A European Perspective on the Future of the Euro Area

A few weeks ago I wrote on this same blog that the main economic problem facing Europe was Immigration.  However, I do not want to leave the readers with the impression that the current financial crisis is any less important and critical. Thus, I will now focus on that other problem, as if the first problem was not enough.  To start, note that the euro area GDP is 3 percent lower than it was in early 2008; its average unemployment rate is above 12 % – 16 percent in Portugal, 17 percent in Cyprus, and 27 percent in Spain and Greece.

What are the problems?

1. There are too many countries – 18 euro member states – that are too diverse.
2. The monetary policy of the ECB is too restrictive, i.e. it is too concerned about inflation when there is deflation.
3. Labor mobility in Europe is limited as unemployed Europeans are reluctant to move to faster growing countries.
4. There are no fiscal transfers from a fast growing region to a depressed region.  This tends to exacerbate recessions as the national authorities are forced to follow pro-cyclical (austerity) policies causing economic growth to fall further and thus their budget deficits and public debts to continue increasing.

Example #1: When Ireland joined the monetary union in 1999, it was forced to lower its interest rate from 6.75% to 3.5% while it was experiencing a housing boom; interestingly, the lower interest rates were beneficial to Germany whose economy at the time was not growing as fast as Ireland.  Thus, the Irish boom was further stimulated by the one-size-fits all monetary policy that was more appropriate for Germany than for Ireland.

Example #2: Prior to its economic collapse, Greece was experiencing massive capital inflows from the Northern core European countries, including Germany.  This was so because investors were looking for higher returns in Greece than in their own countries while the exchange rate risk was eliminated by the creation of the euro.  Those capital inflows caused wages and prices to increase in Greece at a much faster rate than in Germany making Greek goods uncompetitive in world markets.  The result was a large current account deficit financed by German and other European investors.  When these capital inflows stopped or were reversed following the bursting of the housing bubble, Greek borrowers, including banks and government, were unable to service their debt.  This led to the collapse of the economy and the further increase in the government debt.

What needs to be done to save the euro?

In the short run, a more expansionary monetary policy by the ECB and less austerity would help.  The 1929 Great Depression should have taught us that the combination of austerity and internal devaluation (lower wages and prices) when the economy is depressed lengthens the depression and encourages the rise of populism and even fascism (Golden Dawn party in Greece).  Deflation is dangerous as it increases the real value of all debts, raises the real interest rate and pushes consumers to postpone their consumption in order to benefit from lower future prices.  Moreover, when interest rates are low like today (stuck at the so called “zero-lower bound”), some recent IMF studies have shown that reduction in spending causes larger than proportional reduction in economic growth as the fiscal multipliers tend to be larger than when the interest rates are higher.

In the intermediate run[1], the euro area needs a banking union.  In Europe, banks tend to be larger than their national governments.  It is the case because financial integration resulted in banks merging across borders and becoming very large relative to governments.  This is clearly not the case in the U.S. where no large bank is larger than the U.S. government.  Thus no European government is able to bail out a large bank under its jurisdiction and is thus unable to prevent a bank run from spreading to all banks including solvent ones.  This is a problem that can be resolved only by reaching beyond each nation in a way that has never been tried before.  Thus a proper banking union would require a single banking supervisor for the entire euro area, a single resolution mechanism with a euro-wide source of funding for insolvent banks, and a single deposit insurance mechanism for the whole euro area.

To complement the banking union, some elements of a fiscal union (as in the U.S.) would have to be instituted to stabilize the economy.  Thus, a euro area-wide unemployment insurance system would be a step in the right direction.  These initiatives should be financed by issuing some safe euro area bonds guaranteed by all governments; these bonds could be held by banks, thereby breaking the link between the governments and the national banks so that governments would not experience an increase in their debts when a bank failed and vice versa.

The policies mentioned above clearly imply that for the euro to survive there must be more Europe not less Europe.  However, if policymakers at the helm of Europe continue being as incompetent as they have been so far (mishandling the Cyprus crisis, raising interest rates in 2011, demanding more austerity, and calling for ill-timed “structural” reforms, while keeping large number of workers involuntarily unemployed), then the only solution is less Europe and the return to a European Union without a common currency.

Pierre Canac, Ph.D.
Associate Professor of Economics

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