Is the Euro-zone headed for a break up ? (3/3) – Solutions
May 11, 2011 1 Comment
Solutions that are unlikely to work
The bailouts did not solve any of the issues of the euro-zone. The divergences in productivity, growth, current account deficits and inflation trends are still there and without tackling with them there can be no long term survival of the euro. Some solutions often touted are unlikely to solve those structural issues, either because they are politically unacceptable, or because they attempt to prevent the next crisis rather than to tackle with the problem at hand.
According to Robert Mundell’s optimum currency area theory, a successful monetary union must fit four criterion : labor mobility across the region; openness with capital mobility and wage flexibility across the region; a risk sharing system such as an automatic fiscal transfer mechanism to redistribute money to areas/sectors which have been adversely affected by the first two characteristics; and participant countries that have similar business cycles.
In the case of the Eurozone, while capital is quite mobile, labour mobility is relatively low. Moreover there is no true wage flexibility. However, the “no bail-out” clause was de facto abandoned in May 2010 – bringing Europe closer from matching those criterion.For cultural and linguistic reasons, labour mobility is not a realistic objective, therefore the main way to bring the euro-zone towards an optimum currency area is by creating true wage flexibility.
An often discussed solution is for the most endangered countries to create the equivalent of a devaluation, by decreasing real wages. It would help to restore the current accounts the indebted countries. Indeed, Germany adopted these type of policies after joining the EMU. This type of policies can work for small and export oriented countries, but is unlikely to be a success for countries like Greece, Spain or Portugal.
Indeed, in the EMU, most of the foreign trade takes place inside of the union, which means that if Portugal wants to run a current account surplus, it has to compete successfully with current account surplus countries such as Germany or Austria. The likelihood of this being successful is at best, slim.
Moreover, the social consequences are unacceptable for any democratically elected government. The social tensions would be enormous, and if several countries pursue that same policy, the effect on unemployment and therefore aggregate demand would be compounded to a point where debt-to GDP ratios could continue to rise despite the efforts of the population and their governments.
A more radical solution would be to move towards a Federalist Europe, with a central budget and the associated taxation ability. The United States of Europe are not going to happen now, because neither governments nor voters want it. Getting a large number of sovereign states to peacefully relinquish much of their sovereignty will be extremely difficult. Moreover, the time of great visions for Europe seems to be finished. Finally, it could create wrong incentives : a country with high unemployment would be less likely to make efforts to increase job market flexibility if unemployment benefits were financed federally.
Solutions to keep an eye on
A right and realistic answer would probably include the following reforms. Their combination would almost certainly avoid a break-up of the EMU. Some are being worked on
- Transparency in statistics : Greece is the proof that all EMU need independent statistical offices. Status : Not much done yet. The talks about a state backed European rating agency could lead somewhere.
- More intrusion : Again the example of Greece show that greater intrusion by supra national bodies can impose and monitor strict conditions for a bail-out. Status : Officially nothing, but unofficially, Germany is intruding.
- Near-automatic sanctions / New Stability and Growth pact : Germany is insisting on it, therefore it is happening. Governments will be required to let the Commission vet their budgetary plans in advance.on countries that break the euro’s rules, such as cancelling offenders’ voting rights, withholding EU funds or even suspending euro membership. The only weakness of this plan is that governments, being democratically elected, should not, simply accepting Brussels diktats. Status : On the way, favourable outcome probable
- Liberalising reforms by national governments : As the main conclusion of Mundell’s Optimum Currency Area analysis, Europe needs more flexible labor markets. Labor mobility is not achievable on a significant level given cultural and linguistic barriers, therefore the effort must come from labor market rules softening. Status : Not much done
- Productivity increases in peripheral countries : As explained above, this policy would on its own create a huge deflationary vortex, which means that surplus countries will need to do more to create growth, if needed by borrowing more. Status : Not much done
- Fiscal co-insurance : EMU needs a non-emergency mechanism for temporary transfers to countries that do have their public finances in order, but are hit by an external shock. This is the example of Spain, which did have balanced budgets prior to the crisis. Status : Not much done.
- The EMU needs a proper emergency financing mechanism : This can be considered achieved with the creation of the EFSF, if it becomes a permanent institution, which looks likely. Status : Almost certain
- Europe needs coherent bank regulation : The Greek crisis was actually a crisis of the European banking system – under-capitalized and over-leveraged. This ruled out the possibility of restructuring Greece’s debt load, as it would have pushed many banks towards bankruptcy, as they held quantity of Greek debt.That was made possible because European bank regulation is still characterized by a collection of national regulators. Europe needs a single bank regulator to match its single currency. Status : Not much done
- Inflation : This is probably a heretical answer to the EMU’s imbalances (especially for the Bundesbank). However, a higher inflation rate would make it easier to adjust real wages in each country, without less productive countries needing to cut nominal wages. Status : unclear. Inflation is uncreasing in the EMU, but it needs to go higher to help.
The less these solutions are applied, the more we are likely to go – slowly – towards a break-up of the EMU.
 Deja V-Euro – The History of Previous Currency Unions
 PragCap – THIS IS STILL A CURRENCY CRISIS, NOT A SOLVENCY CRISIS
 Fragile Europe of the Single Currency
 The Economist – Euro follies
 The Economist – Fixing Europe’s single currency
 Can the Euro be Saved? – Joseph E. Stiglitz
 Optimum Currency Area
 The Wall Street Journal – Europe Can’t Handle the Euro – Martin Feldstein
 The Weekly Standard – A Predictable Crisis – Martin Feldstein
 FT – Europe cannot afford to rescue Greece – Otmar Issing
 FT – Europe cannot leave Athens on its own – Tommaso Padoa-Schioppa
 FT – The euro will face bigger tests than Greece – George Soros
 PragCap – 10 REASONS NOT TO WORRY ABOUT THE EURO
 PragCap – SOROS: THE EURO IS A FLAWED CONSTRUCT
 To Euro or Not to Euro? – The EMU and Identity Politics in the European Union – Thomas Risse
 Project Syndicate – Europe’s Historic Gamble – Barry Eichengreen
 PragCap – WILL THE “EVIL SPECULATORS” WIN? I HOPE SO
 PragCap – THE INEFFICIENT MARKET IRONY BEHIND THE EURO CRISIS
 PragCap – WHY THE EURO IS DOOMED
 FT – Germans are wrong: the eurozone is good for them – Martin Wolf