Inflation and the Euro: Just try to falsify the single currency

Autor: Lukáš Kovanda | Publikováno: 21.7.2008 | Rubrika: English
Euro 01

Long time ago, people, and even the wisest men, maintained that there is only one general “type” of swans – white swans. If you had lived in those times and had tried to suggest swans are not only white, other people would have thought you were a fool. And they would have been right, at least in Europe. It was not until 1697 when the Dutch explorer Willem de Vlamingh made in Australia the first European record of sighting a black swan. The sighting was significant in Europe where “all swans are white” had long been used as a standard example of well-known truth. Now, if you had said swans are not only white, other people would not have thought you are a fool. Instead, they would have thought you were a wise man.

Sir Karl Popper, a famous Austrian philosopher of science, is known also as a fierce denier of induction. He was convinced that people make mistakes when they are trying to get some universal knowledge from only limited, and thus always unrepresentative, number of observations. Put simply, he thought, and taught, there could be many “hidden black swans” in the world even though we observe a long queue of only “white swans”. Because of that, he proposed a new approach to the process of accumulation of human’s knowledge. Our brain and our reason are limited – we cannot observe all the swans living in the world in one moment. Thus, no theory is definitely truthful, no truth is absolute. The best what people can then do is not to try to prove a theory – because the absolute proof cannot exist – but try to falsify it. It means to test whether a theory is valid under all thinkable conditions, especially under such conditions which clearly are not in favor of the theory. If it is not, if it is valid only, say, under some favorable conditions, it is falsified, argues Popper, and should be modified or abandoned.

Just recently, The Economist wrote (The Economist 2008) an article to celebrate the 10th anniversary of the European Central Bank (ECB). The text is called “A decade in the sun”. Yes, the ECB, as well as the Eurozone, indeed, has luckily avoided economic nightmares like, for example, enormous inflation pressures. Unfortunately, lucky periods are not endless. If they were, we would not have known what the luck is. Current global economy signals serious problems for the near future. Billions of people in China, India, Brazil or Eastern Europe demand their living standards imitate more precisely these of Americans or Western Europeans. Moreover, the Federal Reserve System has fought hardly to rescue collapsing banking system in the U.S. The preferred weapon has been an excessive money supply of the U.S. dollars which, in the short-term, reliefs the banking systems but, in the longer period, creates market bubbles.

These overreactions of the Fed are not a new phenomenon, because they have been with us at least since the stock market crash in 1987, after that Mr. Alan Greenspan, then a rookie in the office, pursued a so called “cheap money” policy, i.e. with interest rates lower than, as many thought, was necessary. After the crash in 1987, Mr. Greenspan’s policy proved successful, at least from a short-term perspective. So, he hold the rates down also in the reaction to the U.S. recession at the beginning of the 1990‘s. This particular cheap money led to the Dot Com Bubble that gone bust in 2000. After this bubble and 9/11 Mr. Greenspan decided for the cheap money again. And again, a bubble was born. Low interest rates brought naive dreams about relatively expensive housing to many relatively poor Americans. Subprime Bubble gone bust last year and housing prices in the U.S. and also in other countries, e.g. in the U.K., have been falling dramatically since then.

Now, not Mr. Greenspan but Mr. Ben Bernanke had to fight. The weapons have been the same, it seems, the cheap money. But it does not work now as in the Mr. Greenspan’s era did. Where is the mistake? First, the Greenspan‘s reign over the Fed was really very long and that means that the supply of American dollars is really very excessive. Just ask the comrades in Beijing or the managers of sovereign wealth funds in Russia, Singapore or Dubai. They simply do not know what to do with so many billions of dollars. No wonder the dollar is depreciating worldwide. Second, Mr. Bernanke took over the reign over the Fed while global conditions were changing rapidly. The cheap money under Mr. Greenspan were creating “only” U.S. bubbles whereas inflation pressures, the inevitable outcome of the low interest rates, were being accommodated by globalization, especially by very cheap workforce in the emerging markets. Not so under Mr. Bernanke. Now, a cheap dollars policy creates not only bubbles but also huge global inflationary pressures. Conditions are getting worse – Fed’s, or Greenspan’s, two decades in the sun are over. Maybe Mr. Greenspan’s success will be falsified later by stating he only was too lucky to reign being exposed to ideal circumstances.

Get back to the Europe. The inflation pressures are present here, too, especially in countries like Slovenia, Greece, Spain or Belgium. The real problem is the Eurozone does not know anything else than the sunny period of the last decade. All the project of the Eurozone and the European single currency, the euro, derives its fruitfulness from being – almost necessarily – successful under favorable conditions of the freshly globalizing world economy. In other words, there has not been an opportunity to try to falsify the euro yet. Maybe the Eurozone’s success will be falsified later by stating it only was too lucky to start being exposed to ideal circumstances.

Taking all this into account, it might be we mistakenly observe two “white swans” – Mr. Greenspan’s and the euro’s successes – whereas the “black” ones – confusion and disillusion that the successes are only a short-term coincidence – have been impatiently waiting to be inevitably found. If so, then in the Mr. Greenspan’s case nothing terrible would happen, since only one man would be thought of more realistically, not as an unmistakable “maestro”. But what shall we do, then, in the case of the euro? If it has been shown the single currency is an ill-fated project, it would be an economic catastrophe.



1.    Inflation, the euro and the Czech Republic

We have just seen the euro is still a suspect project because the single currency has not been tested under really non-favorable conditions. Thus, we do not know for sure whether the euro is not falsifiable, in the Popperian sense, in fact quite easily – just under little bit less “sunny” conditions. If it is, if it will be proved some day, for example, that one-size-fits-all philosophy behind it is very ineffective way in dealing with, say, a global inflation crisis, the euro could be doomed. But, at the time being, we simply do not know. In such a situation, according to a cost-benefit analysis, the optimal way for the Eurozone to deal with the uncertainty surrounding the project is just to wait till the crisis comes. And hope the sort of economic models saying the euro is viable, and hence apparently non-falsifiable, is right. On the other hand, the countries that have not adopted the euro yet but are scheduled to do so, like, for example, the Czech Republic, are better off if they do not swap the national currencies for the euro until it turns out more convincingly the single currency will not be prone to be falsified even under really difficult conditions.

However critical, it is by far not the only reason why countries like the Czech Republic should not hurry to adopt the euro. Considering the Czech Republic specifically, its price level is at around 60 percent of the “old” European Union countries’ average. Currently, the Czech real economy has been converging to that of the Eurozone via two channels: first, via Czech currency’s appreciation in respect to the euro, and, second, via inflation, or, more precisely, via inflation differential (the difference between rates of inflation in the Czech Republic and the Eurozone). In the case of the adopting, clearly only the latter channel would be functioning. It means the Czech economy would be converging through a rise in prices exclusively, arguably enormous. For example, last year’s inflation in the Czech Republic was 7 percent. The Czech currency at the same time appreciated in relation to the euro by 8 percent. If we had already had euro, the inflation would have been 15 percent (Mach 2008).

An example of such an inflationary convergence is the case of Slovenia. The pace of inflation speeded up from 1.6 percent before the adoption, which took place in January 2007, to 6.9 percent this March, the highest in the Eurozone (in such a situation, Slovenia would arguably prefer higher interest rates, but since it must follow one-size-fits-all policy of the Eurozone it has no other option than to follow also a strange and ineffective mix of high inflation and low interest rates). Not to mention, the Slovenia’s price level was higher than the current Czech’s one is, at almost 80 percent of the Eurozone’s average at the time of the adoption. Even only a domestic currency pegging to the euro has a significant inflationary effect as we can currently see in Baltic countries, which are fighting two-digit inflation.

The other reason rests in the fact that the so called “trade effect” is still rather a myth than a real phenomenon. In his widely cited working paper called “Currency Unions and Trade: The Effect is Large”, Mr. Andrew Rose suggested in 2001 (Rose 2001) that the creation of the European Monetary Union (EMU) would lead to a significant improvement of mutual trade and hence to a rise in overall GDP of the participating countries. Nevertheless, the current reality has shown that nothing is further from the truth. Just have a look at empirical data: in 2005, the foreign trade of the Czech Republic (with EU countries), expressed as a share of domestic GDP, was 105 percent. Comparable countries which had been already using the euro – Austria, Ireland, Portugal, and Greece – had much lower these shares: 61, 58, 42, and 17.5 percent. What matters, it seems, is not “trade effect” of the EMU but just the geographical proximity of trade partners (Holman 2008). The “trade effect” is not a good reason to advocate the acceleration the process of adopting the single currency, at least in the case of the Czech Republic.

We can argue that appreciating of the domestic currency is not desirable for whole economy since it hurts exporters. Obviously, such arguments are present in the today’s Czech Republic too. The Czech crown, which is getting stronger very rapidly, does not match exporters’ interests as they are less competitive in the global markets – yes, we have mentioned the word “interests”. The Czech exporters are, as everywhere else, only one of many interest groups. It lobbies for its partial interests and now, exporters say, it would be much better to live on the euro currency. From their perspective that is right – but only from a short-term point of view. On the contrary, in the long-term, high inflation would result in increasing wages and prices also on the side of exporters. Indeed, it is surprising that they do not include these calculations in their plans and are still pushing for a quick adoption (Zahrádka 2008).

Moreover, the real inflation may be possibly significantly higher than that announced by statisticians, since, after the adoption, the prices of non-tradable services (services related to housing, water or energy supply, etc.) are bound to rise relatively more significantly. However, the Harmonized Indices of Consumer Prices (HICP), used by the Eurostat, model  consumer baskets in such a fashion that the share of non-tradable services on the total expenses is much lower than it is in the reality, at least in countries like Slovakia or the Czech Republic (“non-tradables” are more sensitive to changes in money supply, so its lower-than-real share leads to understating inflation by statisticians, too).

Last, but not least, reason for not hurrying with the adoption turns out to be clear when we look at GDP figures of European countries. The data has shown that the GDP growth is slowing down in those countries which had adopted the euro. The same slowing down, on the other hand, is not being observed in the European countries without the euro – like in Britain, Denmark or Sweden. The difference in the GDP growth figures in these two group of countries is one percentage point per year on average, whereas prior the adoption of the single currency the economic growths were the same on average (in fact, only during the first four years after the euro adoption, the Eurozone had lost 4 per cent of its GDP – or 300 billions euro, which it would not have lost, if it, hypothetically, had not thrown away independent monetary policies) (Mach 2007).

Above, we have just said that the euro is, to the date, a successful project because it has not have to go through “a cloudy period” yet, which would be the real test of its success. But, saying that, are not we biased by the poor performances of the U.S. dollar and other global currencies, for example the Japanese yen, that makes the euro an “one-eyed-between-blinds” currency? Can we really say the euro is successful? Because ten or so years ago advocates of the single currency argued that the euro would bring about a significantly higher rise in GDP, not its slowing-down.

2.    Conclusion: Waiting for the test

Ten years ago, the main argument of the euro proponents went that the single currency would help to unify the economic variables of the member countries, e.g. the rates of inflation, and to synchronize business cycles. It means they had admitted that EMU was not an Optimum Currency Area (OCA) – i.e. an area for which one common currency is an advantage, as proposed by Mr. Robert Mundell in his famous article “A Theory of Optimum Currency Areas” from 1961 (Mundell 1961) ­–, but suggested that the single currency would quickly create such an area. Today, we see there has not been established OCA in EMU yet as inflation rates, unemployment rates or business cycles of individual member states are still significantly different – in contrast to the unified monetary policy (not surprisingly, even more asynchronous business cycles have EU countries with and without the euro – for example, the correlation coefficient of Czech and German cycles during the last twenty years is about -0.44). Because the EMU is not an OCA, capital inflows in one of the member countries result in above-the-average inflation while outflows of the capital lead to a rise in unemployment – exchange rates, which would normally adjust the economy, are missing at this level.

Thus, it seems the proponents’ argument was only a political proclamation and that the EMU project has rather political than economical roots. To support such a conclusion we may remind that during the process of the euro introducing, eleven out of the twelve participating countries had not been fulfilling the Maastricht Criteria, officially necessary economical preconditions for the adopting (Maastricht Criteria consist especially of these conditions: 1) inflation.   of no more than 1.5 percentage points above the average rate of the three member states with the lowest inflation 2) a national budget deficit close to or below 3 percent of gross national product and 3) public debt not exceeding 60 percent of gross national product)

The project was quite easy to introduce because politicians, talking to the general public, had accented “microbenefits” of the euro (lower transaction costs via e.g. zero exchange fees or no changes in exchange rates in general, no foreign exchange risks, etc.) while suppressed its “macrocosts” (first of all, the loss of an independent monetary policy), that, as well as their impacts, are more apparent in the long-run or in the “cloudy periods” of non-favorable overall conditions. Moreover, the “microbenefits” could have been in fact overstated since, for example, a study of British economy showed that savings related to such lowered transaction costs would count only for 0.1 percent of country’s overall GDP – and losses connected with lower gains of banks and other money changers were neglected (Gonda 2007).

The question remains whether EMU has a potential to be an OCA one day. One day, maybe, but it may take two or more generations of Europeans, since, for example, the basic assumption for the OCA theory to be valid is to have a very flexible workforce, with workers able to smooth economy imbalances through their high mobility (which can, to a great extent, substitute independent monetary policies), as well as very flexible labor markets. Nothing of that is to be seen in EMU anytime in the near future. A reluctance to optimize working mobility is a traditional, deep-rooted characteristic of many Europeans and a reluctance to make labor markets sufficiently flexible is at odds with interests of, for example, labor unions and, indeed, of many of the national governments.

Having said that, it seems the EMU is still a quite uncertain project waiting only to be tested under conditions that may finally prove its fruitfulness. Or falsify it and, potentially, doom it. An outcome of this statement is that countries still using national currencies which are scheduled to adopt the euro should not hurry to do so until the convincing test proves the euro is a hardly falsifiable project (the accession treaties do not anyhow specify the time moment till that must the euro be adopted – for example, Sweden is, according to its accession treaty, obliged to adopt the euro, because it has no “opt-out” like Britain and Denmark, but, in the 2003 referendum, the adoption was not voted for by majority of Swedes and the country is still using national currency). The countries already using euro are bound to do so till the test comes – the related uncertainty, explicit or implicit, is a negative outcome of the fact that all the (economic) project of the EMU has been pushed by politicians – who prefer short run gains – rather than by economists – who should see long-term price of that short run gains. 

Mr. Paul de Grauwe, then an economical adviser to Mr. José Manuel Barroso, president of the European Commission, said in 2005 that “the euro is not sustainable without further political integration” (Ševčík 2007). But many Europeans, most recently the Irish, apparently do not wish such a further integration. Does it mean the euro is really to be doomed? Not necessarily, but it must not be used in the current manner, that is as a toy in politicians’ hand – an economic tool only supporting their specific political goals. It is too serious thing to be just a toy. 



Gonda, Peter (2007): “Europreteky a europasce (nielen) na Slovensku”, In: Pečínková, Ivana (ed.) Euro versus koruna, Brno: CDK, 2007

Holman, Robert (2008): “Desetkrát ano pro odklad eura”, Hospodářské noviny, July 8th 2008, published [online] at

Rose, Andrew (2001): “Currency Unions and Trade: The Effect is Large”, Economic Policy, CEPR, CES, MSH, vol. 16(33), pages 449-461, October.

Mach, Petr (2007): “Euro a jeho budoucnost”, In: Pečínková, Ivana (ed.) Euro versus koruna, Brno: CDK, 2007  

Mach, Petr (2008): “Euro není výhodné“,, June 13th 2008, published [online] at

Mundell, Robert (1961): “A Theory of Optimum Currency Areas”, American Economic Review, 1961

The Economist (2008): “A decade in the sun”, June 5th 2008, published [online] at

Ševčík, Miroslav (2007): “Nominální kritéria konvergence ČR až na jednu výjimku plní, reálná nikoliv”, In: Pečínková, Ivana (ed.) Euro versus koruna, Brno: CDK, 2007

Zahrádka, Jiří (2008): “Euro nebo koruna, vždyť jsme jedna rodina,, May 6th 2008, published at


This article was prepared as a speech for the conference “Is the Euro doomed?: Threats and Opportunities”, held on July 15th and 16th in Hotel Silken Berlaymont, Brussels. Mr. Kovanda is a Czech economist, demographer and journalist, who teaches at Prague’s University of Economics and is a cofounder of the, a leading euroskeptic and eurorealistic webpage in the Czech Republic. 

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