Wednesday, November 26, 2014

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.

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    1. CommentedPaul A. Myers

      The author dramatically underestimates the imagination and tenacity of national politicians working in their national legislatures and governments to game the European system.

      Fundamentally, benefits and costs have to be aligned to create an incentive for productivity and progress. Hard to do in societies where the rentier model is firmly embedded in the public mind.

    2. CommentedLennart fredrikson

      A BIG NO to all presented ideas is a very likely outcome from coming German elections.The kick down road policy from MERKEL just piling up DEBT has come to an END!
      A breakup of EUROZONE is likely one way or another by forming a NORTH and a SOUTH EURO or simply introduce parallel currencies as suggested by both Prof. HANKEL and HENKEL lately in books.German elections will reflect voters desire to end the fatal DEBT piling partly on taxpayers COST.The EURO is clearly not a ONE SIZE FIT ALL to be recognized after numerous TREATY VIOLATIONS to keep it afloat! The HOLY COW=EURO to be dismantled for benefit to all members.Germany paid a huge prize for the reunification not to be repeated.Part of prize was concession to FRANCE to enter EURO without public support!

    3. CommentedJoshua Ioji Konov

      Well, after going through the article it could be said "the king is dead, long live the king" it is much short of declaring the system of libertarian economics so well applied by the EU on even worsening beaurocaritical approach as a causa perduta, indeed.

    4. CommentedStephen Pain

      I think that the author's points are very valid. There is a real sense of a dichotomy in the EU in the financial world in general. We saw before the North/South divide globally - which still exists - and despite the successes of India and China, one can see that in many respects that the success has come at great social cost to both India and China - and that the main economic driver was capitalistic from the pov of the "West" - manufacturing on the cheap. A result of the economic paradigmatic shift from the real to the virtual. The collateral damage to nations from the fiscal policies based on the futures market with an emphasis away from local production is the financial equivalent of when the UK Conservative government decided to relax the rules about livestock feed - BSE followed - in the 1990s until the burst - we had Mad Bankers Disease. Germany was only able to keep ahead because it had an export led economy - and unlike Japan a competitor - it had a more prudent property market. It survived intact. It did so at the expense of the importers and the countries like Greece who traded with her. After the financial collapse in Greece - Germany now resents the relationship - and sees itself on a higher moral road - and that is nonsense. It did not survive because of its policies alone - it did so because of the markets. Rather than viewing the relations in debtor/creditor terms, or north/south - see them in symbiotic terms.