Thursday, November 27, 2014

An Optimistic Case for the Euro

CAMBRIDGE – The prospects for the euro and the eurozone remain uncertain. But recent events at the European Central Bank, in Germany, and in global financial markets, make it worthwhile to consider a favorable scenario for the common currency’s future.

The ECB has promised to buy Italian and Spanish sovereign bonds to keep their interest rates down, provided these countries ask for lines of credit from the European Stability Mechanism and adhere to agreed fiscal reforms. Germany’s Constitutional Court has approved the country’s participation in the ESM, and Chancellor Angela Merkel has given her blessing to the ECB’s bond-buying plan, despite strong public objections from the Bundesbank. And the international bond market has expressed its approval by cutting interest rates on Italy’s ten-year bonds to 4.8%, and on Spain’s to 5.5%.

Italian bond rates had already been falling before ECB President Mario Draghi announced the conditional bond-buying plans. That reflected the substantial progress Italian Prime Minister Mario Monti’s government had already made. New legislation will slow the growth of pension benefits substantially, and the Monti government’s increase in taxes on owner-occupied real estate will raise significant revenue without the adverse incentive effects that would occur if rates for personal-income, payroll, or value-added taxes were raised.

Reflecting these reforms, the International Monetary Fund recently projected that Italy will have a cyclically adjusted budget surplus of nearly 1% of GDP in 2013. Unfortunately, because Italy will still be in recession next year, its actual deficit is expected to be 1.8% of GDP, adding to the national debt. But economic recovery will come to Italy, moving the budget into surplus.

When the markets see that coming, they will drive Italy’s sovereign interest rates even lower.  Given Italy’s very large national debt, interest payments add more than 5% of GDP to the fiscal deficit. The combination of economic recovery and lower interest rates would produce a virtuous dynamic in which falling interest rates and a rising budget surplus are mutually reinforcing.

The situation in Spain is not as good. Despite cuts in government spending and increases in taxes, the IMF still projects the cyclically adjusted fiscal deficit to exceed 3.2% of GDP in 2013 and 2.3% of GDP in 2015. The key to solving Spain’s fiscal problem lies in the semi-autonomous regions that generate spending and shift the financing burden to Madrid. Perhaps Italy’s success will help to convince Spain to adopt the tough measures that reduce projected future deficits without more current austerity.

If Italy and Spain have budget surpluses and declining debt/GDP ratios, financial markets will reduce the interest rates on their bonds without the proposed ECB purchases. That would remove the serious risk that the ECB could start buying bonds on the basis of agreed fiscal packages, and then be forced to react if governments fall short on implementing them.

None of this would be enough to save Greece, where the fiscal deficit is 7.5% of GDP, or Portugal, where it is 5% of GDP. But if Italy and Spain are no longer at risk of default, or of abandoning the euro, Germany and other eurozone leaders will have room to decide whether to continue funding these very small states or politely invite them to leave the euro and return to national currencies.

Moreover, even under this optimistic scenario, the problem of the current-account deficits of Italy, Spain, and the other peripheral countries will remain. Differences among the eurozone countries in growth rates of productivity and wages will continue to cause disparities in international competitiveness, resulting in trade and current-account imbalances. Germany now has a current-account surplus of about $215 billion a year, while the rest of the eurozone is running a current-account deficit of about $140 billion.

Italy, Spain, and France all have current-account deficits equal to 2% or more of their GDP. As they come out of their cyclical recessions, incomes will rise, leading to increased imports and even larger current-account deficits. Those deficits must be financed by net inflows of funds from other countries.

If Italy, Spain, and France were not part of the eurozone, they could allow their currencies to devalue; weaker exchange rates would increase exports and reduce imports, eliminating their current-account deficits. Moreover, the increase in exports and the shift from imports to domestically produced goods and services would strengthen their economies, thereby reducing their fiscal deficits as tax revenues rose and transfers declined. And a stronger economy would help domestic banks by reducing potential bad debt and mortgage defaults.

But, of course, Italy, Spain, and France are part of the eurozone and therefore cannot devalue. That is why I believe that these countries – and the eurozone more generally – would benefit from euro depreciation. Although a weaker euro would not increase their competitiveness relative to Germany and other eurozone countries, it would improve their competitiveness relative to all non-eurozone countries.

If the euro falls by 20-25%, bringing it close to parity with the dollar and weakening it to a similar extent against other currencies, the current-account deficits in Italy, Spain, and France would shrink and their economies would strengthen. German exports would also benefit from a weaker euro, boosting overall economic demand in Germany.

It is ironic that the ECB’s offer to buy Italian and Spanish debt has exacerbated external imbalances by raising the value of the euro. Perhaps that is just a temporary effect and the euro will decline when global financial markets recognize that a weaker exchange rate is needed to reduce current-account deficits in the eurozone’s three major Latin countries. If not, the ECB’s next challenge will be to find a way to talk the euro down.

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    1. Commentedfrancesco totino

      The weak Western countries need to restructure the political system!/2013/02/the-weak-western-countries-need-to.html

    2. Commentedramon estany

      I can not agree with you about Spain. You defend the official position of the regions, which is of course distorted. I think you simplify the analysis in the sense that you not emphasized in the structures.

    3. CommentedRichard Potter

      The private sector will never purchase Euro-denominated debt if the currency is expected to fall to parity with the USD. Adding in the costs of both credit protection and currency hedging, the yields will have to rise significantly--not fall--to reflect such risks. Speak to bond traders, not just academics, when offering currency devaluation as a policy option, please.

    4. CommentedMarten Klein

      Italy can solve its crisis on its own, they could for instance sell South Tyrol back to Austria - Problem solved! What is more a concern is how the ECB exceeds its mandate. That is institutional anarchism.

    5. CommentedWilliam Wallace

      The bulk of Spain's autonomous regions' debt is in the form of locally administered elements of the welfare state, such as health care and unemployment. It is therefore still incumbent on the national government to reform these programs in order to solve a large part of the problem.

      The other issue is far more difficult. In order to paper over the aspirations for political autonomy in the Basque region and Catalonia, the entire country was parceled into autonomous regions, what's known here as "coffee for all," almost immediately following the restoration of democracy. This has created a vast, bloated surplus of public employees and a spiral of corruption between local political and business leaders.

      Far from being another problem, Catalonia's push for independence is a blessing in disguise. If understood as such (doubtful), Spain should take the opportunity to drastically alter the Constitution in favor of a federal state consisting of far fewer elements and layers of government. For the EU, this is the transition one would want to see, as long term nation states ought to transfer power to a central EU government, which then could act in concert with the local regional governments to both protect cultural identities and to reduce the layers of a future EU state.

    6. CommentedPaul Ruckert

      It seems the key, structural problem is the fact that without the ability to devalue their currencies vis-a-vis the "northern" countries (i.e. Germany, the Netherlands), the "southern" countries (i.e. Spain, Greece, Italy, Portugal) will never regain competitiveness. In keeping a single currency the fact is that companies are going to be much more willing to employ highly productive workers in Germany rather than in the periphery. Perhaps eventually wages will fall enough in Spain, Italy and Greece for them to regain competitiveness, but that process is likely to be a decade-long period of mass youth unemployment, social unrest and untold damage to the fabric of society. Is it worth it?

    7. CommentedJohn Hawkins

      This type of academic article is all well and good but, as noted below by John Silva, it is now out of touch with the reality on the streets of southern europe.

      We are now in the political phase of this crisis, having decided that the economic fault lies with the US and the UK while the solution is to make Germany pay up!

    8. CommentedDavid Nowakowski

      The Eurozone already runs a large surplus with the United States; a strong euro didn't prevent this surplus from rising to a record high.

      The EZ runs large deficits with Asia (mostly China) and Russia (oil and gas imports); these countries are egregious currency manipulators. Talking down the euro will not help if these countries persist in dirty floats that flout IMF and WTO rules against such practices (see Gagnon at PIIE).

      The best hope perhaps is for Draghi and Bernanke to QE some more, spark so-called currency wars (aka global monetary uncoordinated easing) in EM and thus a boost to EM inflation, raising their *real* exchange rates.

    9. CommentedKuldip Singh

      "Many years ago, I asked my Spiritual Master, "All the chaos in this world, who is responsible for it?" The Master replied,"2 classes of people who live by the principle of divide and rule. One is politicians and the other preachers."
      We need to find people who are neither politicians nor preachers to run this World.
      Until the time comes,when the world is run by people who are neither politicians nor preachers,all commentary is wishful thinking.

    10. CommentedJohnny (MoneyWonk)

      I don't know why so many people neglect to emphasize the "Keynesian" reason for monetary policy. With wages and prices "sticky," a monetary devaluation through higher inflation is "easier" than an internal devaluation, which, as we can see, is slow, painful, and has negative feedback loops.

    11. CommentedJohn Silva

      Now i'm not an emeritus college professor, just a simple portuguese unemployed, but it seems to me that this article is completly beside the point. The issue is no longer monetary, financial or economical, it's fundamentally political in this phase.
      Any «exit» will have implications far beyhond the financial or monetary world.
      The Germans don't want a weak €uro, and that currency is simply too strong for the portugues economy for instances.
      Austerity is just a word, but try living under a, so called, «intervention» and soon you'll get the full meaning: poverty, hunger, disease... This is happening just before my eyes...
      I'm sure, at least in Portugal, that we can't stand austerity much longer, and we have a solution: o escudo.
      We kicked the fascim regime before the greeks and spaniards, maybe we should set an example for the world once again...
      And if we can change one, we can change two...
      If just not to make a currency change everytime i go to Spain i have to make all this sacrifices then i'm not willing to stand a common currency, nor the germans, nor the fins, for all different reasons.
      And the we'll have a balcanized Europe, bye bye immigrantes, hello neo-neos...