In the comment section on our bleak view of Italy's debt dynamics, which we argued are to a considerable extent a function of being a member of the eurozone, someone asked us for a follow up article explaining what needs to be done to safeguard the euro and bring back prosperity to this much plagued zone.
Some might argue that the euro has already been saved, and they could be right. But as we argued in our previous article, we think there are still big dangers, most notably:
- The low (or even negative) nominal growth wrecking havoc on debt dynamics (not to mention producing high unemployment and misery)
- The risk of Japanese style deflation setting in, worsening the first problem considerably
- The tortuous improvement in the periphery's competitiveness versus the core due to the low inflation environment
- The one-size-fits-nobody interest rates and monetary conditions
Is the euro worth saving?
Before we start arguing what needs to be done, a first question is whether the euro is actually worth saving, as we're not at all convinced of that. In fact, we think that if an orderly disbandment of the euro could be engineered, it would already have happened.
After all, we argued that the eurozone exerts a similar deflationary pressure like the gold standard did in the 1930s, and as economic historian Barry Eichengreen has shown, countries recovered sooner, the sooner they left the gold standard. Alas, it isn't so easy to leave the eurozone.
There were several arguments put forward in favor of embarking on the single currency, or monetary union:
- Currency crisis and devaluations in the weekend would be a thing of thing of the past
- Having a single currency removes transaction cost and exchange rate risk, and improves price transparency. In short, it's the natural conclusion of the Single Market process
- It will allow countries (the 'periphery') to import German style monetary credibility, ending a cycle of high inflation, inevitably followed by devaluations
- By improving the monetary credibility of the periphery, it would produce a process of convergence in which the periphery's economic conditions would improve faster than those of the core.
Of course, against that was the loss of two important instruments of adjustment, the ability to devalue and the ability to set one's own monetary conditions. This argument boils down to the question whether the eurozone is a so called 'optimum currency area,' we will briefly discuss that below.
What really happened
The euro was lost in the first decade as the periphery allowed inflationary differentials to accumulate, eroding their competitiveness that is very hard to regain without a currency to devalue. This development was largely a result of the euro itself.
The increased 'German' credibility led to a fall in risk premiums in the periphery and an inflow of capital, but these countries didn't have that much chance to fight this, as they were no longer the master of their own monetary affairs.
Here was the first manifest disadvantage of the euro, a one-size-fits-nobody interest rate that was too low for the periphery. The resulting boom was taken as healthy convergence, so it created a false sense of security and no policy measures were really applied to combat the slow erosion of competitiveness.
Of course, the capital inflows suddenly stopped, and then reversed when the financial crisis hit but the loss of competitiveness, produced by a decade of accumulating inflation differentials, remained and is very hard to deal with without one's own currency.
Is the eurozone an optimal currency area?
The optimists argued that convergence would reduce the likelihood of having to need the lost adjustment mechanisms (the loss of exchange and interest rate instruments). You need these mechanisms to deal with so called asymmetrical shocks.
Asymmetrical shocks are economic shocks that impact the members of a currency union in an asymmetrical way and thereby triggering the need for some kind of adjustment. If one member country is experiencing a boom and another is in recession, the booming country needs deflation (higher interest rates, currency appreciation), whilst the recession country needs the opposite (reflation).
The optimists believed that convergence would make the incidence of these shocks less frequent, and alternative adjustment mechanisms more powerful. They're probably wrong on both counts, but especially on the first.
The bigger, more unified market that was forged is also likely to increase regional specialization (through so called economics of agglomeration). One can see this comparing the eurozone with the US, which has been a unified market for much longer.
Increased regional specialization would also increase the likelihood of asymmetrical shocks, and with countries robbed of their interest rate and exchange rate instruments, adjustment to these shocks became a different proposition altogether, as we're experiencing today.
What's more, monetary union itself has increased the incidence of asymmetrical shocks through its one-size-fits nobody monetary policy we've already explained above. This still holds today, where Germany, worried about inflation because of a boom and rising house prices, needs higher interest rates than the periphery, much of which is in deep recession still and on the brink of deflation.
One could even wonder whether countries with such different traditions and philosophies, leading to different policy priorities, should ever have tried to embark on something as bold as a common currency.
Countries that gave up the interest rate and exchange rate instrument in order to join the monetary union do have some alternative adjustment mechanisms to deal with asymmetrical shocks:
- A common budget
- Discretionary transfers
- Labor mobility
- Wage and price flexibility
Unlike the US, the eurozone doesn't have a big central budget which automatically redistributes funds from booming to busting parts (the booming parts pay proportionally more in taxes and get less in transfer payments, vice versa for the busting parts). This automatically smoothes out economic performance.
This lack of a central budget can be overcome by discretionary transfers, and to some extent, this has been happening through the bailouts. But, as Merkel doesn't tire to remind her electorate, these bailouts aren't gifts, they are loans, to be repaid with interest.
And there is of course a reason why Merkel reminds her electorate of that fact, these bailouts aren't exactly popular with the voters, so how big a role they can play remains very much to be seen.
In the US, when states experience economic troubles, many people move to states where employment opportunities are better. Such labor mobility is a lot lower in the eurozone, hindered by different languages, cultures and regulatory obstacles (recognition of diploma's, portability of pensions, etc.).
As we're experiencing today, price flexibility isn't sufficient as an adjustment mechanism. While there have been significant wage cuts in many sectors in the periphery, this has mostly been in the public sector and has only dented their accumulated competitiveness disadvantage.
We conclude that none of these adjustment mechanisms offer a real alternative to interest and exchange rates.
So, is the euro worth saving?
Our opinion is that the disadvantages far outweigh the advantages. The latter are supposed to come from a bigger, more unified market, and more price transparency, therefore fiercer competition and less transaction cost and currency uncertainty. But these effects have been really rather modest.
Research has shown that the quantity of trade and investment flows are actually surprisingly little affected by currency fluctuations, and if anyone can point out a study which shows some measurable effect that increased price transparency has had on competition and hence growth, we would be thankful.
The Teutonic discipline on the periphery turned out to be way too lose before the financial crisis, and way too tight after, and there can be little doubt these countries would be way better off if they would be able to determine their own monetary conditions.
Instead of the arduous path of internal devaluation, they could simply restore competitiveness at the stroke of a devaluation, and embark on monetary stimulus to revive their deeply depressed economies. The ensuing growth (and mild inflation) would also greatly alleviate their public finances, as we showed in our previous article.
What needs to be done
- Lender of last resort
- Share the burden of adjustment
- Restore growth
- Full monetary union
Lender of last resort
This is an absolutely crucial condition. As Paul de Grauwe has shown, without the ECB acting as a lender of last resort, peripheral bond markets are prone to self-fulfilling and self-reinforcing bad equilibriums. When debt dynamics worsen investors flee. In a country with its own currency and central bank:
- There is a backstop, the debt is denominated in its own currency which its central bank can print, the country cannot really go bankrupt
- Money fleeing the country are selling the currency, leading to a devaluation which gives an economic boost, and the buyers of the currency will invest in the countries assets, so the money never really leaves the country.
None of this holds for a country which debt isn't denominated in its own currency. There is no backstop from its central bank, and the money can actually leave the country. Investors could simply sell Greek or Italian debt and use the proceeds to buy German debt. There is no boost from devaluation either.
This situation can lead, and has lead to self-fulfilling panic on the peripheral bond markets which at various times threatened to let bond yields spiral out of control and thereby making public finances untenable. This was only stopped when the ECB announced it was going to "do whatever it takes" to stop these self-fulfilling panics.
That is, it promised unlimited intervention in the bond markets, and that immediately calmed them. Now, the exact mechanism is the so called OMT ("outright monetary transactions") and these are conditional on the country signing up to some stringent policy prescriptions.
This conditionality is to beat the moral hazard problem that exist within a currency union, where countries can export much of the ill effects of bad public finances onto the rest of the member states. If a big country like Italy would go bankrupt, the spill-over effects for the other member countries would be dramatic, hence it could play poker with the ECB on the assumption that the latter would blink first.
But, the OMT has never been tested in practice. Would the Italians sign up (and execute) to the stringent policy conditionality? Would the Germans countenance unlimited bond buying by the ECB? We surely hope so, the alternative for both is probably worse, but we really don't know. Politics has a habit of creating its own dynamic.
Sharing the burden of adjustment
At present, the burden of regaining the lost competitiveness, largely the result of the membership of the euro creating an influx of capital in the first decade falls on the periphery itself. Since they can't devalue, they have to regain competitiveness by 'internal devaluation,' that is, growing wages and prices at a slower pace than the core countries.
But there are considerable problems with this:
- When inflation in the core countries is very low, the periphery has to limbo under a terribly low bar, risking to set of deflation
- The deflationary policies cut growth and inflation (the latter, of course, is the aim) but the resulting stagnation in nominal growth greatly worsens the public debt dynamics, basically a catch-22 situation
- It's an empirical fact that cutting nominal wage growth below zero is very difficult to achieve.
In short, the deflationary policies in the periphery greatly worsens their public finances and create a deflationary bias in the entire currency union. This could be considerably eased if there was some mild reflation in the core.
That would achieve two things:
- It would create higher growth in the whole eurozone, thereby lift some of the gloom
- Higher inflation in the core would make it a lot easier for the periphery to regain competitiveness and mitigate the need for the sharply deflationary policy in the periphery.
While helpful in theory, we don't expect the Germans, Dutch, Finish, etc. to embark on reflationary policies, even mild ones, anytime soon, despite some of these countries having absolutely massive trade surpluses (Germany's trade surplus is 7% of its GDP).
Just about everybody would agree that growth would be the magic elixer which would greatly reduce the problems in the eurozone but consensus about how to achieve this growth is non-existent. Here are some options:
- Reflation in the core countries.
- Structural reforms in the periphery
- Less emphasis on austerity
- A monetary blitz by the ECB
- European wide initiatives
The first we've already discussed. Some progress on structural reforms has been made (especially in Greece) and its necessary to continue down this road, but it's no miracle cure, especially in the short-term. We do think the policy mix has been wrong though, with too much emphasis on austerity and too little on structural reforms.
Austerity has been largely self-defeating when multipliers turned out to be much larger (up to three times) as previously thought, and much political capital has been wasted on this, making embarking on structural reforms more complex.
The big thing missing from the eurozone is some kind of monetary blitz from the ECB, akin to what the other big central banks (Fed, BoJ, BoE) have done.
Market monetarists are calling the latter a big success, keeping US and UK afloat during considerable fiscal drag, and turning Japan around. We're not quite convinced of that yet, but apart from the LTRO, the ECB hasn't embarked on anything comparable.
And there is a good case to be made for lat least trying. The depression in much of the periphery is so severe that the risk of setting of inflation is virtually non-existent, although things are considerably less clear cut for Germany.
Which is, of course, where policy runs up against the one-size-fits-nobody constraint yet again, although as we argued above, for the eurozone as a whole, a bit higher German inflation would actually be a blessing. But try convincing the Germans of that..
While the EU has embarked upon the so called Compact for Growth and Jobs, we're reading the progress report one year after, and it leaves much to be desired. But even implemented in full, it will certainly be helpful but not create miracles. We're considering writing a separate article about this which can tackle this in a bit more detail.
Full monetary union
In essence, the eurozone is what Alan Walters (advisor to Margaret Thatcher) would call a half-baked system, there are some notable elements missing:
- A political union, that is, either a large centralized budget (government) or strict rules to enforce budgetary discipline to minimize free rider problems.
- The issuance of common debt
Together this would go a long way in safeguarding the euro, but the first is necessary for the second, but this isn't likely to happen as it's too much of an encroachment on national sovereignty. We have rules, by the way, but these are still not written in stone, subject to interpretation and wavers.
One should also realize that having rules written in stone, like a 3% deficit rule, could easily rob countries of yet another adjustment mechanism, that of countercyclical fiscal policy and force them instead onto pro-cyclical policies that have a tendency to worsen any adverse shock.
And while these steps are probably a bridge too far for politicians to embrace, they would still not eliminate the one-size-fits-nobody monetary policy of the ECB. There would still be the possibility of asymmetrical shocks, and the insufficiency of alternative adjustment mechanism in the absence of national monetary and exchange rate policies.
After the "do whatever it takes" policy change from the ECB, discussions about alternative measures has died down. We have previously written about things like:
- The Redemption Pact
- Blue bonds (the Delpla plan)
- Giving the ESM a bank status
- Some more creative solutions (and here)
You see, no lack of creativity, but most of these plans are superseded by the ECB as lender of last resort, as they were designed to avoid the acute bond market crisis we used to have before the ECB stepped up to this role.
We're fairly sure that the disadvantages of the euro far outweigh the advantages. The main reason for continuing with the euro seems to be that the alternative, disbanding it, is fraught with immeasurable risk and difficulties.
That is, we have to find a way to make the euro work. Achieving full monetary union seems politically unachievable, apart from the fact that even then we're still stuck with a one-size-fits-nobody monetary policy and the possibility of asymmetrical shocks, with few adjustment mechanisms to deal with these.
So we have to find a way to make the present situation more viable. It is difficult to escape the conclusion that this warrants at least some shifting of the burden of adjustment onto the core countries, those who have benefited enormously and running record trade surpluses.
Without at least a little inflation in the core, the periphery will not recover much of the lost competitiveness anytime soon and will face real economic hardship for quite some time to come, hardship that leads to a low growth, low inflation equilibrium that keeps on increasing the public debt/GDP ratio, until investors start to alarm and the hand of the ECB is called.
The other obvious thing that could happen is for the ECB to embark on a monetary blitz, like the BoJ. This might even become unavoidable if there is another negative economic shock and much of the eurozone sinks into Japanese style deflation.
All of these measures will cause deep unease, if not downright hostility in much of the German establishment and electorate, so we're not counting on any of it to materialize anytime soon. Events might have to force hands here.
The bitter conclusion has to be that rather than spread prosperity, the euro has done quite the contrary. The euro is only worth saving because it's terribly complex to dismantle it, and ways to ameliorate at least some of its shortcomings seem to be politically unachievable.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.