How the crisis in the Eurozone affects all

The economic and financial crisis in the European Union has both captivated and confounded many of us. What caused these disturbing problems? How can it be that a recession in the EU can affect the U.S. and our metro area?

In analyzing the causes of the crisis one can get caught up in the special circumstances facing individual EU countries. Let’s take a broader approach by considering a mythical country called Lowtech, which has not yet joined the Eurozone.

Lowtech has an aging population, a stagnate economy and has not invested heavily in increasing productivity. Yet, it feels comfortable with its traditions and lifestyle. It exports some products, but the pace is becoming sluggish. Lowtech can enhance competitiveness by lowering wages (not politically feasible) and by addressing the need to improve productivity.

What Lowtech does choose is to use its central bank to increase the supply of money. This may help Lowtech boost its exports because it will decrease the value of its currency, making products less expensive for foreign purchasers. Increasing the money supply also will increase prices for domestic goods, and the real value of wages will go down.

Like many countries with a slowing economy and aging population, Lowtech borrows money to meet needs for such things as funding pensions, medical care and maintaining an aging infrastructure. However, its choice to borrow money will have its limits – lenders will demand higher interest rates to offset their risk of loans to a country whose currency is subject to fluctuations. While this isn’t an ideal situation for Lowtech, it isn’t a crisis yet.

Now let’s imagine Lowtech joins the EU’s Eurozone and adopts the euro. Although its products are not price- or quality-competitive, Lowtech no longer has the option of devaluing its currency to ramp up exports. It is bound by the euro. Exports languish and imports increase because products from more competitive EU countries are less expensive.

As its economy falters and tax revenues fall, Lowtech’s need to borrow increases. In this case, the common currency seems like a blessing. Foreign lenders no longer need to worry about currency devaluation and will lend at lower interest rates. This gives Lowtech the ability to increase its borrowing without much restraint. The result is predictable – excessive borrowing, large debts, slow productivity growth and a faltering economy lead to a serious and a chronic affliction.

These potential problems seemed to have been ignored or minimized in 1991 when EU member states signed the Treaty of Maastricht that called for a common currency and closer economic alignment. But the treaty lacked checks and balances and disciplinary rules to curb excesses and promote behavior more consistent with fiscal stability.

The resulting financial crisis will affect all of us. Southern Europe is in a recession that may engulf the entire EU. The obvious impact on the U.S. and our region will be a fall in exports to the EU, which currently accounts for 15 percent of our nation’s exports.

Less obvious, but more impactful, are the financial and business ties that exist between the EU, the U.S. and the Cincinnati metro region. Two of our large employers, Procter & Gamble and GE Aviation, are well known for their European partnerships and business interests.

Hundreds of other firms in Cincinnati also are linked to the economic vitality of the EU. In addition, we hold debt from countries that are in crisis mode, or perhaps we do business with banks that hold that debt. In general, a financial crisis is a complicated event that may take years to work through.

It could have a dampening impact on our national and local recovery. An early resolution of EU’s problems will be better for all of us.

George Vredeveld is director of the Economics Center and professor, Alpaugh Family Chair in Economics at the University of Cincinnati’s Carl H. Lindner College of Business.