Spoiler alert: we conclude that anything could go, and that claiming otherwise is not very serious.
What do we know about the end of monetary unions?
The European elections were marked by low turnouts and increasing support for Eurosceptic parties. These two elements reflect a wave of mistrust vis-à-vis European institutions, which can also be seen in confidence surveys and in the increasingly loud debate about a return to national currencies. The controversy over a country leaving the euro zone or even the breakup of the monetary union itself started with the Greek crisis in 2010. It then grew more strident as the euro zone sank into crisis. The issue of leaving the euro is no longer taboo. If the creation of the euro was unprecedented in monetary history, its collapse would be none the less so. Indeed, an analysis of historical precedents in this field shows that they cannot serve as a point of comparison for the euro zone.
Although there seem to be a number of cases where monetary unions split apart, few are comparable to the European Monetary Union. Between 1865 and 1927, the Latin Monetary Union laid the foundations for closer monetary cooperation among its member states. This monetary arrangement involved a gold standard regime that established a principle of monetary uniformity with a guarantee that the currencies set up by each member state could move freely within the area. Given the absence of a single currency created ex nihilo as is the case today with the euro, the dissolution of the Union that occurred in 1927 holds little interest for the current debate. In fact, experts in monetary unions instead characterise this type of experience as “areas of common standards”. A study in 2007 by Andrew Rose (see here) assesses 69 cases of exits from a currency union since the Second World War, which would indicate that there is nothing unique about the break-up of the euro zone. However, this sample of countries that have left a currency union cannot really be used to draw meaningful lessons. A large number of these cases involve countries that gained their political independence in the process of decolonization. These were also small developing economies whose macroeconomic and financial situations are very different from those of France or Greece in 2014. The most recent experience was the break-up of the rouble zone, following the collapse of the USSR, and of Yugoslavia, both of which involved economies that were not very open commercially or financially to the rest of the world. In these circumstances, the impact on a country’s competitiveness or financial stability of a return to the national currency and any subsequent exchange rate adjustments are not commensurate with what would happen in the case of a return to the franc, the peseta or the lira. The relatively untroubled separation of the Czech Republic and Slovakia in 1993 also involved economies that were not very open. Finally, the experience most like that of the EMU undoubtedly involves the Austro-Hungarian Union, which lasted from 1867 to 1918. It had a common central bank in charge of monetary control but no fiscal union , with each State enjoying full budgetary prerogatives except with regard to expenditure on defence and foreign policy. It should be added that this Union as such could not go into debt, as the common budget had to be balanced. While the Union established trade and financial relations with many other countries, it is important to note that its break-up occurred in the very specific context of the First World War. It was thus on the ruins of the Austro-Hungarian Empire that new nations and new currencies were formed.
It must therefore be concluded that monetary history does not tell us much about what happens at the end of a monetary union. Given this, attempts to evaluate a scenario involving an exit from the euro are subject to a level of uncertainty that we would call “radical”. While it might be possible to identify certain positive or negative results of exiting the euro, going beyond this to give specific calculations of the costs and benefits of a break-up comes closer to writing fiction than to robust scientific analysis. As for the positive side, it can always be argued that the effects on competitiveness of a devaluation can be quantified. Eric Heyer and Bruno Ducoudré have performed such an exercise for a possible fall in the euro. But who can say how much the franc would depreciate in the case of an exit from the euro zone? How would other countries react if France left the euro zone? Would Spain leave too? In which case, how much would the peseta fall in value? The number of these variables and their potential interactions lead to such a multiplicity of scenarios that no good faith economist can foresee, let alone calculate. The exchange rates between the new European currencies would once again be determined by the markets. This could result in a panic comparable to the currency crisis experienced by the countries in the European Monetary System (EMS) in 1992.
And what about the debt of the private and public agents of the country (or countries) pulling out? The legal experts are divided about what share would be converted by force of law into the new currency (or currencies) and what would remain denominated in euros, which would add to agents’ debt burden. So it is likely that an exit would be followed by a proliferation of litigation, with unpredictable outcomes. After the Mexican crisis in 1994, and again during the Asian crisis in 1998, both of which were followed by devaluations, there was an increase in agents’ debt, including government debt. Devaluation could therefore increase the problems facing the public finances while also creating difficulties for the banking system, as a significant share of the debt of private agents is held abroad (see Anne-Laure Delatte). The risk of numerous private defaults could therefore be added to the risk of default on the public debt. How would one measure the magnitude of such impacts? Or the increase in the default rate? What about the risk that all or part of the banking system might collapse? How would depositors respond to a bank panic? What if they seek to prop up the value of their assets by keeping deposits in euros and opening accounts in countries that they consider safer? A wave of runs on deposits would follow, threatening the very stability of the banking system. It might be argued that, upon regaining autonomy for our monetary policy, the central bank would implement an ultra-expansionary policy, the State would gain some financial leeway, put an end to austerity and protect the banking system and French industry, and capital controls would be re-established in order to avoid a bank run … But once again, predicting how such a complex process would unfold amounts to astrology … And if the example of Argentina  in late 2001 is cited to argue that it is possible to recover from a currency crisis, the context in which the end of the “currency board” took place there should not be forgotten: a deep financial, social and political crisis that does not really have a point of comparison, except perhaps Greece.
In these circumstances, we believe that attempting to assess the cost and benefits of leaving the euro leads to a sterile debate. The only question worth asking concerns the political and economic European project. The creation of the euro was a political choice – as would be its end. We must break with a sclerotic vision of a European debate that opposes proponents of leaving the euro to those who endlessly tout the success of European integration. There are many avenues open for reform, as has been demonstrated by some recent initiatives (Manifesto for a euro political union) as well as by the contributions collected in issue 134 of the Revue de l’OFCE entitled “Réformer l’Europe”. It is urgent that all European institutions (the new European Commission, the European Council, the European Parliament, but also the Eurogroup) take up these questions and rekindle the debate about the European project.
 For a more detailed analysis of comparisons that can be drawn between the European Monetary Union and Austro-Hungary, see Christophe Blot and Fabien Labondance (2013): “Réformer la zone euro: un retour d’expériences”, Revue du Marché Commun et de l’Union européenne, no. 566.
 See Jérôme Sgard (2002): “L’Argentine un an après: de la crise monétaire à la crise financière”, Lettre du Cepii, no. 218.
Eurostat just released its flash estimate for inflation in the Eurozone: 0.5% headline, and 0.8% core. We now await comments from ECB officials, ahead of next Thursday’s meeting, saying that everything is under control.
Just this morning, Wolfgang Münchau in the Financial Times rightly said that EU central bankers should talk less and act more. Münchau also argues that quantitative easing is the only option. A bold one, I would add in light of todays’
deflation inflation data. Just a few months ago, in September 2013, Bruegel estimated the ECB interest rate to be broadly in line with Eurozone average macroeconomic conditions (though, interestingly, they also highlighted that it was unfit to most countries taken individually).
In just a few months, things changed drastically. While unemployment remained more or less constant since last July, inflation kept decelerating until today’s very worrisome levels. I very quickly extended the Bruegel exercise to encompass the latest data (they stopped at July 2013). I computed the target rate as they do as
(if you don’t like the choice of parameters, go ask the Bruegel guys. I have no problem with these). The computation gives the following:
Using headline inflation, as the ECB often claims to be doing, would of course give even lower target rates. As official data on unemployment stop at January 2014, the two last points are computed with alternative hypotheses of unemployment: either at its January rate (12.6%) or at the average 2013 rate (12%). But these are just details…
So, in addition to being unfit for individual countries, the ECB stance is now unfit to the Eurozone as a whole. And of course, a negative target rate can only mean, as Münchau forcefully argues, that the ECB needs to get its act together and put together a credible and significant quantitative easing program.
Two more remarks:
- A minor one (back of the envelope) remark is that given a core inflation level of 0.8%, the current ECB rate of 0.25%, is compatible with an unemployment gap of 1.95%. Meaning that the current ECB rate would be appropriate if natural/structural unemployment was 10.65% (for the calculation above I took the value of 9.1% from the OECD), or if current unemployment was 11.5%.
- The second, somewhat related but more important to my sense, is that it is hard to accept as “natural” an unemployment rate of 9-10%. If the target unemployment rate were at 6-7%, everything we read and discuss on the ECB excessively restrictive stance would be significantly more appropriate. And if the problem is too low potential growth, well then let’s find a way to increase it…
Last week the Commission published its second flash estimates for 2013 GDP growth. This allows to update an earlier exercise I had made on forecast errors by the Commission (around this time last year). This is what I had noticed at the time:
The Commission tends to be overly optimistic, and forecasts turn out to be in general higher than actual values. It should not be like this. While I expect a government to inflate a bit the figures, a non-partisan, technocratic body should on average be correct.
Related, it is also surprising that in November of the same year the Commission is still consistently overoptimistic (yellow bar). Let me restate it. This means that in November 2012 the Commission made a mistake on GDP growth for 2012. November!
I had concluded that there was a likely political bias in the Commission’s forecasts, with excessive optimism used to deflect criticisms of austerity. I also ventured in a quick and dirty estimate of the range for GDP growth in 2013, based on the Commission’s past errors. Actual growth turned out to be -0.5%, i.e. at the lower bound of my range (and below the forecast of the time by the Commission, that was -0.3%). I must nevertheless confess that my range was rather wide…
But what about this year? Read more
Last week’s publication of a Lancet article1 on the effect of austerity on Greek public health made a lot of noise (for those who know Italian, I suggest reading the excellent Barbara Spinelli, in La Repubblica).
The Lancet article sets the tone since the abstract, talking of “mounting evidence of a Greek public health tragedy”. It is indeed a tragedy, that highlights how fast social advances may be reversed, even in an advanced economy.
Some time ago (March 2012) I had titled a post “Greek Tragedies“. Mostly for my students, I had collected data on Greek macroeconomic variables. I concluded that austerity was self-defeating, and that at the same time it was imposing extreme hardship on Greek citizens. Of course one needed not be a good economist to know what was going on. It was enough not to work at the Commission or in Germany… But the Lancet article also allows to substantiate another claim I made at the time, i.e. that austerity would also have enormous impact in the long run. It is weird to quote myself, but here is my conclusion at the time:
Even more important, investment (pink line) was cut in half since 2007. This means that Greece is not only going through depressed growth today. But it is doing it in such a way that growth will not resume for years, as its productive capacity is being seriously dented.
What makes it sad, besides scary, is that behind these curves there are people’s lives. And that all this needed not to happen.
I think it is time for an update of the figure on the Greek tragedy. And here it is:
I said in 2012 that investment cut in half spelled future tragedy. Two years later it is down 14 more points, to 36% of 2007 levels. I am unsure the meaning of this is clear to everybody in Brussels and Berlin: when sooner or later growth will resume, the Greek will look at their productive capacity, to discover it melted. They will be unable to produce, even at the modest pre-crisis levels,without running into supply constraints and bottlenecks. I am ready to bet that at that time some very prestigious economist from Brussels will call for structural reforms to “free the Greek economy”. By the way, seven years into the crisis, the OECD keeps forecasting negative growth together with unsustainable (and growing) debt.
I also added unemployment to my personal “Greek Tragedy Watch”: Terrifying absolute numbers (almost 30% unemployment overall, youth unemployment around 60%, more than that for women!). And absolutely no trend reversal in sight. A final consideration, related to the melting of the capital stock. How much of this enormously high unemployment, is evolving into structural? How many of the unemployed will the economy be able to reabsorb, once it starts growing again? Not many, I am afraid, as there is no capital left.
Not bad as an assessment of austerity… And yet, just this morning the German government complained for a very limited softening of austerity demands. Errare umanum est, perseverare autem diabolicum…
1. Kentikelenis, Alexander, Marina Karanikolos, Aaron Reeves, Martin McKee, and David Stuckler. 2014. “Greece’s Health Crisis: From Austerity to Denialism.” The Lancet 383 (9918) (February): 748–753. Back
Today we learn from Daniel Gros, on Project Syndicate that the emphasis on German surplus is misplaced:
The discussion of the German surplus thus confuses the issues in two ways. First, though the German economy and its surplus loom large in the context of Europe, an adjustment by Germany alone would benefit the eurozone periphery rather little. Second, in the global context, adjustment by Germany alone would benefit many countries only a little, while other surplus countries would benefit disproportionally. Adjustment by all northern European countries would have double the impact of any expansion of demand by Germany alone, owing to the high degree of integration among the “Teutonic” countries.
Fascinating. The bulk of the argument is that Germany is a small player in the global economy, and therefore that its actions have no impact. I have two objections to Gros’ argument. Read More
Olli Rehn wrote a balanced piece on Germany’s current account surplus. To sum it up:
- He acknowledges that Germany’s surplus is a problem.
- He acknowledges (albeit indirectly) that the initial source of the problem were capital flows from Germany and the core to the periphery; flows that did not go into productive investment but fueled bubbles.
- He (correctly) argues that over the long run some excess savings from Germany is justified by the need to provide for an ageing population.
- He points out that investment has been too low and needs to increase (possible within the framework of an energy transition).
- He also mentions, without mentioning it, the problem of excessively low wages and pauperisation of the labour force, calling for increases in wages and reduction in taxes to boost domestic demand.
This seems to me a reasonable analysis, and I would welcome an official position of the Commission along these lines. Yet, I think that what is missing in Rehn’s piece, and in most of the current debate, is a clear articulation of between the long and the short run.
I would not object on the need for Germany to run modes surpluses on average over the next years, to pay for future pensions and welfare. It is after all a mature and ageing country. Even more, I would agree with the argument that low wages need to increase, and that bottlenecks that prevent domestic demand expansion should be removed. In other words, I would most likely agree on the Commission’s prescriptions for the medium-to-long run.
Nevertheless, there is a huge hole in Olli Rehn’s analysis, that worries me a bit. Rehn seems to overlook the need to do something here and now. Today, with the periphery of the eurozone stuck in recession, emerging economies sputtering, and continuing jobless growth in the US, the world desperately needs a boost from countries that can afford it. And unfortunately there are not many of these.
Germany is instead siphoning off global demand, making the rest of the world carry its economy when it should do the opposite. As a quick reversal of private demand is unlikely, (this, I repeat should be a medium run target), I see no other option in hte very short run than a substantial fiscal expansion.
A cooperative Germany should implement short run expansionary policies (the need for public investment is undeniable), while working to rebalance consumption, investment and savings in the medium run, with the objective of a small current account surplus in the medium run.
That, incidentally, would not make them Good Samaritans. Ending this endless recession in the eurozone (yes I know, it is technically over; but how happy can we be with growth rates in the zero-point range?) is in the best interest of Germany as much as of the rest of the eurozone (and of the world).
A clear articulation between the different priorities in the short and in the medium-long run would benefit the debate. The problem is that then Olli Rehn should acknowledge that in the short run there is no alternative to expansionary fiscal policies in the eurozone core. That would be asking too much…
Wolfgang Munchau has an excellent piece on today’s Financial Times, where he challenges the increasingly widespread (and unjustified) optimism about the end of the EMU crisis. The premise of the piece is that for the end of the crisis to be durable, it must pass through adjustment between core and periphery. He cites similar statements made in the latest IMF World Economic Outlook. This is good news per se, because nowadays, with the exception of Germany it became common knowledge that the EMU imbalances are structural and not simply the product of late night parties in the periphery. But what are Munchau’s reasons for pessimism? Read More
George Soros writes a piece on Project Syndicate, that is both pedagogical and very clear in outlining a possible answer to the current EMU crisis. He starts with a diagnosis of the EMU imbalances that rejects the “Berlin View”, and argues for the existence of structural imbalances
Normally, developed countries never default, because they can always print money. But, by ceding that authority to an independent central bank, the eurozone’s members put themselves in the position of a developing country that has borrowed in foreign currency. Neither the authorities nor the markets recognized this prior to the crisis, attesting to the fallibility of both. Read more
Just a quick note on yesterday’s announcement by the Commission that virtuous countries will be able, in 2013 and 2014, to run deficits and to implement public investment projects.
Faced with an excessive enthusiasm, Commissioner Rehn quickly framed this new approach within very precise limits, that are worth transcribing:
The Commission will consider allowing temporary deviations from the structural deficit path towards the Medium-Term Objective (MTO) set in the country specific recommendations, or the MTO for Member States that have reached it, provided that:
(1) the economic growth of the Member State remains negative or well below its potential
(2) the deviation does not lead to a breach of the 3% of GDP deficit ceiling, and the public debt rule is respected; and
(3) the deviation is linked to the national expenditure on projects co-funded by the EU under the Structural and Cohesion policy, Trans-European Networks (TEN) and Connecting Europe Facility (CEF) with positive, direct and verifiable long-term budgetary effect.
This application of the provisions of the SGP concerning temporary deviations from the MTO or the adjustment path towards it is related to the current economic conditions of large negative output gap. Once these temporary conditions are no longer in place and the Member State is forecast to return to positive growth, thus approaching its potential, any deviation as the above must be compensated so that the time path towards the MTO is not affected.
For once, the Commission is not vague about what is allowed and what is not, and the result is that this announcement will turn out to be nothing more than a well conceived Public Relations operation. Allow me to attach some numbers to the Commission proposal.
In the past weeks I have argued at length that the eurozone is in recession because of a strong contraction of aggregate demand; and that in spite of this fact the overall fiscal stance is restrictive.
I also argued that in the current situation the best that can be hoped for peripheral countries is a more gradual consolidation (ideally a neutral stance, but this is too much to ask). I do believe that a fiscal expansion, even in the periphery, would be sustainable and growth-enhancing. But at this stage this is just daydreaming. It won’t happen.
The fiscal stance of the eurozone will not become expansionary (as is sorely needed), if the core (and in particular Germany) does not implement robustly expansionary fiscal policies.
If their fiscal space is limited or non-existent, what can peripheral countries do, besides waiting for an improbable fiscal stimulus in Germany? A lot, actually. If public demand cannot be significantly increased (and will actually be further compressed, albeit at a slower pace), it is all the more important that the governments of Italy, Greece, Spain and so on, find ways to restart private demand.
There is a lot of discussion about structural reforms. They are not the answer. First, because they have an impact mostly on supply (and the problem, let me repeat it, is demand); second, because their benefits, if any, won’t materialize before a few years. And there is no time. The cumulate effect of five years of crisis is now threatening social cohesion in most peripheral countries.
A more straightforward policy, that could be implemented in the next few months with immediate effects, is a strong redistribution of the tax burden towards higher incomes. The increasing inequality of income of the past three decades is in my opinion one of the deep causes of the crisis; inequality has further increased since 2008. The squeeze of revenues for low incomes, coming from the combination of high unemployment and fiscal adjustment, is depressing both the capacity to spend and the morale of households. Increased inequality contributed to global imbalances in the past, and is recessionary in the current crisis.
In September, when the season of budget laws begins, governments in the periphery should propose to their parliaments revenue-neutral tax adjustments, lowering taxes on low income households and increasing them on the rich and very rich. This would be fair, and more importantly, effective to boost morale and consumption. I am talking about a substantial shift of the burden, large enough for its macroeconomic impact to be significant. This is all the more necessary if standard Keynesian deficit spending can not be implemented.