Roman Sigae/ShutterstockWhen it comes to creating interconnections, economists and politicians consistently overestimate the benefits and underestimate the consequences. A root cause of four economic crises of the past 15 years, in fact -- the financial crisis of 2008, the Asian currency crisis of 1997, the spectacular meltdown of the Icelandic economy, and the current euro crisis -- was a high level of interconnectivity. The euro is a perfect case study. And as leaders from across Europe hold their summit meetings this week, they will do well to bear this in mind. When strong interconnections are created in complex economic systems, they create large numbers of virulent positive feedback processes, driving things to extremes. When many people hear the term "positive feedback," they tend to think that it will bring happy results. I use "positive" as engineers do: not to refer to the desirability of the outcome but to the fact that change reinforces or adds to further change. Positive feedback processes in an economy can create market bubbles, encouraging consumers and countries to take on extreme levels of debt, as the weak euro zone countries have done. At other times they create economic death spirals, such as when banks refuse to lend to homeowners because they fear the price of homes will drop. When qualified buyers can't get mortgages to buy homes, home prices decline even further.
In concept, the euro is a noble idea. The single currency facilitated trade among euro zone members, and the euro became the world's second-largest reserve currency.But from Day One, the euro was doomed to failure, because its design contained a fatal flaw: it forged tight connections among the disparate economies of the 17 euro zone members by committing them to use a single currency without creating a strong governance structure that would force them to behave responsibly. The destabilizing effects have been devastating. In order for the euro to meet the needs of most of it members most of the time, all of the economies of disparate countries have to be experiencing similar economic situations at the same time. The best way to understand the problem is to think of the euro as a monetary thermostat, with euro members as occupants of a monetary skyscraper with only one thermostat. For the residents on the shady side, such as Germany, the temperature makes them very comfortable, by facilitating exports. But for countries like Greece, Italy, Portugal, and Spain on the sunny side, the temperature is wrong. It makes their exports too expensive and encourages a lack of fiscal discipline. Worst of all, the single currency has made it all too easy to borrow money and run up debt. To be sure, the economies of southern Europe would have struggled even without being yoked to the euro. But I think it's reasonable to blame the euro for turning those problems into a catastrophe. In the first place, the euro made the debt those nations carried look safer than it actually was, and this made it possible for them to borrow money at implausibly low interest rates. If the European banks that are large holders of Portuguese, Greek, Italian, and Spanish debt had been forced to lend to those countries in escudos, drachma, lira, and pesetas, they would have charged higher interest rates, because of the currency risk associated with those loans -- much as they did when they lent to Iceland in kronur. Real estate bubbles were just one of the consequences. Cheap money enabled countries to run up big debts, pay high wages to government employees, and create false prosperity that encouraged consumers to spend and borrow. The strong euro -- strong relative to what each country's local currency would have been valued at -- created a second problem: it raised the cost of exports for the sunny-side nations, making them less competitive in world markets, while making imports less expensive, increasing trade deficits and unemployment. To make matters worse, if the euro thermostat was set too high for the southern European countries, it was set too low for very productive countries like Germany. As a result, Germany's balance of payments surplus now runs around 6 percent of GDP while Greece runs a trade deficit approaching 10 percent of its GDP. A number of solutions have been proposed to deal with the crisis. Some economists have suggested expanding the European Central Bank's charter so it can become a lender of last resort. Others have suggested issuing eurobonds. In return for taking on the risks associated with eurobonds, the stronger euro zone members are demanding ironclad commitments to budgetary discipline from the troubled members. There is a fundamental problem with these proposals. They all increase the number of strong interconnections, which means they will increase the amount of positive feedback in the system. One consequence might be to kick off economic tailspins -- positive feedback processes -- in the Portuguese, Italian, Greece, and Spanish economies. Strict budgetary discipline would cause these countries to raise taxes, which would slow economic activity and cause earnings and profits to shrink. This would reduce the tax base and require further increases in taxes to generate the same income for the state, causing the economy to slow down even more -- a death spiral. My guess is that the positive feedback loops created by attempts to preserve the current structure will lead to yet bigger economic problems in the future. Even Germany isn't immune. Just the talk of eurobonds is creating feedback loops that make it more difficult to auction off German debt: banks and investors, worried that Germany would have to take on obligations that would harm its economy, ended up buying just 3.6 billion of the 6 billion-euro offering in Germany's recent bond auction A long-term solution to the euro problem would require more homogeneous economies. This would take years and would require the creation of a central authority, as well as the surrender of a significant amount of sovereignty. Unless this can be accomplished, the current solutions will be at best short term. Another approach would be to use short-term fixes to ameliorate the current situation while unwinding the euro. Countries with major problems could return to their old currencies, and support could be given to troubled banks to help them deal with solvency issues. One thing is certain: no matter which direction the Europeans take, there will be enough problems to keep the current crop of finance ministers employed for years to come. But if I were in charge, I would get my resume in order, take the heat, and unwind the euro.
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