Missing The Forest For The Trees: Cyprus Edition

Includes: FXE
by: David Beckworth

The Cyprus bank heist has received a lot of coverage, but in most cases the analysis is missing the forest for the trees. The real problem facing Cyprus and the rest of the eurozone periphery is more fundamental than who will be bailed out, who will be bailed in, and how it will happen. For these concerns are the result of a flawed monetary union -- a currency area that does not meet the optimum currency area criteria -- that if not fixed will continue to haunt the eurozone. Figuring out how to deal with Cyprus without addressing the flawed nature of the eurozone is just kicking the can the down road. More radical reforms are needed.

One reform is to alter ECB policy so that it actually tries to stabilize nominal spending for the entire eurozone, not just Germany. Since it inception, ECB monetary policy has been biased toward Germany at the cost of destabilizing the eurozone periphery. This could be fixed by having the ECB abandoned its flexible inflation target and adopt a NGDP level target. Another complementary reform would be to create meaningful fiscal transfers in the eurozone similar in scale and scope to the United States. Both of these options, however, would face stiff opposition from Germany. For the former would require temporarily higher inflation than Germany desires and the latter would require large fiscal commitments for the eurozone from Germany. Neither is likely to happen.

That leaves the final reform option: break up the eurozone into austere and non-austere currency unions. This ideas has been suggested before by Ramesh Ponnuru and Ambrose Evans-Pritchard. Here is Pritchard:

My solution - like that of Hans-Olaf Henkel, the ex-head of Germany's industry federation (BDI) - is to split EMU into two blocs, with France leading a Latin Union that keeps the euro. This bloc would devalue but not by 60pc, yet uphold its euro debts intact. The risk of default and banking crises would decrease, not increase.

The German bloc could launch their Thaler, recapitalizing banks to cover losses from rump euro debt. Disruptions could be contained by capital controls at first. None of this is beyond the wit of man. My bet is that aggregate losses would be lower than the status quo, and the long term outcome much healthier. The EU might even carry on, unruffled.

This reform is very radical, but there really is no other viable alternative. The German response over this crisis has given us no reason to believe the other options of improving the existing eurozone monetary and fiscal structures will ever happen. So why keep pretending otherwise? The current eurozone approach is the equivalent of an economic whack-a-mole game that never truly solves the problem. The Cyprus crisis is just the latest mole to stick up its head.

Fortunately, Matthew C. Klein reports that there already is some movement in Germany to create two new currency blocks. This is a start. But there is a long way to go and there needs to be a greater sense of urgency. Who knows how long the whack-a-mole game can continue before it turns ugly. Martin Feldstein warned in 1997 that the EMU could lead to conflict. I hope he is wrong.

P.S. Matthew Yglesias is one observer that does consider the larger eurozone context behind the Cyprus crisis.

P.P.S. Just how big are fiscal transfers in the United States? Here is one data point from Paul Krugman:

[I]f Florida suffers an asymmetric adverse shock, it will receive an automatic compensating transfer from the rest of the country: it pays less into the national budget, but this has no impact on the benefits it receives, and may even increase its benefits if they come from programs like unemployment benefits, food stamps, and Medicaid that expand in the face of economic distress.

How big is this automatic transfer? Table 2 (in the Krugman story linked to above) shows some indicative numbers about Florida’s financial relations with Washington in 2007, the year before the crisis, and 2010, in the depths of crisis. Florida’s tax payments to DC fell some $33 billion; meanwhile, special federally funded unemployment insurance programs contributed some $3 billion, food stamp payments rose almost $4 billion. That’s about $40 billion in de facto transfers, some 5 percent of Florida’s GDP – and that’s surely an understatement, since there were also crisis-related increases in Medicaid and even Social Security, as more people took early retirement or applied for disability payments.

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