Two Basic Economic Terms You Need to Know

Euro

Euros: Are we near the end? (Photo credit: Fernando D. Ramirez)

By Ben Cohen: One of the reason why I enjoy writing about economics is because it is not a topic that came easily to me. I would always ignore the economic and business news and focus on the politics – it was much easier to understand and a lot more fun. That was until I began to understand that politics was economics, that behind every political decision was a economic motivation. I discovered that without understanding the financial side of how countries work, there was no way of understanding why politicians behaved the way they did. Economics isn’t really difficult either – as long as you understand how credit cards and personal saving accounts work, you’re pretty much good to go. There’s a lot of jargon, but when you boil it down it’s pretty simple.

The crisis in Europe is a prime example of economics dictating politics. The political upheavals are a direct result of economic policy gone awry, and it is vital that people understand what is going on behind the scenes.

The big argument in Europe comes down to how much control countries in the Euro Zone should have over their own economies and if they give it up, what direction it should go in. The shared currency was an attempt to create a common market via a more centralized version of Europe’s already deeply integrated economies, and there have been numerous battles over the extent of this centralization. The architects of the Euro envisioned a new ‘super state’ that could compete with America and other rising economies, but given the resistance to conformity by several European countries (Britain for example) it has experienced some major development issues.

The key to understanding this is to know the difference between monetary and fiscal policy – two terms that politicians throw about a lot, but not many people understand.

Monetary policy is dictated by a central banking institution – in America it’s the Federal Reserve, and in Europe, it’s the European Central Bank (ECB). These banks decide how much money there is in the economy – they can either inject money into the economy (usually by buying bonds) and extract money from the economy (usually by selling bonds).

Fiscal policy refers to the government’s use of its taxing and spending power to influence economic activity (it does this by paying for infrastructure, social services etc).

Both are vital in adjusting and maintaining the economic health of a country, but when there are conflicting interests in a larger union like the Euro Zone, it gets very very messy.

In the Euro Zone, there is a huge row over fiscal policy. Because of the huge amounts of debt in countries like Spain and Greece, more stable countries like Germany are demanding their governments drastically cut spending and adhere to austerity measure in order to meet their debt obligations. Up until now, much of Europe has followed the austerity path as governments slash budgets and commit to severely reduced spending in the future. Leftist and independent political movements have sprung up and are demanding governments reverse the austerity measures and start spending in order to stimulate their economies. The problem is, because there is no centralized control over fiscal policy, the structure of the Euro Zone is inherently unstable and susceptible to major upheavals when one country refuses to follow suite.

There are two philosophies that are inherently incompatible in Europe – one is that of austerity, and the other is of Keynesian spending. Now some countries are fighting German lead austerity, it becomes extremely difficult to have a coherent solution to the regions massive economic problems. Niall Ferguson does a great job of crystallizing this very serious structural flaw:

Here’s the choice, Mein Herr. You accept the logic of the Mitterrand/Kohl era, which always was ‘we’re having monetary union in order to get to a federal Europe’ . . . The logic of the 1990s was that ‘monetary union will force us to ever­closer fiscal union, which is hard to sell politically, but we’ll make it happen — we’ll back into it through a monetary union’. That always was the model — which was one reason for being against it as a British Eurosceptic. Now we’re at the moment of truth when you can no longer maintain the fiction that a monetary union can exist independently of a fiscal union … On the other hand — and this is the message to Angela Merkel — to use George Bush’s phrase: this sucker’s going down. We’ve reached that point.

The problem is very complicated as there are so many factors that are difficult to predict. Getting national governments to agree is one thing, but when it comes to the getting the population to get on board with political and economic relationships they have a difficult time understanding, it gets a whole lot trickier.

There are some very hard choices that need to be made in Europe over the coming months, and if the Euro is to survive, it is likely that some sort of framework to unify fiscal policy is reached. Germany will also have to seriously reconsider its strict philosophy of austerity if it wants to be a major player in this, otherwise it risks alienation and rejection by the other Euro members who are quickly turning against it.

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