The predicament of the Eurozone is financial, economic, and political. The political element I need only sketch out here. It is now – at long last – widely understood in Europe that an effective monetary union requires a fiscal and political union. The current arrangements for the euro represent a half-way house – monetary union light. The task, however, of forging a fiscal and political union between 17 very different countries is horrendously difficult.
Some sort of fiscal and political union is feasible. Yet does it make sense for Germany to be in such a union with Greece, Spain, and Italy? I seriously doubt it. What’s more, the electorates of these countries – and Germany – seem to share my doubts.
It would have been as well to have sorted all this out before embarking on the euro. Instead, Europe’s leaders bungled it. They are now left to scrabble around, in the midst of a crisis, to put together such a union, against the clock, while the financial markets, operating on shorter time horizons, take a view on whether the whole enterprise will hold together. The upshot is that the establishment of the euro, although a technical and political triumph, has proved to be a disaster.
Thus, the political element plays an important role in the financial and economic elements of the crisis. The financial element centres on debt. Several countries have public debt burdens which are unsustainable. In some cases, private debt is also overwhelming. Meanwhile, excessive debt in the public and/or private sectors threatens the stability of the banking system.
The economic problem is that whereas monetary union was supposed to bring convergence, in several members, costs and prices continued to rise rapidly relative to other members of the union, thereby causing a loss of competitiveness. This resulted in large current account deficits and the build-up of substantial net international indebtedness.
As a result of these financial and competitiveness problems, several members of the Eurozone suffer from a chronic shortage of aggregate demand, which results in high levels of unemployment. This worsens the debt position, thereby weakening the position of the banks. Meanwhile, other countries enjoy current account surpluses, often accompanied by more favourable debt positions in both the public and private sectors, partly as a direct result of the weaker members’ loss of competitiveness.
Clearly, the financial and economic aspects of the crisis are closely intertwined. Full adjustment and the establishment of stability require that both these problems be addressed.
Nominal and real flexibility
It is possible to lower the real exchange rate through either nominal exchange rate depreciation or domestic deflation. Indeed, if nominal prices and wages were perfectly flexible downwards, these two methods would be equally effective. But, of course, they are not.
If the troubled peripheral economies of the Eurozone were able to deploy successfully currency depreciation as an adjustment mechanism then they would not only improve their own GDP outlook but would also help to allay concerns about the long-term sustainability of their debt situation and, in the process, perhaps bolster the long-term stability of the ‘core’ countries as well.
Nevertheless, devaluation comes with clear downsides and dangers. History is littered with examples of devaluations that have failed or even brought chaos — such as those in Argentina (1955, 1959, 1962, and 1970), Brazil (1967), Israel (1971), and numerous others, as well as those that have brought a form of solution, for example Argentina in 2002, the UK in 1931, and again in 1992.
Equally, though, it is otiose to compare the difficulties that would face a country that leaves the Eurozone with an assumed sylvan path if it stays in. For all the peripheral countries, continued euro membership seems bound to bring continued economic hardship, accompanied by a significant risk, or in some cases the inevitability, of default. It is therefore a choice between evils.
The austerity solution
The attempt to work down the debt burden and regain competitiveness through austerity – that is, the reduction of aggregate demand through public expenditure cuts and/or tax rises – is fraught with difficulty. It reduces demand both at home and abroad. Countries pursuing this policy risk finding that they are pedalling ever harder to remain in more or less the same place, that is to say, although GDP may be lower, the public sector deficit may not shrink.
Of course, austerity may bring increased competitiveness through the process of internal deflation, that is to say, falling wages and prices. There are recent examples of countries — for example Singapore, Latvia, and Ireland — successfully cutting wages and prices.
This evidence, however, does not make a strong case that deflation would work well in the Eurozone. Indeed, Ireland has recently slipped back into recession, its debt problems are intensifying and its ratio of government deficit to GDP is still about 10%.
In addition, even if price deflation were relatively rapid and could occur without a substantial slump in real output, it would still suffer from a significant drawback: It raises the real value of debt and thereby worsens the financial problem, which both intensifies downward pressure on aggregate demand and exacerbates the fragility of the banking system. Furthermore, because there is a lower bound to nominal interest rates, deflation raises real rates. So the objective of improving competitiveness through deflation is at odds with the objective of reducing the debt burden and reviving the economy.
Productivity growth
“Reform” and attempts to raise productivity do not offer a viable way out, desirable though they are for other reasons. For a start, raising productivity growth is notoriously difficult. If a government were to succeed in raising it by 0.5% per annum, that would count as a miracle. Yet at 0.5% per annum, it would take decades for the benefits of reform to counter a competitiveness gap of 30-40%. Moreover, without some offsetting monetary change, for any given rate of growth of wages, faster productivity growth would work by bringing about weaker growth of prices. This would therefore run into all the problems of deflation discussed above.
Interestingly, Germany’s success in the competitiveness stakes has not been won by securing particularly rapid increases in productivity. Indeed, its productivity growth has been average – and lower than Greece. Of the peripheral countries, only Italy has had poor productivity performance. The peripherals’ weak spot (and the source of Germany’s strength) has been not productivity growth but wage growth.
This lays bare the importance of monetary and price phenomena in a monetary union. It is not that exchange rate changes can wave a magic wand over a country’s real deficiencies, it is rather that, when nominal values have gotten seriously out of line with the fundamentals, the scale of the adjustment is utterly beyond what any real improvements can plausibly achieve. Nominal disequilibrium requires a nominal solution. That is what a break-up of the euro would make possible.
Clearly, if peripheral countries left the euro and their currencies depreciated, the northern “core” countries, led by Germany, would suffer a loss of competitiveness and their net exports would fall, leading to weaker GDP and higher unemployment. The textbook response to this would be to take measures to expand domestic demand – consumption, investment, and government spending. This, too, would be a gain. At present the economies of the north, especially Germany, are lopsided, with weak growth of consumption and excessive reliance on net exports to generate demand. This closely mirrors the situation in China – another severely unbalanced economy. It is about time that German consumers had their day in the sun. That, amongst other things, is what a euro break-up would deliver.
Roger Bootle is Managing Director of the London-based consultancy, Capital Economics. This article is an adapted version of part of his Wolfson Prize winning essay.