WASHINGTON, DC – This is a momentous summer for Europe, because both the eurozone and the European Union could be in danger of unraveling, despite the important steps toward a banking union and direct recapitalization of Spanish banks taken at the June meeting of eurozone leaders. Implementation of the proposed reforms is lagging; there may be legal challenges to the European Stability Mechanism in Germany; and the Netherlands and Finland seem to be backtracking on some parts of the agreement.
Even in a worst-case scenario, some degree of intra-European cooperation will surely survive. But it is hard to see how the EU as we know it could survive even a partial disintegration of the eurozone.
Those who argue that one or more countries on the eurozone’s periphery should take a “holiday” from the euro underestimate both the economic and political repercussions of such a move. The sense of failure, loss of trust, and the damage inflicted on so many if two or three countries had to leave would shake the entire Union.
One of the key challenges is the negative feedback loop between the weaknesses of many banks and the doubts about the peripheral countries’ sovereign debt. The sovereign-debt and banking crises have become even more closely interlinked as banks bought greater amounts of their home countries’ sovereign debt.
That said, Europe’s disparities in production costs and competitiveness, reflected in the “problem” countries’ substantial current-account deficits, may prove to be an even more difficult problem to resolve. Unit labor costs in Greece, Portugal, Spain, and Italy grew 20-30% faster than in Germany in the euro’s first decade, and somewhat faster than unit labor costs in northern Europe as a whole.
This disparity reflected some differences in productivity growth but even more so differences in wage growth. Broadly speaking, capital inflows led to real revaluation and a lower domestic savings rate relative to investment in the southern countries, resulting in structural current-account deficits. In Greece, large fiscal deficits accompanied and exacerbated this trend. In Spain, the counterpart to the current-account deficit was private-sector borrowing.
The eurozone crisis will not be resolved until this internal imbalance is reduced to a sustainable level, which requires not only fiscal adjustment in the troubled peripheral economies, but also balance-of-payments adjustments across the eurozone as a whole. That, in turn, implies the need for a real exchange-rate adjustment inside the eurozone, with peripheral countries’ production costs falling relative to those in the core.
Real exchange-rate adjustments inside a monetary union, or among countries with fixed exchange rates, can take place through inflation differentials. The real value of the Chinese renminbi, for example, has appreciated considerably relative to the US dollar, despite limited nominal exchange-rate changes, because China’s domestic prices have risen faster than have prices in the United States.
A similar adjustment within the eurozone, assuming similar productivity performance, would require wages in the troubled peripheral countries to rise more slowly than in Germany for a number of years, thus restoring their competitiveness. But, because Germany and the other northern surplus countries remain hawkish on price stability, real exchange-rate adjustment within the eurozone requires actual wage and price deflation in the distressed southern economies.
This pressure on the peripheral countries to deflate their already stagnant economies is turning into the eurozone’s greatest challenge. The ECB’s provision of liquidity can buy time, but only real adjustment can cure the underlying problem.
That could be achieved with less wage contraction and loss of real income if productivity in the peripheral economies were to start growing significantly faster than in the core, thereby allowing prices to fall without the need for lower wages. But, while structural reforms could undoubtedly lead over time to faster productivity growth, this is unlikely to happen in an environment in which credit is severely constrained, investment is plummeting, and many skilled young people emigrate.
Price deflation is not conducive to bringing about the sort of relative price changes that could accelerate reallocation of resources within the countries under stress and increase overall productivity. Relative prices are much easier to change when there is modest inflation than when nominal price reductions are required. The need for higher productivity in the troubled countries is undeniable; but achieving it in the current climate of extreme austerity and deflation is unlikely, given an atmosphere of latent, or open, social conflict.
These economic adjustments could occur much more smoothly if the eurozone as a whole were to pursue a more expansionary policy. If the target inflation rate for the eurozone were to be set temporarily at, say 3.5%, and if the countries with current-account surpluses encouraged domestic inflation rates somewhat above the eurozone’s target, there could be real price adjustment within the eurozone without price deflation in the troubled countries. There are finally some signs that Germany will welcome more rapid domestic wage growth and somewhat higher inflation.
This could and should be accompanied by an overall depreciation of the euro, though that would be no panacea. High public-debt levels would still have to be reduced to create fiscal space and keep interest rates low enough to restore long-term confidence. That means that courageous structural reforms must still be pursued in the peripheral countries – indeed, throughout Europe.
Similarly, the eurozone would still need to strengthen its firewalls, as well as its mechanisms for cooperation. But a temporary and modestly higher inflation rate would facilitate the adjustment process and give reforms a chance to work.
Deflation discourages optimism about the future. Shifting the entire adjustment burden onto peripheral countries with current-account deficits, while core countries continue to run surpluses, obstructs adjustment.
The eurozone’s inflation target is not a magic number, and it is irrational to let it determine the overall macroeconomic framework. If lower is always better, why not set the target at 1%, or even zero? In fact, there are times when 3-4% is better than 2%. Europe is at such a moment.