The Euro patient is in the intensive ward, but the doctors cannot agree on how to help. While Eurosceptics are already preparing the funeral, Europhiles keep praising the single currency in the hope of avoiding its premature death.
Maria Joao Rodrigues has written an excellent overview of the Euro crisis showing how economists and political scientists, as well as politicians, are groping around in the dark looking for a solution. One aspect of this problem is the erroneous use of economic theories. I am not just referring to the group of chauvinistic economists in Germany who have stirred up the debate last week; their lack of economic foundations has quickly been exposed. No, there is a more profound mistake that results from applying international economic concepts to an integrated currency area. Here are three major errors, which will prevent our Euro patient from recuperating its health.
First Error: The Euro Area is a fixed exchange rate regime
It is a common mistake to reason about the euro as if the Euro Area is a fixed exchange area. It is not. The European Monetary System, which lasted from 1979 to 1993, was such a system, but in monetary union, there are no exchange rates, because everyone uses the same currency, the euro. The central bank creates money and provides domestic reserves to banks, which have unlimited access to liquidity as long as they are solvent. In international economics with different currencies, by contrast, countries can run out of foreign reserves and become illiquid. Foreign exchange is the international budget constraint. Countries must, therefore, balance current accounts or generate capital inflows in order to preserve their foreign reserves. The exchange rate is the price for foreign currency, and it adjusts to balance demand and supply in the exchange market. Within the same currency area, however, the price for domestic money is the interest rate, and money is the domestic budget constraint, which is generated by the central bank keeping money scarce.
This makes the nature of the crisis in the Euro Area fundamentally different from international exchange crises. In monetary union the first priority must be maintaining financial stability and the integrity of the banking system. The ECB was given this task by art. 127.5 of the Lisbon Treaty and it has fulfilled its role as lender of last resort to banks impeccably. However, national governments have caused a lot of damage by refusing to delegate efficient financial supervision to the European level. In many member states the cosy alliance between banking and political elites has generated excesses, which are now at the charge of the whole European Union. The populist demand for “punishing” banks and bankers for their mistakes (for example by “private sector involvement” in the Greek haircut) has let politicians off the hook and simultaneously increased financial instability.
This system cannot go on. The top benchmark for dealing with Europe’s banking crisis must be a consideration of its systemic aspects.
Second Error: The debt crisis was caused by fiscal profligacy
European authorities have spent an enormous amount of time and energy in tightening the constraints on fiscal policy, because they believe that the debt crisis was caused by “irresponsible governments” borrowing excessively. While this may have been true for the Greek Karamanlis government between 2007-9, a quick look on the data shows that European debt ratios were falling in southern Europe before the financial crisis in 2008 and only shot up when the world fell into its deepest recession since the 1920s. This is not surprising. When economic growth becomes negative, public revenue falls and governments should stimulate demand as they did in 2009. As the examples of the United States or even Japan show, financial markets do not necessarily worry about new public borrowing in such situations.
What made the situation so dramatic in Europe was the lack of proper financial integration and loss of confidence that European authorities were willing to preserve their common good, the euro. The so-called “no-bail out clause” in the Treaty (TFEU art 125), though surely well-intentioned, has proven to be disastrous, because it gave institutional backing to the idea that every member state alone was responsible for doing its “homework”. But this principle ignored the important systemic externalities which arise from decentralised budget policies in a single currency area.
When the Euro-economy was hit by the shock of the financial crisis, rational investors were quick to sell risky assets in order to preserve their own and their clients’ wealth. This caused a fall in asset prices, which then deteriorated the balance sheets of banks and companies. To restore their capital, banks reduced their liabilities, companies stopped investing and households increased their savings. It does not take a genius to see that if governments then also start to cut back, the economy will have to shrink. In the USA, Obama has done the right thing: borrow to stabilise the economy. As a consequence, the US economy has been crawling out of the crisis. Maybe with a different Congress more could have been done, but the contrast with Europe, which is falling into its second recession in two years, is striking.
However, a fundamental difference between Europe and America is the lack of financial coherence. While Obama can issue treasury bonds in a deep financial market, the 17 Euro-dwarfs believe it is useful to “discipline” member states by markets. Yet, imposing risk premia on government bonds as high as 7% (not to mention the 24 percentage points spread on Greek debt), makes public debt unsustainable and therefore increases financial instability. While the European Central Bank has provided liquidity to European banks, the Euro Area is missing a financial tool that minimises the negative spillover effects from national fiscal policy to all others. Eurobonds, or Union Bonds, as I have suggested, could accomplish this task.
Third Error: The Euro Area suffers from current account imbalances
It is often argued that even in monetary union, “foreign” debt must be repaid by current account surpluses, but this is wrong. First of all, a euro-denominated debt is not “foreign”; it is debt in our common currency. Secondly, if I owe money to my bank, I do not pay it back by paying with apples or cabbage or giving lectures on economics, but by transferring money. In a currency area, money is supplied by the banking system and if I need to pay my debt, I need to generate an income that allows me enough to save and service my debt. Hence, what is needed to make intra currency area deficits sustainable is economic growth in the local economy to service local debt and not lower net imports.
One consequence from failing to realize that monetary union is not a fixed exchange rate area is the new obsession with current account imbalances. New policy instruments to correct macroeconomic imbalances have been created recently. While it is a good idea to reduce social imbalances in Europe, the focus on current accounts of member states is actually making the crisis worse, because it imposes severe austerity policies on southern member states.
To see why reducing current account deficits will impose austerity, we can use the well-known national accounts identity:
(2) Y = C + I + G + X – M
where national income (Y) can be expressed as the sum of consumption (C), investment (I) and spending by government (G) plus the difference between exports (X) and imports (M). National income also equals total consumption plus savings (S) plus taxes (T) paid to the government, so that the identity linking private and public savings takes the form:
(T – G) + (S – I) = X – M
In other words, if an open economy wishes to reduce a current account deficit or even generate a surplus, the public sector must consolidate and the private sector must increase savings or reduce investment. Hence, policies focusing on reducing current account deficits in the Euro Area will lead to country-specific austerity policies. The European Commission (2012: 36) is surprisingly lucid about the consequences of the policy it prescribes: “In general, rebalancing processes featuring strong deleveraging in the private sector and fiscal consolidation weigh on growth. Since economic agents are forced to increase savings and cut investment, domestic demand in deficit countries is constrained and thus limits output expansion.”
These three errors taken together are highly likely to kill the Euro patient off. We may not want to see this happen. We may praise European integration and its wonderful new tools but if we continue this line of thought, we may soon come to bury the euro.
This column is part of the Eurozone Scenarios Project of the Friedrich-Ebert-Stiftung and Social Europe Journal. The long version of the scenarios paper can be downloaded here. A Statistical Annex is also available.