 1993, 41 pages. https://fraser.stlouisfed.org/docs/meltzer/maremp93.pdf
X. Sala-i-Martin et J. Sachs. Fiscal Federalism and Optimum Currency Areas: Evidence for Europe from the United States. NBER, Working Paper 3855, October 1991. http://www.nber.org/papers/w3855
H. Van Rompuy, J. M. Barroso, J.-C. Juncker et M. Draghi. Towards a Genuine Economic and Monetary Union. December 5 2012. http://www.consilium.europa.eu/uedocs/cms_Data/docs/pressdata/en/ec/134069.pdf
Data sources are cited indicated below graphs
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