4

The Eurozone’s Misplaced Orthodoxies

ATHENS – With the euro crisis still far from resolved, the currency union’s future remains at the center of heated debates. But, in many cases, positions have become so polarized that they miss the point, impeding the ability of EU policymakers to agree on and implement an effective crisis-response strategy.

Consider the question of who the euro’s real winners and losers are. Given that the eurozone is typically divided into two categories – the northern creditor countries and the southern debtor countries – this question can be understood in terms of whether a current-account surplus signifies economic success or failure.

According to the orthodox view, external-deficit countries “profit” from capital inflows, until increased imports and rising wages erode their current-account position further and investors stop financing their deficits. This means that any gains derived from sustaining a current-account deficit are temporary, illusory, and dangerous – suggesting that deficit countries are eurozone “losers.” After all, short-term booms soon become bubbles, and when bubbles burst, they trigger financial crises, eventually leading to default and depression.

This view also holds that capital flowing out of an external-surplus country means reduced investment, causing an economic slump. But history is far kinder to surplus countries, with exports having fueled the United Kingdom’s economic rise during the nineteenth century – a pattern that many other countries have followed. The UK then invested its accumulated foreign assets, gaining revenues that bolstered its financial position and limited its borrowing costs.

This suggests that Germany, whose exceptionally strong financial position has enabled it to weather the ongoing crisis and protect its savings, is a winner in the eurozone. But can national success within a crumbling currency union really be considered a victory?

In fact, a “normal” economic and monetary union would account for productivity and competitiveness divergences among member states, which can arise from differences in asset endowments, access to technology, or spending patterns. This implies a system of rewards and sanctions that encourages member states to reform and compete, along with a back-up financial-support network. But there is also much debate over how such financial support should be provided.

At one extreme lies the notion that the euro cannot function like the dollar, given that the eurozone is not a federalized state. Rather, it should resemble the Bretton Woods system, under which countries could exit and re-enter after bolstering competitiveness through austerity and reform.

But this strategy carries serious risks that ultimately make it unworkable. Realigning relative prices would require internal devaluation, which could lead to social and political instability in the weaker countries. Civil unrest and the rise of neo-Nazi parties in Europe’s South exemplify these dangers, threatening the very purpose of European integration.

Moreover, the ease of exit and re-entry would increase uncertainty, invite speculation (expressed in widening spreads), and encourage capital flight from weaker countries to “safe havens” like Germany. All of this would negate the positive impact of fiscal consolidation and reform and, ultimately, make macroeconomic adjustment and financial stability unattainable.

At the other extreme is the “transfer union” model, in which the eurozone’s weaker members depend chronically on their stronger counterparts – a model that the citizens of Europe’s North have rightly rejected.

Clearly, eurozone leaders must find a middle ground, informed by a thorough understanding of the currency union’s weaknesses and today’s policy failures.

Austerity must be counted among those failures, for it led to a much deeper recession than was forecast – resulting in persistently large fiscal deficits and high debt/GDP ratios – and made it increasingly difficult for governments to convince citizens that current sacrifice would ensure a better future. And, while privatization, market liberalization, the opening of closed professions, and government downsizing inevitably invite conflict with powerful vested interests – such as protected industries, public-sector trade unions, and professional lobbies – economic hard times raise the stakes and prolong the fight.

Against this background, a return to growth is imperative. Eurozone leaders should pursue a five-pronged strategy that integrates the current emphasis on reform into a wider context.

First, fiscally sound economies should relax their budgetary policies in order to rebalance demand across the eurozone. They should also mobilize substantial resources through the European Investment Bank and make use of EU Structural Funds to provide relief to countries with unsustainably high debt levels, such as Greece.

Second, reducing interest rates further and enhancing the ECB’s unconventional monetary-policy instruments would bolster demand, allow higher inflation in the stronger economies, and restore the effective transmission of monetary policy.

Third, European public debt should be partly mutualized. The gradual introduction of Eurobonds would reduce borrowing costs for the over-indebted countries and curb speculative attacks from global financial markets.

Fourth, in order to separate private losses from sovereign debt, eurozone leaders should create a European banking union, built around centralized supervision and resolution authorities, and a deposit-insurance scheme. The plans that are currently being pursued fall far short of this goal.

Finally, Europe needs stronger institutions, accountable to the European Parliament, to take responsibility for improving fiscal- and economic-policy coordination. This must be complemented by political unification, in order to ensure democratic legitimacy.

To be sure, pursuing this strategy would bring its share of challenges, not least popular resistance to further integration. But once Europeans begin to see positive change, gaining support for such policies will become increasingly easy.

Continued inaction will perpetuate stagnation and eventually lead to a eurozone breakup, either through gradual attrition, with weaker countries defaulting, or through Germany exiting to pursue a policy of narrow fiscal advantage. One hopes that after Germany’s forthcoming parliamentary elections, its leaders will liberate the country from its dogged adherence to dubious orthodoxy and embrace a more realistic, effective response to the eurozone’s – and Europe’s – ongoing crisis.