Edward Harrison on the Political Economy of the Eurozone

The Eurozone has been long teetering on the edge of collapse, but a complete dissolution may prove too costly to transpire.

Edward Harrison is a consultant with Global Macro Advisers and founder of the investment news blog Credit Writedowns. He joins Macro Musings to discuss the political forces that led to the establishment of the Eurozone and the turmoil that has plagued it since the Great Recession. Edward also shares his thoughts on whether the Eurozone will survive.

Read the full episode transcript:

Note: While transcripts are lightly edited, they are not rigorously proofed for accuracy. If you notice an error, please reach out to [email protected].

David Beckworth: Edward, welcome to the show.

Edward Harrison: I'm very happy to be here.

Beckworth: Well, I'm glad to have you on. We've interacted before on TV. We've been in the blogosphere together, Twitter ... So, it's great to have a fellow traveler come on the show. As I do all my guests, tell me, how did you get into economics?

Harrison: I saw an outlier of what we're going to talk about, and that was something that you had suggested, and I have a two-part story, you can call it. Or, maybe we'll call it a three-part story.

Beckworth: Sure.

Harrison: So, it started with me being a math guy, numbers guy, when I was really growing up. I skipped a grade, and I did advanced math and so forth. My dad had it set up that I was going to be an engineer, and then I was going to do physics and so forth. And, when I got to college, I had no desire after the first course to do anything like that.

Harrison: Eventually, I switched over to economics. I did a lot of social science type of stuff. Psychology ... I did a lot of languages, as you know, in school. And, to me, international economics, which is what I majored in when I was there, was the exact thing that I really was very interested, because it had a mix of not just numbers and math, but also the social science aspect and the language. For me, it really defined the world in a way that just resonated for me.

Beckworth: Just to be clear to our listeners, you know six languages, right?

Harrison: That's right. Yeah.

Beckworth: Okay. Continue.

Harrison: And so, using all of that, I ended up in the diplomatic corps for the US. I was over in Germany for two years. But, eventually, I decided that's not the route that I wanted to go, and so, I left macro or international economics and decided to go the micro route by going into business school.

Harrison: I got an MBA. I went to Deutsche Bank, Yahoo!, and so forth, and my last job, which was at a company called CEB, that's here in the DC area ... I actually ended up getting Lyme disease and took some time off. When I did, I started up a blog, and when I started the blog, that's exactly when the financial crisis happened. And so, that precipitated this move back into macro and leaving micro altogether.

Beckworth: Interesting.

Harrison: And so, that's where I am today, almost 10 years later.

Beckworth: Fascinating. Well, it was a good time to start blogging.

Harrison: Definitely.

Beckworth: For better or for worse ... I mean, a lot of human suffering, but good time to jump on the blogging bandwagon.

Beckworth: All right. Well, let's move to Eurozone because you've written a lot about that. Like you said, you've been there. In fact, you just got back from Germany, didn't you?

Harrison: That's right. Yes.

Beckworth: You were on a trip. And so, you really have your feet in the ground. You have a feel for what's going on. And, I want to get into the Eurozone crisis. We've had previous guests talk about it. I want to get into the political economy, maybe some of the deeper forces that are driving things there.

Beckworth: So, the Eurozone crisis ... It's been going on, depending when you date its beginning ... It was 2010, or you go back to the original Great Recession ... It's almost a decade, maybe a little bit less than that. One of the areas that always comes up in this discussion is the influence the Germans have had in creating it, prolonging it, and preventing, maybe, a more robust recovery.

Beckworth: One of the terms that gets thrown around a lot is ordoliberalism. Can you tell us, what is ordoliberalism, and do we see it influencing how the Eurozone is being run?

Ordoliberalism and Its Influence on the Eurozone

Harrison: The way I look at it is ordoliberalism is the German neoliberal variant strain. And, to a certain degree, you could say that it has a more state influenced part to it ... that is, if you think of the economic system that Bismarck built up when Germany came together, in terms of factory production and all of that. That basically was something that was very much a state structured, ordered type of system.

Harrison: And so, when the depression happened, I think that, starting in the 1930's and so forth to 1950, this whole idea of a free market, a market economy, took hold, but from a German perspective, meaning that we're not going to actually just let market forces take over because what happens when you have a monopoly? It could be that a monopoly naturally imposes itself on the system. A perfect example would be Microsoft, in technology. At some point in time, you could say that Microsoft was an inevitability in the nascent computer world. How do you deal with that?

Harrison: The ordoliberals would say that you deal with that by making sure that doesn't happen, whereas a true market force individual would say, "Actually, eventually, that monopoly will go away because competitors would try to compete away the gains associated with that. And, during that interim period of time, we need to just wait it out."

Harrison: The ordoliberals say, "No, that's not how it's going to do. We're here to create a government that creates the preconditions for an overall market forced type of interaction, a social democracy, social market force type of world, and it can't be done without the intervention or the guiding hand, if you will, of government."

Harrison: Ludwig Erhard, he was the second German Bundeskanzler. He was the guy who started that under the first Bundeskanzler, who was Konrad Adenauer. That created the economic miracle in Germany, and they very much believe that this is a great ... Angela Merkel, if you hear her talking, it's very much in that vein.

Beckworth: Yeah. So, another individual I've heard under this discussion of ordoliberalism is Walter Eucken. Is that how you say his name? How do you say his name right?

Harrison: I think that's right. Yeah. For an American.

Beckworth: Okay. You're so great in your German pronunciation. But, I had a previous guest on who talked a little bit about ordoliberalism, and he mentioned Walter Eucken is the most influential economist you've never heard of because he was the architect of this thinking. Is that right? And, his influence, in some sense, is like Milton Friedman's influence in the US today. Walter's influence is pervasive through the German mindset or psyche, in terms of economic policy.

Harrison: Right. I mean, because if you think of their period where they had the Weimar Republic breaking down, and then you had the National Socialists and then the disintegration of the German system ... During that time, that was when this was building. And so, right when 1949 came around, and the German republic began again, you had already an economic framework that you could use. And so, Ludwig Erhard took on that and was able to start already in 1949 because it had already been formulated by Eucken before that time. That's how the Germans would probably say it.

Beckworth: Okay. Thank you for correcting me. Yeah, I had Rudi Bachmann from Notre Dame on previously, and he talked a little bit about it. Some of the impression I got is they definitely see a bigger role for states management, intervention ... They want a free market, but they think it's very important for the state to be involved.

Beckworth: And so, some things are very similar. Some things are a little bit different. Things that are similar to, maybe, a free market view is that they want balanced fiscal budgets. They want very strong price stability. They believe in structural reforms, and we'll talk about that in a minute, making the economy more competitive through painful, sometimes, structural reforms.

Beckworth: They're leery of full employment policies. They think that's going down a dangerous path if you start engaging in them. It's maybe a path to central planning. So, they believe in the state helping the market flourish, I guess, is my sense of what that is.

Harrison: Right. That's exactly how I would put it. I would say that there's a German term: [speaks German], which means "the central guiding hand." If you think about it, there's a ring fence that you can put, and you can put the market into that ring fence. The ring fence is the [speaks German]. And, you need to have a robust set of guiding principles that allows anything that happens within that arena to occur.

Harrison: So, you're really allowing freedom with that arena to occur, and maybe, here and there, you're going to have to intervene, but you're going to try to intervene as little as possible. But, it's very important to set up a structure that is robust over the long term. And, by doing that, you have rules, and you must adhere to those rules very strictly. That's very much within what we think of as the Germanic way.

Beckworth: So, the rules and structures are very important, and Rudi ... This previous guest, Rudi Bachmann, mentioned in Germany, traditionally, lawyers have been much more prominent in policy making than economists because of this, that there's-

Harrison: Look at Schäuble as an example. Exactly.

Beckworth: He's the finance minister, right?

Harrison: Exactly. And, he's a lawyer by trade. He knows nothing about economics, to be honest with you.

Beckworth: And, he's helping shape the policy through the Eurozone crisis, right?

Harrison: Exactly.

Beckworth: And, was it him that, at one point, wanted to send a German economic planner down to Greece to take over the budget and the process, imposing this ordoliberalism on Greece?

Harrison: I'm not sure now, in retrospect, what he had to say ... because the rumor versus the reality-

Beckworth: Okay. What was the rumor?

Harrison: Well, I think the rumor, basically, in general, is that the Germans wanted to re-impose their economic model on the Greeks, in order to make it work, and that they were going to do that by force if necessary. And, they were using the ECB and the troika and so forth to make that happen.

Harrison: But, I think that the Germans, they understand their role in history and that they really don't ... They're not as heavy-handed as that. To a certain degree, their hands were tied politically because of the toxic nature of the concept of giving Greece a bailout and a free hand, et cetera.

Harrison: Whenever we say "the Germans," we should always be thinking that means Germany, the Netherlands, Austria, and other like-minded allies within the Eurozone structure. Oftentimes, that means Slovakia. Sometimes that means Finland. But, it's not ever just the Germans. If you look at Dijsselbloem, who is the head of the Eurogroup, who was the Dutch finance minister ... This is a social democrat, by the way. He is as much in line with what Schäuble was saying as anyone else.

Harrison: So, when you think about ordoliberalism, you think about the Germans making the Greeks toe the line and so forth. Really, it's not just the Germans. They're the whipping boy, and that's because they're the largest economy within the Eurozone. And so, what they say really is the driving force. They dictate policy to a certain degree.

Beckworth: Yeah. So, just stepping back and looking at the Eurozone crisis, there has been more of this push towards let's fix the crisis through deep structural reforms, as opposed to in America, there's been more openness towards full employment policies, Keynesianism, prime the pump, whether it's monetary policy or fiscal policy. Over there, it's like let's avoid that, and let's stick to structural reforms. Is this a consequence of the ordoliberalism?

Harrison: To a certain degree, it is. Plus, it's also a consequence, I think, what I would say, of two cases of success in Germany, or perceived success. One is the first case, which was definitely dominated by the ordoliberal ideology. That's the Wirtschaftswunder, which was in the '50s under Erhard.

Harrison: And then, Germany feels like they lost its way at some point in time. It had the reunification of Germany in the 1990s. They were the sick man of Europe. It was stagnating and so forth.

Harrison: Then you got a social democrat in Gerhard Schröder, who came in there, and he had this 2010 agenda, which was basically to reform to a more American model, if you will, to where you could fire and hire people more easily. There was more flexibility in the structure of the labor market.

Harrison: Now, interestingly, a guy from the Center for European Research by the name of Christian Odendahl, who's a half-German ... He released a report just recently about what you should make of those label reforms. I think that his analysis is spot-on when he says that in general, many of the things were good, but the Germans were very fortunate, in terms of a timeframe, that there was no generalized decline in the growth rates.

Harrison: The emerging markets were doing really well. Growth was going forward. That's the perfect time to take on these structural reforms. And so, even though they were able to do it, it's not necessarily the case that exactly what the Germans did and the way that they did it would translate to other countries like France, as an example, who is the next test-tube baby here to try this action.

Beckworth: So, speaking of France, the new elected leader ... Macron?

Harrison: Mm-hmm (affirmative).

Beckworth: He is eager to experiment with some of these policies. Is that right?

Harrison: That's right, yeah. And, I think that there's the structural reform, and then there is the discipline. He understands the German mentality, that what they really want is they want the discipline first and then the reforms afterwards. What that means, basically, is to get to the three percent deficit hurdle, get all of that in order first, and then move forward with other things. And, to the degree that they do move forward, they will have a goodwill that they've established, and the Germans will be much more likely to give them leeway when necessary, and so forth.

Harrison: I think that's a very good strategy, and now's a favorable time because when you look at the global growth outlook right now, Europe is doing incredibly well within all of the G20 countries, and I think that this is going to continue for a while. That gives the French an ability to not only use growth to reduce the deficit, and not just cutting, but also gives them a little bit of leeway when it comes time to do these structural reforms on a backend, which are actually going to be spending money. You're going to actually have to ... There's going to be money associated with that, which will be negative for the fiscal balance.

Beckworth: Now, France has had really rigid labor markets. Is that a fair assessment?

Harrison: I think so. I think that's a fair assessment.

Beckworth: And so, these reforms that Macron is proposing would be to loosen the labor markets. So, you could both fire people easier, but you can also hire them more easily. Is that right?

Harrison: That's right. Exactly. So, essentially, exactly what the Germans are doing, have done, what the Dutch have done and many other countries, including the United States.

Beckworth: I think it's ironic, and of course, I'm an American, sitting over here on the side of the Atlantic, to watch some of the protests in the past years in France. When any of these issues have come up before, there's riots that break out. Everything shuts down, and there are young people who are rioting.

Beckworth: These young people have high structural unemployment rates in France. I mean, they're rioting to maintain the privilege of if they get a job, it will be very secure. But, they first have to get that job, and there's a really high unemployment rate, and yet they're still protesting. I have a hard time reconciling that as an American, so help me out.

Harrison: Well, I think that it's because ... I would say that a lot of this goes back to the feudal system and the social contract.

Harrison: My wife, she has some ancestry that's in western Pennsylvania, where we had a completely different social contract. I remember looking through some of the documents in her historical past and how some of these people ... They had to hunt, and they almost starved to death in the winters of northwestern Pennsylvania, which were really hard, and so forth. And, there was no government to support them in any way, shape of form.

Harrison: At the exact same time ... This was probably the mid-19th century, late 19th century. In France and in Germany and other places in Europe, they were setting up ... They were breaking down the feudal system, going to the industrial system, and in that guise, there was a social safety net right from the start. So, there's a completely different mentality about what the state's responsibilities and role is in order to make sure that what used to be peasants, but now are the working and the middle class, get what's coming to them.

Beckworth: So, there's an expectation there that we don't have here.

Harrison: Exactly.

Beckworth: I guess what's challenging for me, though. If I'm a young person, if I'm right out of college or in college ... I'm in France, I want to go get a job, and I see all these barriers that prevent me from getting work because of labor protection laws, or just through rigidity of the labor markets there. Do I not process in my mind, the chances of me getting a job will be much easier if they had more flexible labor markets. Or, am I so caught up in my expectations of the social safety net there that I get clouded in my thinking?

Harrison: Well, I think what happens is ... I mean, you can see this in Germany, in particular. It more likely is the insecurity of the opposite side of that. You're liking the fact that you have this social safety net, and, to a certain degree, these laws.

Harrison: For instance, in Germany, I think that they went through a huge shift, where you have reunification, you have Eastern Germans who are a cheap labor force, by comparison. Then, there was a quick move towards central Europe. We're talking Hungary and Czech Republic. There was a massive move of German Mittelstand, manufacturing, to those places.

Harrison: If you go around, and you look at some of the... You go to a typical German department store. You look at Braun. They make razors and mixers and things like that. In America, I think we call them Braun.

Beckworth: That's what I'd say.

Harrison: Or, Braun. We call them Braun. I think that's what we call them.

Harrison: If you looked underneath the mixer, it would've said "Made in West Germany" in the early 1990's. I used to do this all the time, when I went to Germany, just to see what was going on. But, by the early 2000's, it would've said "Made in Hungary." And then, later, it was made in Slovakia, Romania, Bulgaria. And then, eventually, some of this stuff is now made in China as well.

Harrison: So, they've been put under pressure, and I think that a lot of the reforms, as a result of that globalization pressure ... You feel a certain insecurity ... people losing their jobs, and to a certain degree, this whole state coming on top and saying, "Wait a minute. We're not going to allow that to happen" ... is important.

Harrison: A great example of this is when GM tried to leave. This year, they tried to get out of Europe. That means Vauxhall, which is in the UK. They wanted to sell that, as well as Opel, which is in Germany. Those are their two brands, and they've been there for three-quarters of a century. They sold to Peugeot, but immediately, the German government got involved and said, "This deal will not happen unless you guarantee jobs."

Harrison: I think that the British said something similar, but not quite as ironclad. They said, "We're concerned about the jobs. We want to make sure that they're there" ... something of that nature, but the Germans basically said, "This deal won't happen unless the jobs are secure." So, I think that mentality pervades not just from a government perspective-

Beckworth: Interesting.

Harrison: ... but also just the societal perspective. And, again, to a certain degree, it goes back to the ordoliberalism that we're talking about.

Beckworth: Yeah. And, that gets us back to the Eurozone crisis. So, this thinking, this approach, this society, this social contract that the Germans are bringing into the Eurozone crisis, it affects the decision making and it affects how the Eurozone crisis unfolds.

Beckworth: Let me go back and look at a few of the developments of the Eurozone. So, the treaty in 1992 that led to the creation of the Eurozone ... Would you pronounce it for me correctly before I maul it?

Harrison: Maastricht.

Beckworth: Thank you. I leave that with you.

Beckworth: So, it had this convergence criteria, right? It had that inflation rates had to be at a certain low level, deficits under three percent of GDP, debt to GDP no more than 60%-

Harrison: Or declining to that level-

Beckworth: Or declining ... So, they had all these requirements in place. The requirements of this treaty, were they also a byproduct, do you think, of the ordoliberalism?

The Maastricht Treaty and Ordoliberalism

Harrison: I think it was definitely a product of the German mentality, which I think is less a factor of inflation and more of a factor of debt that they're concerned about. A lot of people think that the runaway inflation of the Weimar Republic was really something that scarred the Germans, and they care about that. My understanding, from looking at things is that what they're concerned about is debt, making sure that debt is as little as possible.

Harrison: If you look back to their early 1990's, there were two or three problems. I think the biggest problems were Belgium and Italy because their government debt-to-GDP ... In both cases, it was above 100%. And so, if you look back and say, "We had six countries in this union, of which those are two. There's no way that we could actually do any sort of euro or closer union without those two." How do we deal with the debt problem?

Harrison: And so, a swag, if you will call it, was created, which had a hard rule that they felt was good enough. Three percent deficit in hard times is good enough. Things will be bad, but they won't be so bad that you can't make that three percent hurdle was the thinking of that time.

Harrison: I mean, any person who knows economics, and of course, we know that lawyers were involved, who necessarily didn't know economics, knows that if you make a measure, a target, you compromise that measure's ability to work as a measure because there's a certain degree of reflexivity that gets put into that. When you start cutting the deficit because you want to meet the specific target, that measure becomes reflexively involved in how the economy works out. We see that in the downward spiral in Greece.

Harrison: So, basically, what happened is that they said the 60% or going down to that level allowed Belgium. It allowed Italy into the measure, and then they had these hard targets. If Belgium and Italy weren't there, they would've said three and 60, point blank. You got to be under three percent, and you got to be under 60%, which is ironic because the Germans were in breach of that 60%-

Beckworth: Yeah, I was going to say the French and the Germans both-

Harrison: Right. For most of the succeeding period after that. But, the whole concept is that we're about to get into a union that now includes the likes of Spain, the likes of Italy, the likes of Greece, and these are countries that do not have the same ideas about fiscal probity that we do.

Harrison: We feel that fiscal measures are very important, and the only way that we as Germans know how to deal with this is to set strict guidelines. And so, that's what we have to do. We're not going to give you any sort of leeway. We're going to try to give a hard and fast rule, and hope that people stick to that rule.

Beckworth: Now, how did Greece get into the Eurozone? I've read accounts that their numbers were fudged going into it, so they actually weren't meeting the criteria. But, I've also heard it was a political decision to bring Greece in. What is your take on how Greece made the cut?

Greece and the Eurozone

Harrison: I think the way that Greece made the cut is that, basically, you had a play, which was called the convergence play, back in the day. And so, the convergence play was strong enough that it was very uplifting to the likes of Italy, Portugal, and Spain. And, in the end, it was also uplifting enough to Greece that they had a chance to get in. And, when they saw that they had the chance to get in, the government did what was necessary with banks like Goldman Sachs to create a fictitious surplus of money to bolster their government finances, to get to the magic level necessary to be able to meet the criteria.

Harrison: So, I think that they were almost there. We're talking about a period of time which was favorable, globally, because if you think back to the '90s, we're talking about the United States with a budget surplus during that time. We're talking about a period where you had massive increases in wealth, stock wealth, as a result of the TMT bubble. Greece benefited from that, as did many other countries. And so, that was a really good time for them to be able to actually meet the criteria.

Beckworth: All right. So, going back to the political economy of the Eurozone and leading to the Eurozone crisis, the German influence was also there at the beginning of the ECB, right? I mean, as you mentioned, the Germans were very leery of coming together with all these other Europeans who they couldn't trust, based on their track record. They're not as steered and as disciplined as the Germans.

Beckworth: And so, with the ECB, my understanding is they wanted that to be just like the Bundesbank. They wanted it to be like a clone in terms of culture, how they view price stability, and the first person to look at it from the Netherlands was basically the same spirit as them. They insisted that the culture, the approach, the policies of the ECB would effectively be a German bank. Is that fair?

The Political Economy of the Eurozone

Harrison: I think that's a fair assessment. And, yeah, I was going to mention that Duisenberg, he was ... If you think about the Netherlands, basically, they had the exact same policy. Whatever the Germans did, they would follow. And, the guilder track, the Deutsche mark ... Four years, and there's was no problem whatsoever. There was that ban of 2.25% between the two, and it stayed within that ban.

Harrison: I think that this was a sell to the German people because, ultimately, the euro is not a democratic institution, nor is the Eurozone, because when the Euro was put to the test for democratic vote, it failed that test. It failed the test in Denmark, and it failed, I believe, in some other countries that re-voted. But, it was never put to the test in Germany. And, the reason it wasn't is because it would've failed.

Harrison: If you had asked Germans in 1994, '95, whatever it might've been, "Do you want to join the Euro?" they would've said no because we don't want to be in an economic zone with Italy and with Portugal and Spain and so forth. The only way to deal with the political fallout associated with that was to make sure that the ECB was as close to the Bundesbank as possible. And so, you had Duisenberg, and then you had Trichet as the two first people. And, if you remember, Trichet was hiking interest rates in the midst of the last-

Beckworth: Good old Trichet, yeah. What's interesting, as I was preparing for this show, I read that Trichet actually wanted the job first, or the French wanted him there first, but a compromise was to give him the job second. And, the Germans wanted the other individual ...

Harrison: Duisenberg.

Beckworth: Duisenberg, right ... And, in retrospect, Trichet seemed more German than the first guy because he jacked up rates in the midst of the Great Recession, and in 2011 again. So, this is an interesting story here, personalities and people at the ECB ...

Harrison: What I found really interesting about that is the guy ... What's his name? The head of the Bundesbank now is Jens Weidmann, who, if you remember, there were two guys. I think Jürgen Stark was one, and then the second ... I'm forgetting his name ... who resigned in protest over the policies of the ECB. I believe this was under Trichet because they thought there was too much. I think it had to do with quantitative easing or something like that.

Harrison: But, irrespective, Weidmann is doing an incredibly good job of selling himself as a reasonable individual, meaning that when Mario Draghi leaves as the head of the ECB, it is a high probability, I would say at least 40-50%, that Jens Weidmann, who's a German, will be his successor. And so-

Beckworth: And, he's a relatively young guy, too.

Harrison: Yeah. He's like-

Beckworth: Forties ... yeah.

Harrison: 48 ... something like that. I think that he's actually playing a game, if you will, meaning that he is shading his view to be much more conciliatory in order to make sure that everything goes according to plan, not necessarily that he gets the job when Draghi leaves, but rather that the ECB comes together, and there's more harmony within the ECB's regs. But, really, his preferred ways are much less dovish than Draghi's.

Beckworth: Right. So, for our listeners, you probably know this, but under Mario Draghi ... Mario is the one who said, "We'll do whatever it takes." And, that shifted the tone of the Eurozone that began QE ... And, I've become a little more skeptical of QE over time, but I do think it made a difference there. There's the signaling effect and the commitment to do something different, but if the Germans take over ... I guess one takeaway would be don't get your hopes up they're ever going to hit two percent inflation again. I mean, if this happens.

Harrison: Right. Well, now, let me give you an example, because for two or three years, there have been rumors circulating around in the German press about asset bubbles and so forth. I was in Germany last week, and ... family and friends, we were all talking about the lack of savings.

Harrison: Germans, the way that they used to invest, the average German would put in their Sparbuch, their savings plan, in order to save. That's how they invested. Now, they can't do that without having zero percent interest. And so, really, they feel robbed. Therefore, people are looking for other ways to save money and invest.

Harrison: This is a perfect example of what the Austrians talk about. It's not necessarily the actual amount of credit that's given out, but the structure of credit that is transformed-

Beckworth: Okay. The malinvestment, huh?

Harrison: Malinvestment, exactly, by having a low interest rate. So, what's happened is that Germans are now investing in real estate instead of saving and putting their money into banks which then lend the money out. In this case, we know that those banks lent money to Spanish and Greek investment vehicles, and that wasn't necessarily such a good idea.

Beckworth: Right ... Then it got bailed out, of course.

Harrison: Exactly. So, I talked to some people in Germany, and they were telling me that ... I said, "Give me an example of family, friend ..." They sold a house for however much money a year ago. Their mother ... And, my friend's sister said it was like 350,000 euros. That's how much that would put the estimate of what it's really worth. But, a house down the street just sold for 600,000 euros, even though, in my mind, actually, my mother's house, which is nearly identical to that house sold for 60% less.

Harrison: So, the Germans are saying that basically, real estate is incredibly inflated, not just in the central cities. This is a suburb of the fifth largest city. We're not talk about Berlin. We're not talking about Munich or Hamburg. We're talking about Cologne. We're talking about a suburb in Cologne. So, you're talking about a massive escalation in property.

Beckworth: So, you're seeing asset inflation, asset prices go up over there. And, I'm sympathetic to this point, that if rates are too low, you can have malinvestment. But, to me, the bigger critique is the Eurozone itself, right?

Beckworth: I mean, the ECB's stuck between a rock and a hard place. When it sets monetary policies for the entire Eurozone, and that includes underperforming Greece, Spain, and then, you've got Germany ... We've had this discussion before, when you've had me on your show, how if you look at a Taylor rule, which is the rough way of getting a sense of whether a monetary policy is appropriate for your country or not, other than 2008-2009, ECB policy, maybe not recently, but it has been relatively decent for the core austere countries that you mentioned ... Germany, Netherlands, Austria ...

Beckworth: It sounds like recently it's been too easy with QE, but if you look at the periphery countries, it's been either boom, bust, in terms of it's way too easy for Greece or for Spain, for Italy during the housing boom, early in the 2000's. And then, it's been too tight since the crisis.

Beckworth: And so, in some sense, poor ECB or ... It's easy to understand their frustration if you're in the periphery. The ECB has been too tight for us. If you're in Germany, you can take the other view. Man, ECB has been too easy for us. But, this, to me ... Instead of blaming low rates, per se, blame the creation of the Eurozone.

Harrison: Exactly. I mean, this is the problem with the euro. As I said, it was undemocratic to begin with. That was a problem. And then, on top of that, you're putting all of these countries into the same bucket, who have very different business cycles, and also, vulnerabilities, as we see between the periphery and the core. Unless you have some sort of mechanism to even that out, which the Eurozone doesn't have, then you're going to run into these problems constantly.

Harrison: I think we could talk about banking quite easily here as an appropriate example of this. Italy versus Spain is a perfect example. Italy just bailed out two banks. They bailed them out, not bailed in. Spain just bailed in Banco Popular before it was sold to one of their biggest banks. And so, the Spanish are like, "Wait a minute. Our investors just lost lots of money, and these other guys are not losing money."

Harrison: But, this is a political problem, and the problem is that Italy's not in the same place that Spain was, in terms of a bank resolution, and as a result of that, the flexibility that the European common bank oversight, a board, had gave them the discretion to be able to allow these Italian banks to be resolved from an Italian perspective ... that is, to have capital pumped in and then to have them wound down, as opposed to bailing in investors as had been done in Spain.

Harrison: That shows you that this is an ad hoc kind of system. That's exactly the opposite of what we were talking about before, with regard to the Germans talking about strict rules and adhering to those rules. And, that creates a problem politically because I think that this ad hockery doesn't really go over that well. It creates tensions within the Eurozone.

Beckworth: That was my impression. It's not very consistent. Creditors take a hit in Spain. In Italy, they're bailed out. The taxpayers will be the ones taking the hit-

Harrison: Exactly.

Beckworth: ... in Italy. But, there's no consistency, where, if you're going to make this work, you got to do it.

Beckworth: Now, you mentioned the other things that would make it work. I mean, probably the big thing we're talking about is fiscal transfers. So, in the US, if Michigan is hammered because it's been a recession, and Texas is thriving, then through our federal tax system, when I pay my income tax and my payroll tax, it's flowing up there into Michigan, and indirectly cushioning the blow. Another solution would be just to have your own currency and have your currency depreciate, which, historically, is what Greece did, and Spain ... That was another way to cushion the blow.

Beckworth: And then, I guess a third option would be more labor mobility, but that ... In the US, that's feasible. We speak the same language. Culturally, not that different, though some might argue there's big differences in the US. In fact, recently, I had a guest on here. We were talking about the declining labor mobility in the US. But, relative to Europe, though-

Harrison: It's pretty robust.

Beckworth: Speak to that. I mean, if I'm unemployed ... mass unemployment in Greece ... How easy is it to move up to Germany and find a job where the economy's more robust?

Economic Mobility in the Eurozone

Harrison: I think that it can be done. It's not very difficult. I think that even historically, we see that. If you think about the great waves of immigration ... This includes the Netherlands as well. You're looking at a lot of immigration from North Africa. You're looking at a lot of immigration from Spain, a lot of immigration from Turkey, a lot of immigration from Italy and from Greece, into places like the Netherlands and Germany, in the '60s and the '70s and the '80s. And, even today, the same sort of thing.

Harrison: So, I think that can happen, and it has happened since the eurozone crisis began. However, then the question becomes what's the incentive for Belgians and Germans and Austrians to move to Italy and to Spain? Is there a reverse migration, or is it a one-way migration? And, if it is a one-way migration, what sort of problems does that create?

Harrison: I think that, yeah, there's not a perfect fluidity of the migration patterns. Especially when you have an ancient society, that creates a problem. I think I saw this on Twitter from Jonathan Tepper recently, who runs Variant Perspectives. He had a tweet which showed the average age within European countries, and all of them were in eastern Europe. If you looked at the net migration patterns of those countries, all of those countries were net out migrants of younger people. So, all of the people ... the baristas in London from Estonia or wherever it be ... And, the last time I was in London, there were tons of people from those countries there, in the hospitality sector. Those are people who are not contributing to their country-

Beckworth: Back home.

Harrison: ... back home, and creating a demographic which has more young people within the economic system.

Beckworth: Well, western Europeans, those young people ... in terms of fertility and birth rates, they need more immigrants to come in. But, I guess, going back to my question, the shock absorbers ... You have a one-size-fits-all monetary policy straitjacket, the euro and ECB policy ... If the ECB is not giving you the right monetary policy based on the state of your business cycle and your economy, then these shock absorbers, if they kick in, either you move to a place where there's more work, or you get transfers from the federal government, which they don't have that.

Beckworth: So, my question is, you have mass unemployment in Greece. Is it really practical for all these Greeks to move into northern Europe? I mean, my sense is no, but are you saying that it is possible?

Harrison: It's possible to a certain degree, but you have a hollowing out that will actually-

Beckworth: Oh, I see.

Harrison: ... somewhat be negative to-

Beckworth: Back home in Greece.

Harrison: ... to the economy back home. Certainly, over the longer term, but probably over the shorter term, to a certain degree. It may alleviate some of the pressures on transfer payments and things of that nature, but it also means that when things get going well, you don't have the manpower, necessarily, to get it done.

Harrison: I mean, my general sense is also that the mass that you're talking about, you really couldn't move the 50% of youth unemployment out of Spain, out of Italy, and out of Greece, and move them into northern European countries, especially from, I think, a political perspective. I mean, this is why we had Brexit, ultimately, is because the UK was the first country to have unrestricted migration from eastern Europe.

Harrison: One of the biggest problems with the EU, as well as the Eurozone, is that it's all happened way too fast. There was a time when you had six countries, and they were fairly homogenous. Italy was an outlier, to a certain degree, in the EU. You had Germany, France, the Benelux, and then you had Italy.

Harrison: Then they expanded it out over time to countries that were fairly homogenous. They took in the former dictatorships of Spain, Portugal, and Greece, and over a relatively long period of time were able to absorb those countries, which were on a relative basis, lower social economically. But, it was nine years before they took the next three in, which was Finland, Sweden, and Austria. And, those were richer countries.

Harrison: When 2004 hit, and they started to take the eastern Europeans in after the wall fell, to me, that was when things started to unravel, meaning that there were too many moving parts. You have 28 ... soon to be 27 members of the EU. You don't have the ability to have voting rights, which everyone votes unanimous votes. Now they have majority votes that they put in because they're so one country could block ...

Harrison: You have the eastern Europeans, which are hidebound with regard to immigration policy ... very different than, say, even in Spain, which, if you compare Spain to Hungary, from a socioeconomic perspective, they're similar. But, from a cultural perspective, with regard to immigration, vastly different with regard to their ability to absorb, say, Syrians during the refugee crisis.

Harrison: So, my sense is that 2004 was the tipping point for the EU, in terms of its structure. You already mentioned the fact that the euro ... You didn't have enough buffers. But then, when you add in all of these different countries together at the same time, you're creating a multifaceted problem that's very difficult to solve.

Beckworth: Another observation I've heard people say is that history is just not on its side, that's there too much bad blood, figuratively and literally, that the Germans will never, ever concede to a fiscal transfer system. Even proposals for the deposit insurance system for the entire Eurozone, so banks are regulated on the same standard ... Germans will never do that.

Beckworth: Those lazy Greeks. They'll never live up to our standards. Or, vice versa. The Greeks may hate those Germans because of World War II and stuff. Do you see history really being a big obstacle to further convergence and integration?

Harrison: I'm an optimist. I don't see it as dire. I see economic cycles as exacerbating those historical antagonisms. That is, when bad things happened, then suddenly people start pointing the finger and saying, "Wait a minute. 50 years ago, you had your boot at our throat, and here you are doing it again!" But, when times are good, things are much better. When the Greeks are winning the European Cup, the European championship in football in 2004, people are loving it, and this is the birth of the Olympics and all of this kind of thing.

Harrison: But, I think we're in a special window here. Macron, he's already talked about that. He says, "I have a window of opportunity. If I fail ... I mean, me, Macron, who's much more in your court ... you, the Germans ... Then, basically, that's it. It's done because it's the German-French Alliance. I'm your guy. I am left of center, but I'm as close to a guy who you would want in power. We need to get this thing done. We need to get closer together now, or when bad times come, Marine Le Pen will be waiting in the wings."

Harrison: I think that's a correct assessment. So, I think that the Germans ... And, if you listen to any of the Germans, including Jürgen Stark and ... In fact, Axel Weber's the other guy who left the ECB board ... Listen to what they say. What they have said is all the things that you just said ... fiscal transfers, debt mutualization, whatever ... We can do only once we get what we want ... that is, that you guys are similar to us.

Harrison: And so, I mean, to a certain degree, you could say that it's a Germanification of Europe. And, some people are not down with that particular economic model. The Germans are completely willing to have more Europe and more integration, but they feel that they're not going to give their money and get closer together unless the countries are much more similar in terms of their economic model.

Beckworth: That's perfectly reasonable from the Germans' perspective. They're the rich ones. Why should they bear the burden? I completely understand that.

Beckworth: Do you see that actually happening, though? I mean, it is surprising, on one hand, the Eurozone has lasted this long, right? Everyone, including myself, was predicting that it was going to break up in 2010, '11, '12 ... But, it's survived. So, is this the sign, then, that the Eurozone project does have hope and that maybe it is becoming more German?

Will the Eurozone Survive?

Harrison: I think that there is hope. Going back to what you were saying about we thought it was going to break up, I certainly thought that Greece was going to leave. Who would've thought that they would've put up with as much austerity and pain as they've put up with?

Harrison: I think there are two things that are positive here. One is that the Brexit is constantly a reminder for everyone of how difficult it is, and the Brits don't even have the euro. They can barely extract themselves from the European project. And, of course, if you leave the Eurozone, probably you'll have to leave the EU. That's what a lot of people say.

Harrison: The concept that you would leave the Eurozone is going to be really difficult. So, Spain would not only have to do what the UK is doing, but then they would have to convert their currency and so forth. They're not going to want to do that. My sense is that, also, we're at a point in time economically in the cycle that's positive as well, so that needs to be used.

Harrison: The second point, I think, that's most important besides the Brits is that it's so difficult to get out that, really, you're going to have a crisis before you have people get out. I agree with you that it's a very difficult process, but I think that what happens and what will happen is that you're going to have a crisis, and then we're going to have to see where the politics are in the individual countries as to where we're going to head next.

Harrison: Generally speaking, where we're going to head is towards more integration, that it's too difficult to disentangle things, and the Germans will eventually concede. They will do what's necessary to keep the union. That's my view.

Beckworth: We had a previous guest on here, Jesús Fernández-Villaverde. He's an economic historian. He's a Spaniard, and his analogy was this was a marriage that should never have happened, the Eurozone. But, the divorce is way too costly not to take place. We're just too tied together. The divorce would be so messy that it's better to work through it and try to resolve, kind of where I rank where you're going with this here.

Harrison: Yeah. That's how I look at it. Unless sentiment within the Netherlands, Germany, Finland, countries like that, turns, it's not going to happen. It has to happen either through a massive downturn like you had in Greece, and they just decided to pull the trigger, or you get people like the AFD party taking over.

Harrison: You have the ... What's the guy in the Netherlands who came in first in the polls? He takes over in some capacity in the Netherlands ... Only in those circumstances is that going to happen. That only happens in a downturn. So, the Marine Le Pens of the world have to be in power in some capacity, in very important central European countries.

Harrison: I would say what happens in Italy ultimately will be what decides what happens in the Eurozone, because of the most vulnerable countries, they're the ones that are the largest. And so, what happens with them and the reactions to what happens in Italy, both politically in Italy, but also in Germany, France, and some of the other core European countries ... That's what's going to decide whether or not the next crisis is going to be winnable, or whether they will accede to some sort of disintegration.

Beckworth: But, tell our listeners quickly. What's happening in Italy that's so pivotal?

The Italian Story

Harrison: I think what's happening is their banking system's weak. They have no growth for the last 20 years, and they have a huge debt-to-GDP government debt that can't be financed unless they have a higher growth. When you add that to their demographics, which are really poor, basically what it says is that when the next cyclical downturn hits Europe, they will be one of the first countries to hurt. They're so large, and their banking system is so weak ... We see this with the bailouts, that they're getting that the Spanish did not get, that they're going to be a problem.

Beckworth: They're the weakest link, but a big weak link.

Harrison: Exactly.

Beckworth: Okay. Interesting. Well, there's been a few proposals to make the Eurozone more robust, and I wanted to get your sense of them. One of them is creating Eurozone safe assets. So, if you look at interest rates on government bonds in Europe, they've been really, really low lately, and the safest countries have been really low. Germany has been below zero. They're positive now, but Switzerland had negative rates.

Beckworth: The fact is people are basically paying governments to take their money just to preserve the principal, just to keep my money safe. And, if you could somehow consolidate, maybe securitize all those into Eurozone safe assets ... There's been different iterations of this argument, but basically create the equivalent of a treasury bond for the Eurozone as a whole. Do you see that happening, or is it a good idea if it could happen?

Safe Assets for the Eurozone and Other Proposals

Harrison: I think, yeah, the next crisis will make it happen if they haven't already come up with it before then. The real question is will they come up with it before then because ideas have been put together about this European safe bond. Germans are actually on the group that's come up with this idea, so it's not something that the Germans wouldn't be down with.

Harrison: And, basically, there's a risk-on, risk-off profile a lot of times in markets. That is, we're ready to take risk, or we want to go to a safe asset. If you don't have that safe asset or if that safe asset is only one country's bonds, the Germans, then that creates a problem of divergence within your government bond market. So, having this overarching bond is very important in terms of giving people a place for safe assets.

Harrison: For me, it doesn't solve the problem entirely, obviously, because you could still have a default. I mean, even if you have European safe assets, and that's what people want, what happens if Italy runs into difficulties? They could still default on Italian government bonds, and then that default will weaken the capital of Italian banks, and then those Italian banks will need a bailout or bail-in. Do you give them the bailout? How big are those banks that need the bailout? Those are the kind of questions that are going to come to play, and safe assets don't change that.

Beckworth: I mentioned this earlier, but what about a deposit insurance scheme for the entire Eurozone? Good idea, bad idea? Feasible?

Harrison: I think that if you're going to have more Europe ... that is, if you're going to integrate more together, make it work, ultimately, you're going to have to have one regulator. You're going to need one deposit insurance scheme. And, ultimately, you're going to have to have that at the European level. That is, the resolution of those banks has to happen at a European level as opposed to a state level.

Harrison: If you do that, the nexus that I talked about between the government and the banks at the state level goes away. I think that's important because it's like saying that we have the fed oversight for all these banks, but since you, Citigroup, you're domiciled in Delaware ... When you go bankrupt, Delaware's on the hook for making sure that you have the funds to get bailed out. That's not going to work because Delaware's just not big enough to be able to deal with a behemoth of that size.

Beckworth: Okay. Finally, going back to a point we've touched on, but have the ECB actually hit two percent inflation? Now, you gave me some posit earlier because you mentioned in Germany right now, the ECB's policies may be too easy because they're having this asset crisis, or even if it's too tight somewhere else ... One of the explanations I've heard or arguments I've heard is that if the ECB had been hitting two percent all along ... I know the target is close to two, not quite two ... But, let's say it had been closer to two, maybe 50 basis points more on average ... One argument is that the price level inflation would've risen faster in Germany because it's near full employment, so that added monetary stimulus would've first been seen or felt in Germany.

Beckworth: Greece, you wouldn't see it as much because they're in a slump. But, what that would've meant is price level is going up in Germany faster than it is in the periphery, like Greece making the periphery's goods more competitive in terms of price. Or, another way of saying this, technically, is the real exchange rate in Greece would be going, and it'd be a depreciation in Greece, which is what they need. And so, if they just did hit two percent inflation, that would've maybe got that realignment more in line. What you said earlier suggests that there would be some unintended consequences to that.

Harrison: Right. And, to break it down in simple terms, I think that there's the financial economy, and then there's the real economy. When you have monetary policy as a dominant force, basically there's a disconnect between those two at key points in the economic cycle. In the down cycle period, near the down cycle, you're going to get a lot of asset price inflation on the upside, much before you get any sort of real economy benefits. What that ultimately means is that the interest rate that is neutral, if you will, for asset prices is different.

Harrison: In Germany, it's not necessarily wage inflation or price inflation that you would have to worry about. It is asset price inflation, which has already taken off, which you have to worry about, which is destabilizing for the country. I mean, we saw this when German reunification happened, that there was an active price bubble, and that's part of the reason why they were the sick man of Europe the last time, because there was a lot of this speculation in eastern German assets.

Harrison: I think that ultimately the real problem is that the ECB is a single institution, and there is no fiscal agent which is at the same level that can actually do something to benefit system-wide. It's really just a fatal structural flaw of the Eurozone that needs to be corrected.

Beckworth: And so, that's maybe where some of my pessimism comes from, right? Even if we get these Eurozone safe assets, even if we get the deposit insurance scheme for the Eurozone, I guess, would that be enough to offset the fact that there's always going to be some country who gets the wrong monetary policy from the ECB? And, if not, then we're going to have perpetual business cycles within the Eurozone. Germany's doing great. The periphery's doing poorly. The periphery's doing great. Germany's doing poorly. It seems like that could be a never-ending problem.

Harrison: Right. And, it will be. Then the question becomes when and how do you solve those problems?

Harrison: I think that what we've seen in the last few years is that it takes a crisis to solve a lot of those problems, and it's so difficult to get out of the Eurozone that they will use the crisis to solve many of those problems, but they won't solve them all. So, you will get this perpetual crisis situation.

Harrison: I think that eventually, it's going to create populism that will imperil the Eurozone. It doesn't necessarily mean that it's going to break apart, but you have a tension there, and that creates the potential for it to break down.

Beckworth: All right. Well, we're out of time today. Our guest has been Edward Harrison. Edward, thank you for coming on the show.

Harrison: Thank you. It was very good to talk to you. I've never had an opportunity to speak at length about these topics with someone who really knows what they're talking about. It was a wonderful experience.

Beckworth: Oh, I learned a lot. Thanks so much.

About Macro Musings

Hosted by Senior Research Fellow David Beckworth, the Macro Musings podcast pulls back the curtain on the important macroeconomic issues of the past, present, and future.